My Investment Game Plan: A Mid-Year Review

by: Ray Merola

In early January this year, Seeking Alpha editors published the article, "My 2012 Investment Game Plan." The link is found here.

As I have done in years past, I am now writing you with a mid-year review of the general plan assumptions and a first-half look back. Then I will offer results and analysis of the specific plan investments. Included are my second half portfolio adjustments, with the promise to write you again at year-end to summarize the final 2012 results.

For clarity, I have blocked and italicized original segments from the January plan, then followed up with a short discussion after each section.

"My 2012 Investment Plan" Basic Assumptions and Analysis

The global economy continues to move forward, but the European wildcard has the ability to create an unusually wide range of growth outcomes. Indeed, the EU debt crisis remains an overhang on the world economy that I find very difficult to handicap. If this issue does not blow up, I believe the economies of the United States, China, and emerging markets will do just fine. In any event, Europe will experience recession. If the EU situation is mishandled (which I think is a significant risk), then a world flat line scenario is likely. That said, I forecast a low likelihood of a global recession in 2012.

First half look back: Partially correct. The EU debt crisis has fulfilled the promise of roiling global markets. It has been difficult to handicap. Most of Europe is in recession. However, the economies of the U. S., China and emerging markets are not "doing fine." They have experienced net muddle-along scenarios, punctuated by crosscurrent shocks and shots-in-the-arm. There has been no global recession, nor do I believe one is coming, unless the Europe experiences a "Lehman moment." I continue to place a low probability on an Armageddon outcome.

U. S. interest rates will remain low. Indeed, the Fed has stated their intent to keep rates down. Corresponding inflation will be low to moderate. Banks will continue to mend themselves, but the pace will be glacial. Housing will see spotty recovery. I see no rapid economic expansion until the banks are healthy. However, robust bank health is not part of my 2012 vision.

First half look back: This premise is essentially intact. Despite hyperventilating pundits, we've seen no spike in U.S. inflation or interest rates. Our banks are in much better financial shape than a year or two ago. But our financial system is not "robust," either. No change to my 2H outlook.

Gold will continue to rise.

First half look back: This is an interesting one. Gold ran up, then fell. The first half ended with gold prices, as measured by the GLD, largely flat. However, I am sticking by the January premise and continue to hold gold as significant function of the portfolio. Nevertheless, while not a technician, I am watching carefully the GLD chart. I see a descending triangle pattern that formed early this year. This pattern tends to be bearish. We just bounced off it again on Friday.

U. S. equity markets will advance. While I make no numerical predictions on the broad markets, I premise that 2012 will be a reasonable year for overall corporate earnings. Therefore, modest market gains are assumed, though dividends will be a major component of this year's investment return.

First half look back: A presidential election years tends to be favorable to equities. The market has been difficult, but the first half has been up by any reasonable measure. Corporate earnings were good for 4Q 2011 and 1Q 2012. I suspect we'll get some negative surprises in the Energy, Materials, and Industrials patches this month. But I plan to keep my premises in place for now.

"My 2012 Investment Plan" Plan Strategies and Critique

Concentrate equity investments in the Industrial, Materials and Energy sectors. My go-forward rationale is that 2011 was a "lost" year. The economic cycle neither advanced convincingly nor retreated. Typically, business cycles last five to seven years. Therefore, I plan to maintain an overweight of many of the same cyclical companies as last year.

My favorite Industrials include Caterpillar (NYSE:CAT), Honeywell International (NYSE:HON), and Illinois and Tool Works (NYSE:ITW); these stocks emphasize diversified global giants. Basic Material picks include Nucor (NYSE:NUE), and International Paper (NYSE:IP); both sporting good yields and strong balance sheets. My Energy investments are centered around Royal Dutch Shell (NYSE:RDS.A), Exxon Mobil (NYSE:XOM), and Halliburton (NYSE:HAL); Shell offers a generous yield, Exxon plays to the boom in natural gas, and Halliburton is a beaten-down favorite to capitalize on the need for energy services, especially in North America.

I also like Energy Transfer Partners (NYSE:ETP), a pipeline MLP that offers a generous 7.5 percent distribution yield and focuses upon the Texas natural gas / shale gas infrastructure.

