This year's review was considerably more difficult than 2009 or 2010, for the simple fact that two years of radical outperformance were followed by a year of serious underperformance. The objective is, to determine whether changes to strategy, tactics, or selection methods are required going forward.
My discretionary portfolio, consisting of approximately 1/4 of liquid net worth, is actively managed, while remaining assets are in index funds, core type mutual funds, or CDs. It's a synthetic portfolio, consisting primarily of LEAPs or other long term deep in the money calls, against which covered calls are sold. The income generated by the sale of calls is intended to enable myself and my wife to maintain our pre-retirement standard of living without drawing against our other assets.
In the wake of the financial crisis, a number mismatch developed, whereby assets, primarily US equities, were no longer adequate to fund retirement as planned. To avoid liquidating positions for living expenses, and allow the passage of time to create recovery, the discretionary portfolio has been run on an aggressive basis, employing considerable leverage by means of derivatives. Because expected returns for the stock market, coming off the March 2009 lows were very high, this strategy made sense on a risk/reward basis.
The internal rate of return was 61% in 2009, 52% in 2010, and -30% for 2011. Hence the review.
Internal Rate of Return
IRR (internal rate of return) reflects the return on an investment, using compound interest. The spreadsheet function XIRR develops the internal rate of return on an irregular flow of funds, and is the best way to determine actual returns, particularly where, as in this case, funds are withdrawn from time to time as needed.
The portfolio is 56% financials, 29% industrials, and15% technology. The financials consist almost entirely of insurance companies. The primary cause of underperformance for 2011 was a sector bet that went the wrong direction. While I was rightly suspicious of banks, and hedged my portfolio with XLF puts, insurance companies were not spared the general distaste for financials. Here's a chart showing the ratio of the SPDR S&P Insurance ETF (KIE) to the SPDR S&P 500 ETF (SPY) for the past three years:
Applying leverage to a poor year for insurance stocks accounts for 80% of underperformance.
Individual Stock Picks
I had two picks last year that I later identified as mistakes: mortgage insurer Radian Group (RDN) and LDK Solar Company Ltd (LDK). I wrote both of them up as lessons learned, and the articles were well received.
I developed a theme of "old tech," as a label for technology companies that are considered to be behind the curve. Hewlett Packard (HPQ), Cisco (CSCO) and Xerox (XRX) fit the category, and contributed their fair share to the year's results. Corning Inc. (GLW) probably should be classified in this group. In each case, I think they're undervalued and expect substantial gains as reversion to the mean asserts itself.
Third Party Opinions
Checking the stocks in my portfolio against ratings from Morningstar and Schwab, average stars works out to 3.41 for Morningstar on a scale of 1-5, and 3.48 for Schwab, after converting A-F to 1-5 and averaging. There are no 1 star or F stocks.
Portfolio Valuation Metrics
5 Year Average
Morningstar places Price/Fair Value at 0.82. Their valuations are generally similar to what I develop by my own methods. A simple reversion to the mean on any metric would resolve a lot of performance issues.
Based on the ratio of the S&P 500 to GDP, I see 1,400 as a midpoint value for the index, and expect a return of approximately 11% for the year, substantially higher to the extent leverage is maintained. My research suggests there is little reason to invest in equities if the market is above its midpoint value, as 5 year returns can be expected to be low single digits.
2012 so far has been a welcome change, up 17.3% vs. 4.4% for the S&P 500. After putting all of the above through the blender, I still think Mr. Market is getting a lot of things wrong -- to include insurance, particularly life insurance, and old tech. The combination of sector rotation and mean reversion should work favorably going forward. With that in mind, I plan to hold existing positions.
The portfolio strategy described here actually met its objective in April last year, in that the number mismatch was resolved, while the market sat near a midpoint value, by the GDP/S&P method. If and when mean reversion again does its magic, I plan to take a less aggressive approach to my discretionary portfolio.
Disclosure: I am long GLW, XRX, CSCO, HPQ.