Portfolio Construction And Valuations

by: Chowder


Prices drop regardless of valuations.

Valuations rise or fall based on earnings.

What may look overvalued may be undervalued in the short term.

During the Great Recession, I paid very close attention to valuations, and with this in mind, every company I purchased saw its price go down immediately anyway, every single one of them, no company was spared. My portfolio dropped more than 30% in value, and I can't sit here and tell you I wasn't concerned.

The S&P 500 Index I owned in my 401K dropped 57% from peak to valley and I learned that blue chip companies hold up better in declines. This helped soothe my concerns somewhat, but it was still a concern.

It was during the Great Recession when I decided to go all-in on dividend growth investing. I looked around and started buying nothing but blue chips, the top 1 or 2 companies in sectors that provided a service or product people had to buy in spite of the Great Recession.

People are going to pay the light and phone bill, even those who lost their jobs during those tumultuous times. People are going to buy groceries, personal hygiene articles, and over-the-counter drugs as necessary. I decided that if Johnson & Johnson (NYSE:JNJ), General Mills (NYSE:GIS), Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG), Dominion Resources (NYSE:D), etc., were going out of business, everyone was going out of business, and it was that thought process that eased my pain, and it was these companies and sectors that brought me back to whole again and beyond. And here we are.

Warren Buffett, I believe, said that if you can't withstand a 50% decline in prices, you shouldn't invest in equities... any equities, including ETFs and mutual funds. They don't protect you against falling prices, SPY dropped 57% in value.

Own the best in breed and you increase your odds of owning a successful portfolio. It won't always be the best performer, but it will always be successful over long periods of time. It is this that has me ignoring all of the short-term noise we face, and that includes some valuations with best in breed companies.

Why do people always assume overvalued means price isn't going higher. Why is it that people don't understand that valuations rise all the time. What may seem overvalued today can be undervalued tomorrow.

M* had a fair value number of $71 for Visa (NYSE:V) a week or two ago, and at $73, it was overvalued. Some may have taken a profit, others may have avoided buying it, and then over the weekend, M* raised fair value to $104 which now means that what was selling at a premium just a week or so ago, is now selling at a 29% discount to fair value.

Some people only look at price today via where it's been. They ignore forward looking guidance.

I don't care how overvalued a company may seem to be, but if they continue to meet and beat earnings expectations, they are going to stay overvalued because, in fact, they are a more valuable company. Valuations rise and fall all the time.

On March 21, I made this comment in the comment section of my most recent article:

I will be starting a brand new equity portfolio for someone whose 401K rollover money has been released and on the way to the new broker. I have already selected the companies for purchase and the breakdowns are going to stun some of you.

I will be opening up 1/2 positions in HD .. V .. CBRL .. SBUX.

I will be taking a full position, that's right ... full ... in the following companies:

O .. JNJ .. PG .. KHC .. GIS .. MO .. D .. PEP .. UL .. TGT .. XOM.

There you have it.

Here is that comment.

I opened that portfolio on March 23 during the last hour of the trading session. I actually added a few companies and announced them in real time as well.

The following companies were purchased as full positions and a full position represents 5.6% of the total portfolio value.

Dominion Resources - D

General Mills - GIS

Johnson & Johnson - JNJ

Kraft Heinz - KHC

Altria - MO

Realty Income - O

Paychex - PAYX

PepsiCo - PEP

Procter & Gamble - PG

Sempra Energy - SRE

AT&T - T

Target - TGT

Unilever - UL

Exxon Mobil - XOM

The following companies represent a 3/4 position.

3M - MMM

Welltower - HCN

The following companies represent a half position.

Cracker Barrel - CBRL

Home Depot - HD

Starbucks - SBUX

Visa - V

The timing of this portfolio, and the valuations of these companies generated some interesting comments.


It is my opinion that there are better values out there for income than overreaching with O. Can this person watch O take a 15%-20% retracement, or more without panic? Can she withstand a losing capital structure during a recession when everything will be hit? What is the aversion risk she is comfortable with for an extended period? If this is her first foray into stock specific portfolio building, I would assume you need answers to these questions.


She won't be looking at the portfolio, it's why she wants me managing it. She doesn't even know her user ID or password... Ha!

Could price drop 20% or more? Sure, as it can with everything else we own. The task I have been assigned is to put the money in what she might consider a safe company. She wants the income from that portfolio to be reliable over the coming years.

Where someone might tell me that Monster Beverage (NASDAQ:MNST) will be a better investment going forward than PEP, she would want PEP because it provides her with peace of mind.

To her, and having decades of selling experience, I know how to listen to one's needs when I have had time to sit down face to face. She wants to know she owns safe companies regardless of what the price does in the near future.

