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Todd Mayberry
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Todd made his first trade in 2006 and has been fascinated with the stock market ever since. He is a value investor and has found success implementing philosophies endorsed by Phil Fisher, Seth Klarman, and Warren Buffett.
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  • Hold Cash to Beat the Market

    When investors seek to beat the market, the discussion revolves around which stocks will comprise one’s portfolio. This is as it should be; however, allocation can be used as another tool to best the market. Allocation is simply the pieces that make up a portfolio. This could mean stocks, bonds, gold, REITs, etc. There has been a mind-numbing amount of research done around this subject, but I will solely be talking about the cash portion of a portfolio otherwise composed of equities. This article is somewhat of a philosophical approach to portfolio management revolving around the types of equities to hold and how to incorporate cash in order to beat the market averages.

    Investors typically go through a lengthy process to research and select stocks. However, even stocks that appear attractive relative to their peers can result in substantial losses if the overall market declines shortly after shares are purchased. This is called systematic risk. It is risk that cannot be diversified away. Therefore investing in the greatest stock in the world likely won’t keep your shares from losing value if there is a downward revaluation of the entire system. Professional investors and retail investors are both susceptible to this risk. One would think that a professional would be able to determine if the overall market was overvalued and avoid investing on the brink of a market fall, but this has not proven to be the case time and time again. Ken Fisher, Warren Buffett, and countless other professional managers saw their holdings rapidly shrink after October 28, 2008. If the best minds in the investing world are not immune to broad based market moves, how can anyone else be expected to consistently determine when they will occur and time their investments accordingly?

    It is impossible for an investor to purchase shares after a market fall, sell at a market peak, and repeat this cycle with any kind of regularity. Attempting to do so will almost certainly guarantee the investor underperforms market averages, and likely by a wide margin. To accommodate for the fact that nobody can see when exactly a downward market move will occur, it is wise to hold a large cash position. By fully investing in equities and taking your cash holding to zero percent, you are essentially handcuffing yourself. I like to say you are, “Holding and hoping.” Of course, if you have done your due diligence the stock will perform better than the market, but you could miss out on even greater outperformance because you are locked in. If you loved a stock at $25, wouldn’t you love it even more at $20? A large cash buffer gives investors the opportunity to be flexible and buy on market declines. Buying at these lower levels increases the probability of subsequent outperformance and can actually reduce risk.

    Obviously this strategy seems tailored to investing in falling markets. The biggest risk is keeping a lot of cash on hand during a rapidly rising market because the investor is earning zero percent on the cash which can be a drag on the portfolio’s return. That takes us to the type of equities that make up the portfolio. In order to keep up with the market while also holding a large percentage of cash, it is important to hold stocks that are more volatile than the overall market. The most common metric used is a security’s beta. Beta is simply a regression analysis that compares a security’s returns to that of the S&P 500. However, beta is not always perfect. Just as past returns are not necessarily indicative of future returns, past volatility is not necessarily indicative of future volatility.

    To determine a portfolio beta, merely multiply each stock’s beta by the portfolio allocation. (Assume that the beta of cash is zero.) Then sum this number to reach a portfolio beta. The portfolio beta should come out to around one to ensure that the portfolio will earn returns in line with the S&P 500 even if the investor gets caught in a rising market and cannot deploy cash at lower levels.

    The goal of this strategy is to keep up with the S&P 500 if one finds himself in a rising market shortly after a purchase, but the big time outperformance comes from buying at depressed levels. I learned this lesson first hand. During the Financial Crisis, I began looking at blue chip companies that had precipitously fallen. I knew they did not have the same default risk as smaller firms, and the implied growth rates were far too pessimistic. One example of the strategy at work was first buying CAT at $43.10. Had I made a larger initial investment and handcuffed myself, I still would have earned a healthy profit. However, the heavy cash allocation allowed me to purchase CAT all the way down to $24.92. Over the lifetime of the investment (I sold at $87.51), the shares outperformed the S&P 500 by 279%. The same approach allowed me to get a better average price on BP shares. After the spill, I believed that the amount of market cap lost was far greater than that of the ultimate spill costs. I first tested the waters at $48.75—down almost 20% since the spill but actually higher than today’s price of $46.65. The flexibility afforded by my cash holding allowed me to make two more purchases—the lowest being at $29.11—and lower my average price to $36.39. I did not catch the absolute bottom, but the BP holding has outperformed the S&P 500 by 16.1%. Keep in mind that had I taken all funds ultimately invested and dedicated those to the first buy, I would be sitting on a 4.3% loss while underperforming by 16.3%. This strategy of holding a large proportion of cash offers an additional margin of safety to investors because all future prospects are not contingent upon one buy point.

