Over the past month offices around the country have been consumed with March Madness and “bracketology” chatter. Admittedly, I’m a big college basketball fan, so this is one of my favorite times of the sporting year. You may be asking what does it have to do with managing your portfolio or the investment world? At first glance it may not, but I thought I would have a little fun and couple it with some asset allocation parallels. After all, there are many folks who have simply thrown their hands in the air at one time or simply succumb to the notion that investing is like educated gambling. There could be some truth to that depending on your approach…
For those of you that aren’t familiar with the NCAA and it’s annual basketball tournament…(let’s not be friends)…just kidding. Basically there are 68 teams selected and seeded based on their season results and perceived quality. Every March the NCAA holds a single elimination tournament to crown the number one team. As of this past weekend the field was whittled down to the Final Four teams left to battle it out in Houston, Texas; Butler University versus Virginia Commonwealth University and University of Kentucky versus University of Connecticut.
Part of the appeal of such a tournament is that theoretically any team that makes the “big dance” has a shot at winning it all. Each and every year there is a proverbial “Cinderella” team that surprises everyone including all the experts. Prior to the tournament there is always plenty of banter and opinion on who wasn’t invited or furthermore arguments around the seedings of the teams that did make it. That’s where I see a sort of parallel or analogy to investing and having to make choices among the multitudes of investment choices. As many investment choices as there are, there are also about as many differing opinions…
Even President Obama gets his bracket done and shows his passion for the game. Granted, there are those that opine his attention might be better allocated elsewhere, but regardless much of America gets into March Madness. Speaking of the President and his picks…. like many, he chose all number one seeds this year and this is only the third time in history that there were no number ones left in the Final Four. I should also mention that a number 16 seed has never upset a number one seed but when it comes to investing...this happens all the time. If you have ever looked at a chart of all the different asset classes and how they perform year to year…there is rarely a pattern or consistent way to determine next year’s “winner” :
For chuckles, I’ve “seeded” or ranked four major asset classes (like the regions) and several of their components. I was lightly scientific in this process as I basically focused the results on just the past year. In some cases I gave a lower performing investment a higher seed if it was trending higher with recent strength or was more consistent over a longer period of time.
I will now comment on some of the key match-ups and explain why my Final Four going into Q2 2011 looks the way it does:
Large Cap – What I’ve done in this asset class is break it down with two major “styles” (Growth versus Value) and then focused on several of the 10 major economic sectors. For the sectors that I favor right now I have selected a few individual companies to consider. I’ll do the same thing for a few Small and Mid Cap companies in the opposing regions.
Let me begin by saying that obviously past performance can’t predict future performance but it should be noted that the third year of a Presidential cycle is the strongest averaging +17.1% and within that year the second quarter is also the strongest coming on average at +5.3%. Several economic sectors this past year continue to show strength. Of the 10 major sectors, especially within Large Cap, the ones to favor are Energy, Industrials, Materials, and Technology. For the sake of my bracket illustration I want to highlight the #16 Alcoa Aluminum (NYSE:AA) run. As mentioned earlier a #16 has never upset a #1 but in this bracket I could see something like this playing out. Alcoa Aluminum is a stock that may not knock your socks off at first glance but in this asset class that’s sometimes what you want. Here is a consistent player with an expected 5 year growth rate of 13.2%, a forward P/E of 11.2, and has returned 19.6% so far in 2011. A global stock like this still has solid fundamentals and is likely to continue with aluminum orders up 4.2% in February (along with the two prior months at 2.6% and 3.8%).
Aside from Large Value being the overall winner in this bracket a familiar “team” and recent star is Energy. On a very basic consumer level we’re all noticing the uptick in prices at the gas station and that trend is likely to stay. With any economic recovery you will see an uptick in the demand for consumption for oil. Along with this increased demand comes higher prices. The US is still at pre-recession levels and even if we continue to slowly recover, the trend for increased consumption is clear. Couple this with substantial demand from India and China and the Energy sector has plenty of continued upside.
Lastly, the bracket contains a few stocks that I’m not implicitly taking bets on but rather want to highlight why they might be part of your portfolio mix. We can run countless screen to determine which stocks to own but sticking to some of the main themes I touch on above you may want to look at : (1) Apache Corp (NYSE:APA); Materials sector / Oil & Gas exploration and production, +9.7% YTD (2) General Dynamics (NYSE:GD); Industrials sector / Aerospace, Defense products & services, 10.78 P/E, 2.50% dividend yield and (3) Applied Materials (NASDAQ:AMAT); Technology / Semiconductor equipment & materials, +10.2% over past 3 months, 2% dividend yield.
