In one of my recent articles, "Is A Stock Market Drop Imminent," I recommended long investors to consider two specific portfolio options - one based on dividend growth and the other on utilities. At first glance these suggestions no doubt seem to be outdated platitudes. But don't be turned off by the words "dividend" and "utility" … these are actually sophisticated models with a twist that will conserve cash, analyze value and include a market timing component.
But before we talk about strategy, we should understand how well utilities have performed over the past 14 years. The chart below invests in any stock over $1 per share that is found in the utilities sector (GICS 55).
This translates into a 12% compound annual growth rate if you could invest in all utilities. Just buying utility stocks was still a volatile ride with a 35% drawdown during the 2008/2009 crash. But this gives us a benchmark to weigh our new system against.
The Defensive Utility Portfolio
The Defensive Utility Portfolio is one of my favorite stalwart portfolios for investors that don't want to and eat a fistful of Melatonin followed by a Pepto Bismol chaser just to get some sleep during volatile markets. What makes this defensive utility strategy so different than simply holding the entire sector?
This portfolio has two major components: rules that are permanent and rules that change depending on the market cycle.
This is nothing elaborate but these rules demand higher yields and any new holding must not have an excessively high correlation to the rest of the portfolio. Stocks must be in the utility sector and be reporting a dividend. Prices must be above $1 per share. That's it.
Market-Based Ranking Rules
Having market-based ranking rules does not mean you go "all long" or "all short" ... in fact we never go short with this system. These market-based rules simply favor certain ratios in bull markets and other metrics in bear markets. How does this work?
- In a bull market we favor certain fundamentals such as positive earnings revisions, better analyst rankings, higher short-term growth and deep value ratios that include sales, assets, and earnings.
- In bear markets we focus on financial strength and stability. In downward markets the focus is on stability of earnings, low debt ratios, higher liquidity, strong long-term growth, a tight earnings estimate range with few revisions and low volatility price action.
The chart below will show the S&P 500 in red (SPY), all utilities in blue, the top 10 bullish (defined by rules above) utility stocks in black, and the top 10 bearish(defined by rules above) utility stocks in teal during the 2008/2009 crash. The bearish utility stocks held up the best.
During a typical bull market period, the "bullish utility" strategy outperforms with "all utilities" and "bearish utilities" coming in close behind with the S&P 500 lagging.
Remember, the above charts are 100% invested at all times. Even if we are fully invested, we can lower downside risk somewhat by choosing "safety ratios" in bear markets and "growth ratios" in bull markets.
What market timing rule do I use to switch factors? This is based on total earnings trend of the S&P 500 which is a topic for another article ... although I have written about it extensively on Seeking Alpha.
Finally, some investors will want to conserve cash and not be "all in, all the time." Some investors/traders will use market-timing techniques to determine when to raise more cash but I prefer to do it on a stock by stock basis. How does this set of rules work?
My ranking rules (discussed above) look at various ratios and metrics depending on whether we are in a bull or bear market. The charts I have shown so far simply pick the best 10 stocks based on those ratios. But what if the average utility yield dropped to 1% ... would picking the best 10 still be prudent? If all utility stocks had a price to earnings ratio of 20, would the best 10 still be good enough? In addition to relative valuations, you need to consider some absolutes to lower your exposure when few good stocks abound. But how do you know what threshold to set?
One method is to run your ranking rules on a previous bear market from the 80s or 90s. Use a few different settings for your ranking system to see how quickly to cash the portfolio goes. For instance, I may set a minimum ranking of 50/100 based on my factors. If the 'best 10' are all above a rank 50, we buy all 10 stocks. When the individual stock ranks fall below 50 we sell. In a bear market there could be few stocks, if any, that are above 50.
The goal is to set a standard that is easy to achieve in bull markets but very difficult in bear markets. For instance, low volatility and standard deviation may be a cinch in bull markets but very difficult to find in a market crash when setting an absolute threshold. Each bear market will be different but setting your minimum rank threshold conservatively is better than none at all.
This next chart shows the bullish (green) and bearish (purple) utilities with cash conservation rules versus all utilities (blue). On their own, the effects are not that impressive. But wait until we rotate between bullish and bearish utilities with these cash conservation rules.
Putting It All Together
Finally, we want to put it all together. We have some static utility rules, some that change depending on the market and an absolute ranking high-bar that each stock needs to clear in order to be allowed admittance into our portfolio. The chart below has our final dynamic portfolio (yellow), all utilities (blue) and the S&P 500 (red).
This gives us a compound annual growth rate of over 18%, a maximum drawdown of 21%, a Sharpe ratio of 0.84, an annual turnover of 286% with a correlation to the S&P 500 of 0.61. More stats and figures associated with this model can be viewed on the Defensive Utility page. Right now we are still in (and have been for a couple months) in a fundamental slide due to the consistently downward earnings forecast across the S&P 500.
This next chart shows the drawdown and % cash holding.
Utility Stock Picks
The top three stocks to hold based on my fundamental ranking system in a bear market are:
The top three stocks to hold based on my fundamental ranking system in a bull market currently are:
This may not be the most exciting and flashy portfolio, but its consistent income and capital growth with downside protection makes it a healthy alternative to owning a utility fund (XLU) for the do-it-yourself investor.