    As mentioned above, the strategy of buying on declines can actually reduce risk. There is a false belief that stocks that have performed poorly over a certain period are more risky than those that have performed well. Of course, there can be reasons a stock has fallen. Perhaps earnings are deteriorating, maybe the product line is becoming obsolete, or possibly there is a default risk. It is imperative to differentiate good value stocks from value traps. Assuming an investor is able to avoid value traps, buying after a decline greatly enhances the risk/reward characteristics of a stock. Here is an oversimplification with all things being equal: a stock that has declined and is now closer to zero does not have as far to fall as a soaring stock. The downside risk shrinks while upside return potential correspondingly rises. Holding a large cash position also mitigates risk in a falling market because as the market falls (allowing you to buy at more attractive levels) your cash has been “outperforming” the market and can be deployed at levels that will likely generate market beating returns.

    I have avoided presenting any hard and fast trading rules such as buying after a pre-specified percentage drop, initially investing “x” percent of the portfolio in a stock, or allowing for “x” number of future buys. My goal was to make this a thought provoking article to allow investors to consider how utilizing cash in this manner might have changed his or her returns. For the sake of this article, stock selection was largely ignored to focus on allocation. By coupling excellent companies with a flexible allocation, investors can use systematic risk to their advantage in order to make outperformance far more likely. 



    Disclosure: I am long BP.
    Jan 26 1:28 PM | Link | Comment!
  • Alternative Bonds...With Unlimited Upside
    My previous article explained my negative outlook for the bond market, and also promised an alternative to fixed income. As I'm sure you have guessed the answer is dividend stocks. The proper approach can provide the reliable income associated with bonds and also the unlimited upside characteristic of equities. This article will delve into the process for choosing suitable equities to replace and/or augment bonds in your portfolio. 

    According to Robert Shiller, the current dividend yield of the S&P 500 is 1.74%. Now I know you're saying, "That's only half the yield on the 10-year T-Note!" That's true but consider the growth rate of dividend payouts for several blue chip firms: CAT, MCD, and PG.

    In a span of ten years each of these firms substantially increased nominal dividend payments. This means an investor is continually improving his or her cost basis dividend yield. For example, buying $10,000 of MCD stock (282 shares @ $35.47) ten years ago would have meant a dividend yield of 0.65% ((annual dividend payment of $0.23 x 282 shares) / initial investment of $10,000). This yield is nothing to write home about. However, over the course of ten years the dividend had a compound annual growth rate of 25.64% which equates to a cost basis dividend yield of 6.37% ((annual dividend payment of $2.26 x 282 shares) / $10,000). On top of this fantastic dividend growth, the investor also enjoyed share price appreciation. At the end of ten years, the investor would have a healthy profit of 135% after combining capital gains and dividends. A CAGR of 8.9% for a security with bond-like payments is a great alternative to fixed income. Obviously this strategy cannot be implemented overnight, but with proper planning and thorough analysis this strategy can blow the 3.3% 10-year T-Note out of the water.

    Dividend & Capital Gains Returns
     TICKER COST BASIS DIV YIELD 2001 COST BASIS DIV YIELD 2011 DIV CAGR DIV RETURN CAP GAIN RETURN TOTAL RETURN CAGR
    CAT 3.42% 8.64% 9.71% 56.05% 373.83% 428.88% 18.12%
    MCD 0.65% 6.37% 25.64% 26.69% 104.88% 134.56% 8.90%
    PG 2.03% 5.30% 10.07% 39.27% 84.61% 123.88% 8.39%

    While I believe the risk/reward trade off of this strategy is acceptable, there are several arguments against it. The most obvious is that by investing in equities the investor is taking on more risk and putting his or her capital in a position where it could lose value. I will not argue that there is potential for loss, but this necessarily means there is also the opportunity for larger gains because the risk/return relationship always holds. Additionally, when a long term investment horizon is employed, the risk of loss is further reduced. Since 1935 there have only been four negative rolling ten year periods. When the time period is expanded to twenty and thirty year rolling periods, there have been no negative returns for the S&P 500 index since 1935. Of course, the S&P 500 was used a proxy for comparing equity returns, but that doesn't mean every single stock will follow this pattern. However, there are steps one can take to help avoid the stock of poor companies.