Results and Critique: This strategy missed the mark. Big time. Energy and Basic Materials stocks were at the bottom of the S&P 500 sectors' performance list. Being overweight in these sectors pretty much blocked me out of meeting or beating the overall averages.

Indeed, Energy stocks in general and Halliburton in particular, did nothing to help my first half portfolio performance. HAL burned me by dropping about 20 percent. I continue to own the stock and the loss. I've mitigated the damage with income options and by purchasing some puts. I bought more into the weakness. I plan to hold the shares, but continue to write covered call options aggressively. It's an undervalued security, good balance sheet; but in a lousy sector, worse industry, and the stock has no yield support.

During the first quarter, I sold my Exxon shares into strength to reduce exposure in the sector. That turned out well. I continue to have a large position in Royal Dutch Shell that has gone nowhere. Nonetheless, I bought more when the stock dropped to the low 60s, and will patiently accept the 5 percent yield. I believe the stock has been unduly punished by being associated with Europe. Yet only 13 percent of Shell sales come from Europe.

Royal Dutch Shell and Halliburton are my Energy positions entering the second half of the year.

My Materials stocks peaked in March and have fallen back into June. I thought hard about paring them back when they were fully valued back in March, but did not. I intend to stick with International Paper and Nucor going forward. These two stocks are solid companies with sound balance sheets, both generating good cash flows, and are well-managed. Having held them both since the 2009 generational low, my yield-on-basis is at or above four percent. I remain long-term bullish on them. Materials stocks tend to peak when the economic business cycle is at its apex. We never reached an apex! The years 2010 and 2011 were not nearly enough fun for even a regular, garden-variety economic expansion.

In addition, I began to scale into a position in DuPont (NYSE:DD) during the second quarter. While classified as a Material stock (Chemical industry), I see the company as a play on technology and agriculture, too. I believe the stock is perched at a resistance level; yielding about 3.5 percent.

I plan to hold Materials stocks International Paper, Nucor and DuPont for the second half. Nucor is my favorite in this sector, and one of my largest positions. I'm a buyer at $35 or less. I'll round out a full position in DuPont only if the stock falls back to $43. There's that magic four percent yield.

The Industrials did little to help me in the first half. I was a bit overweight in this sector. I sold off a chunk of my position in Caterpillar during the late-February pop, and hedged much of the remainder with options through August. I sold off Illinois Tool Works after I felt it reached full value and had good long-term gain. Honeywell had been a favorite holding for several years, but in June I swapped the position out for Eaton Corporation (NYSE:ETN) shares. Eaton is now one of my largest positions. I really like their recent Cooper Industries acquisition. The stock is getting no credit for that deal. The recent four percent yield was the trigger to buy.

I would like to buy more Caterpillar if it falls below $80 a share. I'm pleased with my new Eaton position. If that stock falls back to $37 or less, I'll add to it.

Energy Transfer Partners is another core holding. I like the jumbo 8 percent distribution on this aggressive pipeline MLP. I added units during the recent secondary offering: market shares fell considerably below the secondary offering price. While classified an Energy stock, this hydrocarbon transportation company has a compelling number of catalysts to propel it going forward. However, I am watching the cash flows, capex and borrowing carefully. Recently, Fitch offered a positive credit statement regarding the company's recent acquisitions / finances including the Sunoco and Southern Union Company ETE/ETP drop-down arrangement.

Increase holdings of selected Tech stocks. My two core investments in this area are Apple (NASDAQ:AAPL) and Intel (NASDAQ:INTC). These two represent bookends of this sector: one high growth company and the other a dividend star. I believe both remain undervalued.

Results and Critique: Clear winners. I added to my Apple position early in the year. It's now my second largest holding. Income-generating options have just added luster to the underlying shares. Apple has long been an investment for me, not a trade. Ditto Intel . I continue to sell cash-secured puts against the shares, collecting nice premiums thus far. The dividend-growth story remains outstanding. I'm happy to buy more around $25 a share.

These two tech giants rescued my overall portfolio performance.

Underweight Financials and Health Care. I suspect that the risk-reward profile for Financials will remain weak and volatile. Therefore I will remain largely on the sidelines for this sector. I have small positions in Citigroup (NYSE:C) and Hudson City Bancorp (NASDAQ:HCBK) to stay in the game. I do like the iShares Preferred Stock ETF (NYSEARCA:PFF) for the high yield coupled with low European bank exposure.