Small Cap – I’ve done the same thing with this “region” as for Large Cap but also added Mid Cap to this portion of the bracket. One could argue that Mid Cap should have its own bracket as it is a very distinct asset class. Some firms and investment advisors incorrectly lump the two asset classes (small and mid) together but for the sake of this illustration I will join them! Instead of choosing Sector ETF’s (Exchange Traded Funds) for this asset class I’ve selected individual companies.
The energy theme plays out strong in this portion of the bracket as well. Sometimes it’s safer to pick an ETF in a more volatile asset class like this and “watch all the boats go up in a rising tide”. Since we’re having fun picking “teams” here let’s take a look at the #6 seed with Newfield Exploration (NYSE:NFX). Again, I’m following a winning sector and highlighting a company that has done well amongst its peers. Newfield Exploration has been on a tear as of late being up 39.6% over one year. Is their tournament run about to end? Goldman Sachs recently pared down their holdings in the company by about 3%. Things may slow from this torrid pace but this oil and gas exploration company still forecast increased production and with higher crude oil prices the company stands to benefit. S&P recently increased its price target to $92/share and it currently trades at $75.91.
For the bracket’s sake…every good run comes to an end and I simply believe this part of the bracket has too many teams that did not get selected. In other words…Small and Mid Cap is an asset class that recently has led and it may be time to focus more on a shift in leadership. As the market recovery and bull market matures, take this opportunity to size up which Small Cap “teams” you still want to hold on to. The divergence between Small and Large cap will begin to emerge over the next few quarters and it’s time to avoid being enamored with past performances.
One materials company that may continue their recent winning streak is Eastman Chemical (NYSE:EMN). This #12 seed goes far in our bracket and for decent reasons. It’s easy to think that after a +54.6% increase the past 12 months that the company is due to take a breather. Not so ; Eastman Chemical continues to surprise Wall Street expectations and still trades at a reasonable valuation. EMN has an attractively diversified business and seems to be firing on all cylinders right now. Sales and growth continue to show strength and the company also recently re-opened a Texas facility that was once closed to accommodate for increased capacity. Investors are also being treated to a 2% dividend yield on this stock.
Bonds – This “region”/ asset class is sure getting lots of press and many fans feel the choices here have run their course. It’s not the safe haven it once was…or is it in fact this years best choice after a remarkable recovery in the stock market? One side note here is that I threw in two precious metals and real estate. Again…there are only four regions and even though the NCAA wants to add more teams every year…I need to stick to a manageable bracket too…
There is no one favorite in this bracket and it wouldn’t be surprising to see any of these “teams” put together a nice winning streak except for any that have the “mascot” long-term in their name. Oh sure…that’s obvious to everyone but why do so many investors still hold longer-term instruments? I do a decent amount of due diligence on why certain bond mutual funds are outperforming others in a low rate environment. Without going too deep into this here, it’s worth taking a peak underneath the hood of your bond fund if you haven’t over the past year; it’s safe to say that they’ve likely changed a few things.
In this region of your investing bracket diversification is again the name of the game. I mean that on several levels (maturities, types of fixed income, and geography). The one thing I tend to avoid is picking corporate bonds unless I see a particular value in one. That said, our #4 seed will likely go far in this year’s tournament again. It won’t win the big dance but you can look for iShares Investment Grade Corporate Bond ETF (NYSEARCA:LQD) to provide excellent diversification, the right maturity range, and a current yield of 4.75%. All this with just one line on your brokerage statement instead of 20 corporate bonds or a bloated mutual fund that will charge you north of 0.50%. The very popular PIMCO Total Return Fund (MUTF:PTTRX) charges 0.46% but has underperformed LQD over 3 months and 1 year. LQD has an internal expense of just 0.15%.
One area that we could almost devote an entire bracket to is with regard to International Bonds. Most advisors and investors ignore this area and aside from a token exposure (intentional or not) it’s simply misunderstood and overlooked. I have them seeded #2 and going deep into the tournament. One could easily make the case for this being a Final Four candidate in 2011. Everyone complains about interest rates being so low at the local bank and for the bond investor this poses another frustration. With rising inflation it’s prudent for the fixed income investor to remain in cash and/or low duration instruments. The two main risk factors in bond investing are credit and interest rate risks. You can take a few more chances with the associated risk by going high yield with our #5 seeded SPDR Barclays Capital High Yield (NYSEARCA:JNK). Alternatively, you should focus on always incorporating a percentage of your bond portfolio overseas.
Lastly, take a look at our seeds that “play” in the ‘inflation conferences’…Each deserves a look and should be a part of your investment bracket/portfolio. I touch on shorting US Treasuries, or at the very least limiting your exposure to them, at the end of this article. You can do so by owning TBF (ProShares Short 20+ Treasury). Another added inflation hedge is to own some TIP’s (Treasury Inflation Protected Securities). These types of bonds tend to outperform regular bonds when inflation is projected to rise. Even if you don’t believe that we are headed towards hyperinflation do yourself a favor and root for our #2 seed (NYSEARCA:TIP) for at least a couple of rounds. They have enjoyed a +5.7% return over the past year and boast a current yield of 6.4%.