As to the dividend, I'm convinced that O is as solid as they come. Any company that advertises itself as "The Monthly Dividend Company" is going to do everything within its power to see it continues to be paid. The shorts did everything they could to drive O into the ground during the real estate crisis and couldn't do it. Price dropped significantly, but that dividend continued to be paid and increased, and look at it now. If the real estate crisis couldn't crush O, higher interest rates aren't going to either, whenever that should come into play. I'll cross that bridge then, it isn't going to happen any time soon.

What may appear to be overvalued today, may not be a couple of years from now. If it is, so be it. O is a foundation type company in the portfolios I manage. If I were concerned with price action, and I'm not, I would put O on hold, but this is an initial position from which we will build on over time, so current price will have less prominence over the long run.


In the past week, I sold the last of my MLP headaches and I'm looking to add one full position to my portfolio. I want to add a utility and SRE is top of the list (I own WEC, SO, D, NEE, SCG, DUK). Only issue I have with SRE is valuation - like most of the utilities it's extended. I won't be drawing income for 10 years. M* fair value = 97 and S&P = 91.40. Too expensive at this level?


S&P has actually raised fair value to $94 effective yesterday. M* has it at $97. I'd split the difference at $95.50 and would be happy to pay 5% above that at $102 and change.

SRE at $103 is close enough for me, but I don't need hero price to own a utility. SRE is not one I wish to sell, and it along with D has the greater potential growth in my opinion due to their LNG plants and SRE is going after Mexico expansion.

If you are uncomfortable with buying a full position at this price level, then take out a 1/2 position would be my suggestion.


For this portfolio, what comprises a full position percentage wise? Are you holding back any cash for near-term opportunities?


Ok, chowder. We hear you say KHC, V and probably XOM, UL, maybe D are in good price range. But the rest are quite above fair value and O is pricey. But you are going to buy them anyway once money shown up in your friend lady's account, who's nearly 60? Is that right?


That is correct. I am going to buy them anyway.

Yeah, O is expensive but most analysts are still calling them a buy. Look at O today, up in a weak market. That's strength and I buy strength.

Keep in mind, this will be a core position and that means she will not be selling it. If she's not going to sell it, then whether it's up 20% or down 20% is of no concern. Others can't get their mind wrapped around that concept, but I can, I've been doing this long enough to know any price draw down on a best in breed company is temporary. I ignore temporary.

GIS overvalued? Probably so, but why?... Safety. You are going to pay a premium for safety in an extended bull market. Why? Because if the market starts to correct, you're going to see a flight to safety, a flight to quality, a risk off environment.

GIS is an income play, not a cap appreciation play. GIS has not lowered the dividend in 117 years and that's what we are buying. The safety of that dividend, a dividend she will start to draw on in 5 to 6 years.
The analysts at Starmine on Fidelity have GIS a 9.2 buy. A number of 10 is perfect, anything over 7.0 is a buy. Think safe dividend, think flight to quality.

Are there safer dividends than O and GIS?

HD is a cap appreciation play that S&P thinks is selling at a 9.1% premium, but S&P thinks they are selling at fair value. If you saw HD's last earnings report, and forward guidance, HD is a buy and most analysts agree.


Thanks for that info on KHC. Very useful.

For comparison sake, M* has a $69 fair value estimate. It is generally very bullish on the company, but said: "We intend to review our near-term assumptions, but don't foresee a material change to our $69 fair value."

I suspect that when they do a full review, they also will lift their FVE. Not sure it will go to 111, but I agree that KHC is at worst fairly valued here.


M* has an 11% premium currently on KHC, so any adjustment is going to take it to fair value.

KHC had its first profitable quarter, if it follows up with another, I believe you are going to see price rises. 3G is known for making companies more profitable and most analysts thought the merger was too large to have an effect short term. 3G is now showing they are getting it together.

I was looking forward with my additions to KHC, and keep in mind, I sold more than half my position on the merger announcement to fund our London trip and other things. I am looking at getting it back to a full position.

To sum it up, the portfolio belongs to a long-time friend who was eligible for an in-service withdrawal from her 401K to a Rollover Ira. She asked that I fully invest it in blue chip companies the same way I did for her husband 10 years ago.

She isn't as concerned about share prices as she is about owning safe companies. Her objective is to draw the dividends later in life without the need to sell shares. Since her objective is to buy and hold, it doesn't matter if the price is up 20% or down 20%, she doesn't plan on realizing the gains or losses anyway.

The dividends will be collected in cash and the current positions will be added to, based on performance going forward.

Disclosure: I am/we are long CBRL, D, HD, GIS, HCN, JNJ, KHC, MMM, MO, O, PAYX, PEP, PG, SBUX, SRE, T, TGT, UL,V, XOM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: All companies in the article were purchased this week.