I bailed a bit early on the run-up in Health Care stocks last year. Now I believe the prices are too high to get back in.

Results and Critique: I took a beating in January on Financial shares as I sold out of Citigroup (C) and Hudson City Bancorp early in the first quarter. Made a bunch of money on Citi in 2009 and 2010, then gave most of it back this year. However, I learned my lesson and parked all the proceeds and more into my favorite Financial sector stock, Wells Fargo (NYSE:WFC). I had been in Wells in 2009 and out in 2010, but came back around. As Peter Lynch said, "Sometimes an old friend is your best friend." My analysis lead me to believe that Wells is the best-of-breed large U.S. Bank stock. Their acquisitions, scale, and boss management team will position the company to dominate the Main Street banking business for years. It's a play on the ultimate recoveries in the U.S. Housing and commercial loan businesses. I like the fact that Wells Fargo management has kept their business model and metrics simple. I own both the common shares and the warrants that expire in 2018.

For years, I've held shares in the iShares Preferred Stock Fund . While acting more like a bond than a stock, this holding has added good "ballast" for the portfolio.

Unfortunately, while the Financial sector was a first-half winner, I spent too much capital goofing around re-arranging losers and lost out on the upside. However, I'm very happy with where I am going into the second half of the year and onwards.

Health Care stocks have been an enigma to me. This was one of the best performing first-half sectors. I was on the sidelines. I looked into the Drug companies, but didn't like any of them enough to buy. Frankly, I've been befuddled by Obamacare debate, Supreme Court calculus, and go-forward expectations to do anything with the sector. So I did nothing. I may elect to continue with this approach for the second half of the year, too. I'm just not comfortable with it. Eli Lilly (NYSE:LLY) is the only stock I have considered seriously.

Retain moderate exposure to Utilities, Telcom and Consumer Staples, holding current securities. During 2011, I picked up positions in American Electric Power (NYSE:AEP), Vodafone PLC (NASDAQ:VOD) and PepsiCo (NYSE:PEP) when the valuations just got too compelling. I think the price tag on these shares are now too rich to buy more, with the exception of Vodafone. I'll continue to hold and collect the dividends, but won't add to the positions unless they "come in." Big picture, I'd like to accumulate more Utility / Telcom sector stock to round out my portfolio. However during the EU crisis last year, the field became too crowded with investors flocking to companies with high yield and little European exposure.

Results and Critique: I held a mixed bag in these sectors, with an overall positive bent. I swapped out of my long-term shares of American Electric Power with a good gain; I became less confident that the Ohio rate case and the anti-coal EPA regulators would work out acceptably for the company. I scaled into Exelon (NYSE:EXC) during the second quarter around $38 a share. I liked the forward thesis: the stock being held back due to low natural gas pricing, negative perception around nuclear power generation, uncertainty around their merger with Constellation, and associated weak EPS growth going forward. However, I view the bad news now being baked into the stock price. Plus the 5.3 percent dividend is pretty tasty while hanging around for management to get the act together.

Vodafone has remained a solid, high-dividend holding. I'll add more on a fall back below $26, and keep writing cash-secured puts until that happens or until the stock price runs up too high. I am pleased with their management, business plan, and of course the 45 percent ownership in Verizon Wireless. The juicy, first quarter special dividend was quite welcome.

Lastly, I opted to sell my shares of PepsiCo north of $69 on the basis of them reaching what I thought was full value. To remain in the sector, I took small positions in Lorillard (NYSE:LO), and General Mills (NYSE:GIS). The U. S. tobacco company has a strong balance sheet and grinds out excellent dividends. I purchased "The General" on what I considered exceptional stock weakness after their June earning report, and on the heels of a dividend increase that offered a 3.5 percent yield.

I like these positions as a counterweight to my continued exposure to Energy and Industrials, both sectors that I believe are susceptible to volatility and downdrafts in the second half of the year.