    Two simple metrics can be used to screen for stocks with potential to increase dividends: 1) free cash flow (NYSE:FCF) and 2) payout ratio. A firm that kicks off a large amount of FCF is very flexible. The company can pay down debt, grow through acquisition, fund capital projects to increase future cash flow, buy back shares, or increase dividend payments to shareholders among other things. Payout ratio is important because it is an indication of the sustainability of the dividend. It is derived by dividing the cash paid to shareholders in the form of dividends by net income. Anything over one means that the firm is paying out more than it is earning in profits. If a company has a payout ratio over one it is very likely that the dividend could be cut or discontinued which will have an adverse impact on the share price. I usually like to see payout ratios under 75%. Two industries that are exceptions to this rule are REITs and utilities. Companies in these industries typically have higher payout ratios due to the nature of their business and the more regimented fashion of revenue.

    The table below illustrates the FCF strengths of the companies outlined above and also shows reasonable payout ratios. All three of these companies were cash machines back in 2001 and continue to generate a great deal of FCF today.

    FCF & Payout Ratio
    TICKER FCF '01 PAYOUT RATIO '01 FCF '11 PAYOUT RATIO '11
    CAT $1.3B 44% $4.0B 45%
    MCD $0.8B 18% $3.8B 51%
    PG $3.3B 66% $13B 43%

    For the investor who has decided it is wise to avoid bonds, the long term commitment to finding great companies with a history of increasing payouts to shareholders can reap dividends. The investor is not subject to the same interest rate and inflation risk as bondholders, and can enjoy growing dividends coupled with the potential for substantial share price appreciation.




    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Jan 14 1:57 AM | Link | Comment!
  • Are Bonds Really a Conservative Investment
    It has long been a common assumption that bonds deserve to be a core allocation in any balanced portfolio--especially if the investor is nearing retirement. Bonds are lauded for their steady and predictable coupon payments, repayment of principle, and are typically viewed as "less risky" than equities. However, interest rate risk and inflation can undermine fixed income returns. Both issues are quite relevant currently.

    The first issue to examine is interest rate risk. Bond values and interest rates have an inverse relationship. This means that when interest rates are falling due to Fed intervention or natural forces, the value of bonds increases. If a bond investor is fortunate enough to buy before rates fall, he or she will be positively impacted. However, the more dangerous scenario involves rising interest rates. An investor purchasing bonds during a trough in interest rates will have the misfortune of watching the value of his or her bond diminish as rates rise. 

    The chart below shows rate history for the 10-Year Treasury Note. As a result of government intervention, rates are currently hovering near all-time lows, and seemingly miles away from rates in the late 1970s and early 1980s when inflation was running rampant. It would seem that the only direction rates can go is up which, of course, means bond values must necessarily go down.



    The long term investor planning on holding a bond to maturity would argue that changes in interest rates aren't of any concern. He would contend that my previous discussion involving the fluctuating value of a bond are only pertinent to short term investors. The hypothetical long term buyer does not mind seeing a constantly changing value because the rate at which he bought is locked in and any price movements are just "noise" if he holds to maturity. This savvy investor would be correct. Buying today, he or she would earn 3.3% on the 10-year by holding to maturity. In past years, this buy and hold approach would be prudent, but doing so in today's landscape could prove harmful to one's wealth. 

    When reviewing an investment's success, it is important not just to consider the nominal return but also judge if purchasing power has been preserved, increased, or decreased. This is referred to as an investment's real return which simply means the return after accounting for inflation. A return of 3.3% really takes on a different look when inflation is brought into the picture. The chart below shows the history of inflation in the United States as measured by the CPI. In years during which inflation was high, it is very possible that bond investors earned a negative return.



    Investors should be wary of purchasing fixed income securities. There is a reason many corporations have been issuing bonds. According to Morningstar, December 2010 net debt issuance rose 10% year over year. This is during a time when corporate balance sheets have been at their strongest with many firms holding an unprecedented amount of cash. Corporations get cheap money at the expense of investors earning poor and possibly negative real returns. Interest rate risk and inflation risk make the fixed income arena appear to be a dangerous place. Buying today could cause a deterioration of one's purchasing power.

    While the bond market should be avoided, there are still well suited alternatives for the investor seeking income. I'll discuss these very attractive securities in my next article titled "Alternative Bonds...With Unlimited Upside."



    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Jan 13 11:14 PM | Link | Comment!
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