As a frequent contributor to Seeking Alpha, I receive tremendous feedback whether through posted comments, emails or even traffic to my websites. I am deeply indebted to the readership for its role in leading me to launch my second model portfolio, the Conservative Growth/Balanced Model Portfolio. Over the next few days, I plan to share details about the security selection process, but today I wanted to focus upon the asset allocation.
Before going further, allow me to briefly explain the goal of Invest by Model, which I launched in May with the Top 20 Portfolio. The service allows me to efficiently share my research and investment decisions with the general public and targets specifically do-it-yourself investors and even those who currently perhaps invest in mutual funds or managed accounts who would like to take control and perhaps reduce investment management costs. While I suspect that some subscribers might be following the models precisely, it also serves as a source of ideas with transparency and accountability.
My first launch of a long-only portfolio, which ended Friday down almost 8% from its post-Memorial day inception, offers painful evidence of performance measurement. While the portfolio is down, primarily a function of exposure to some riskier Financials, it has outperformed the benchmark by about 1%.
The Conservative Growth/Balanced Model Portfolio [CGB] follows the tremendous interest I have had in a series of articles I have contributed regarding “high-quality dividend-paying growth companies”:
The basic premise behind the articles is that a focus on current income or dividend yield alone is inferior to considering the long-term total return. Long-term total return consists of price appreciation (or depreciation these days) and dividends received over time. For those who are focused on building a nest-egg to fund retirement, the greatest concern shouldn’t be the income level today but rather the size of the pot down the road.
When I started considering this challenge of funding retirement (which is often a longer period than it used to be due to extending life spans), I was rather bearish on the market. Using StockVal, a powerful institutional-quality analytical system, I created a screen that attempted to identify companies that had growth potential but that offered investors a reasonable margin of safety. Most of the articles linked above have the exact parameters. In any event, the CGB model portfolio is an extension of this idea and includes several companies that meet the tight parameters of that original screen.
The CGB model is aimed at long-term investors who need to grow their portfolios in a conservative fashion. It is designed to protect capital as well. Of course, these two goals are often in conflict. As the name implies, it is a “balanced” account, meaning that investments are in both stocks and bonds. The benchmark is a traditional 60/40 split between the S&P 500 and the Lehman Aggregate Bond Index. I have set ranges around those asset classes:
- Stocks: 45% to 75%
- Bonds: 10% to 55%
- Cash: 0% to 45%
A neutral portfolio would have very little cash and about 60% exposure to stocks and 40% exposure to bonds. At a time when bonds were relatively attractive to both cash and stocks, their allocation could rise to as high as 55%. Conversely, the exposure could be as low as 10%. Stocks similarly could go as high as 75% but as low as 45%. Cash is generally not a great way to grow one’s portfolio, especially taking into account inflation, but there are times when it is superior to other financial assets. I intend to adjust the allocations both tactically and strategically and believe that this should help enhance returns over the long-haul.
Looking at the equity component, the portfolio will be somewhat concentrated (typically 5% positions, though ranging from 3% to 7%). I don’t expect that the turnover will be that great. The stocks will be selected should have above-average growth, though certainly not exceptional. A little growth helps, a lot of growth is risky! In all cases, the companies will have good balance sheets relative to their industry and generally in absolute terms. Sustainability of sales, earnings and dividend growth is really the key consideration, with valuation also serving to protect capital.
I don’t intend to use security selection at all for bonds, but will rather use iShare ETFs to manage both overall exposure as well as potentially sector exposure (Government, Credit, Mortgage). Initially, I used the iShares Lehman Aggregate Bond Index ETF (NYSEARCA:AGG) solely. Cash variation is an important tool at my disposal to help control risk
So, what are the characteristics of the initial portfolio, which will be “purchased” 7/21/08? First, the initial allocation is 60% stocks, 20% bonds and 20% cash. Though I am somewhat bullish on stocks longer-term here, the initial allocation is neutral, primarily a function of not being ready to pull the trigger on another 7-10% of equity exposure (either new names or allocation to the initial names). In this kind of market, patience is rewarded.
The bond exposure is set exactly where I believe it should be. While the current “yield” on bonds is about 5%, the likely path of interest rates is moderately higher. I believe that stocks look better – the majority of the cash would go there before bonds. Helping to support an allocation above the minimum of 10% is the high credit spreads and the steepness of the curve, both of which should mitigate any exposure to moderately higher rates. The initial allocation, then:
As I previously stated, I will be sharing my thought process behind the initial 12 equity selections in coming days. As a portfolio, it is overweight relative to the S&P 500 in Industrials, Consumer Discretionary and Financials. The underweight in Energy is rather intentional, while the largest underweight in Technology is a function of security identification. Taking a longer-term view, the Industrials more than adequately discount the tough environment for profit margins and offer extremely attractive entries.
In the Consumer Discretionary sector, investors have the ability to purchase deeply discounted franchises with favorable long-term industry fundamentals. While Financials are a challenging sector, there are several companies that don’t share the same risk profile yet have been penalized. The lack of exposure to some of the smaller sectors (Materials, Telecomm Services and Utilities) is primarily a function of the concentrated nature of the portfolio as well as some unfavorable investment characteristics. Utilities, in particular, while offering high yields, have regulatory and capital limitations.
The underweight in Staples in primarily a function of valuations. Technology companies are a challenge due to low barriers to entry and valuations in many cases. I believe that Energy stocks have peaked for now and don’t offer a timely near-term entry but am certainly expecting to increase exposure over time. Finally, Healthcare is an area where the larger companies generally don’t offer the margin of safety I am seeking while the smaller ones with better growth prospects are constrained by their valuations.
The market capitalizations range from $700mm to almost $200bln, with a median of $7.6 billion. The blended portfolio has a current income of about 2.7% (5% for the bonds, 2% for the cash and 2% for the stocks) relative to a 3.2% yield on the benchmark. It is important to remember that the overall equity portfolio has many superior attributes to the S&P 500:
- PE: 13 (slightly lower than market)
- PE relative to 5yr Median: 74% (relative to 84%)
- EV/EBITDA: 7.7 (relative to 10X for S&P 500)
- Debt to Capital: 18% (well below market of 45%, even better netting out cash)
- Pre-Tax Margin: 10.6% (vs. 9.7%)
- Return on Capital: 17.3% (vs. 7.2%)
In summary, then, the equity component, which is quite diversified by sector despite being concentrated in a few securities, has a lower valuation despite much better capital structure relative to the market. The portfolio is designed to carefully navigate the Scylla and Charybdis of Risk and Reward. Too much focus on one without taking into account the other leads to sub-optimal long-term growth of principal.
I look forward to sharing the individual securities (which you can actually view by visiting the website) in coming days and welcome your feedback.
Disclosure: Long AGG and several of the stocks in the CGB Model Portfolio.