Other Equity Investment Notes:

While not part of the original investment plan, I staked a position in TRW Automotive Holdings (NYSE:TRW) in February, then watched as the auto safety parts manufacturer took a bath. Despite upbeat North American auto sales projections and an improved balance sheet, the stock has been snakebit by its exposure to the European auto market, an industry antitrust investigation, and lack of yield support. It's a 15 percent loser for me. At this point, my original thesis for owning the stock hasn't changed. So I plan to hold on.

In addition, I've long held some real estate securities to diversify my portfolio. I staked a position in Annaly Capital Management (NYSE:NLY) during the second quarter by swapping out of a long-term REIT ETF. The localized assets and dividends will continue to add much-needed stability. I believe Annaly is best-of-breed. My concern is the health of their outstanding CEO, Michael Farrell.

Keep some bonds as a hedge, but basically the party is over. I still like the PIMCO Total Return Fund (MUTF:PTTRX), despite last year's performance and Bill Gross' mea culpa. Rounding out some fixed income exposure, I will continue to hold a Global Bond fund and a High Yield fund to stay balanced in the bond space. The run-up in Treasuries was a pleasant surprise last year, but I don't think it will be duplicated again this year. So I'll take some profits on a TIPS fund.

Results and Critique: Here was a great lesson in why to remain diversified. I thought bonds could have a very rough go of it in 2012, but I stuck with my portfolio allocations. These funds became some of the first-half anchors. PIMCO Total Return Fund (PTTRX) provided nearly a 6 percent uplift. The High Yield bond space was likewise accommodative, with two funds clocking a net 6.6 percent total return. I added to the High Yield positions in January/February with very good results. My view was the economy was not going to crater, and the junk bond yields were pricing in an overly pessimistic year.

Going forward, I will continue to hold bonds in accordance with my allocation model: selling if overweight, and buying more if underweight.

Increase exposure to Gold: Now. I believe that the yellow metal should be part of my portfolio as a hedge and insurance. I think the dip in gold prices now is an opportunity to accumulate the position on the cheap. Last year, various institutions and investment houses were forced to sell gold to raise cash. Now I see gold continuing its climb upward in 2012. No silver, copper or mining stocks for me. I will add to iShares Gold Trust as my preferred access to the precious metal.

Results and Critique: I did not follow through on my initial plan to buy more gold. Early in the year, the price ran up; and I refused to "chase" the commodity. Then when it weakened, I didn't like the chart. So I just held tight. Gold is one of the largest single positions in my portfolio, so it's not like I'm going to miss a train. Hence a tremendous advantage individual investors have: we only answer to ourselves. Yes, I had a plan. No, I didn't follow it: but for what I considered sound, rational reasons. And I don't have to answer to anyone for it.

Lastly, CASH is king. I tend to hold a fair percentage of cash in my portfolio, and it doesn't bother me to live with today's near-zero interest rates. Holding some cash permits me to sleep easy at night. I simply ladder some one-year CDs, even if the interest rates are awful.

Results and Critique: Yup, cash is king. I hold a considerable amount of cash. I might deploy some if the market tanks, or I might just continue to stay put. My current cash percentage is 15 percent, and my "regular" portfolio target is 10 percent. So I'm overweight. While the returns are lousy, I ladder some CDs, and grind out the best, safe, yields that I can with the rest. No remorse, no apologies.


My original premises were left reasonably intact. However, going forward, I suspect that 2012 will offer some considerable surprises: more than usual. I'll be doing a lot of homework in 2012.

My first half "all-in" portfolio return was approximately five percent. That trailed my benchmark, the S&P 500 total return. My objective is to meet that benchmark with less volatility due to being diversified into asset classes other than equities.

Big losers like TRW and HAL were somewhat offset by AAPL and INTC. Option income, dividends, and interest were key components to what I classify as a "hanging in there" performance. As is often the case, I found strength where I expected none (bonds) and weakness where I expected strength (Industrials and Gold). Always remain diversified, even when it seems there's no need to do it.

Readers please note these views are my own. I am not trying to sell anything, nor providing specific investment advice. I simply enjoy sharing / exchanging views with fellow SA investors, based upon my nearly thirty years of practical experience. Your comments help me keep sharp. Seeking Alpha has published articles of mine detailing many of the stocks mentioned above if you are looking for more color on them.

Good luck on all your investments for the remainder of 2012 and beyond.