International – Many investors ignore international investing or simply don’t allocate enough towards it. More than half the world’s opportunities are overseas (58%) so for one to not have exposure here is a major mistake. While investing in foreign funds and companies presents unique risks such as currency fluctuations and economic/political uncertainties, you can actually lower your portfolio’s volatility over time by being exposed to this asset class. Another wrinkle in this region, however, is the balance between developed countries and emerging markets. Emerging markets trounced all asset classes from 2003 to 2007 and then lost -53.18% in 2008. Should we run away from that volatility? Well…check out the brackets because the following year they led everyone again with +79.02% return in 2009.
Did I briefly mention the word hyperinflation in the Bond bracket? Yes…and that’s all that needs to be said for our #1 seeded friends in Argentina. Even with the recent tragedy in Japan and their relative lack of economic performance over the past 20 years, I will forecast another #16 seed upsetting a #1 seed. In this case, you have Argentina (NYSEARCA:ARGT). Soybeans, wheat, and flour accounted for about 70% of the country’s exports last year. Commodity prices have been soaring and with weekly price increases often in the 5-10% range this country is fighting the battle of selling goods priced lower than what they now cost. ARGT is up 905% over the past three months.
Maybe with all the gold bugs out there if I mentioned that Peru ranked fifth in the world in gold production it would garner some interest? I once hiked the Inca Trail and recall the guide telling us that we were going to pass more microclimates than anywhere in the world within a five-day hike. This fact leads me to talk about the investing merits of our #4 seeded country, Peru (NYSEARCA:EPU). With commodities in increasingly high demand this country deserves a strong look.
With a 30% return over the past 12 months Peru actually will end up losing to a very consistent “team” in this bracket ; Canada (NYSEARCA:EWC). Two of Canada’s strongest sectors (Energy and Materials) make up over 46% of this country’s economy and are the very favored in terms or global positioning. Investing in Canada is a strong way to play rising commodity prices along with a weak dollar. Canada is the largest supplier of oil, natural gas, uranium, and electricity to the U.S. so as we continue to recover and demand increases, Canada stands to also benefit.
Final Four summary:
As I alluded to earlier, the advantage and distinction an investor has in choosing their “Final Four” over that of a basketball bracket is that you need, and should….choose more than one winner. It’s almost too cliché to state that one “shouldn’t have all their eggs in one basket” but I can’t stress this enough. All too many investors get caught up in chasing the most recent winners. If I were to overweight my investments each year based on last year’s winning asset class I would be consistently wrong, frustrated, and eventually broke. Why do so many investors do this?! If you’re ever in line at the grocery store it doesn’t take long to see a financial magazine touting the “10 Must Own Stocks of the Year” or “Hottest Mutual Funds you Need to Buy Now!”. How many of those are actually in the top 10 the next year? Very few… One recent study showed that of all Large Cap funds that beat the S&P 500 Index one year, only 41.6% managed to do it again the following year. After three years that same group had only 9.7% still beating the index. What a fund, index, or advisor did one year (or five) tells you nothing about how the performance will look going forward.
My Final Four is actually very short-term as I believe this year will have several themes continue to play out but there will be some adjustments to asset classes that have seen recent success. In general I see stocks outperforming bonds as one major race this coming year. Breaking that down further, I believe we must have a very healthy weighting towards international equities and in particular countries that are benefitting the most from a global recovery and increased demand. Don’t ignore emerging markets but having exposure to countries like Canada makes sense as it has benefitted from higher global demand for industrial metals and crude oil while still enjoying stable inflation levels.
Speaking of inflation…another Final Four candidate to incorporate into your portfolio is you haven’t already is TBF (ProShares Short 20+ Treasury). When one of the most renowned bond managers in the world, Bill Gross, decides to unload treasuries as quickly as he can…something tells me that his take on the Fed and the direction of Federal Reserve policies might be closer to the mark than off of it. With an impending lack of demand in US Treasuries after QE2 ends this coming June, we’ll see Treasury yields rise and prices fall. Don’t wait for more writing on the wall to be etched in…just hedge your bets a bit within your bond allocations and pay attention to your overall percentage in Treasuries.
Typically we see Small Cap lead Large as economic recoveries take place. Over the past 12 months this has been the case. Going back further the trend also holds true but I’m not here to show you how to look in the rear view mirror. The road ahead is bumpy and in my opinion, the safer route appears to be Large Cap. While there will still be several Small Cap stocks that will continue to outperform I believe that a weaker dollar and a very cheap Large Cap asset class makes this a very attractive place to be. In particular, I would overweight Large Cap exposure to value over growth. Part of managing money is being able to account for mistakes and unforeseen occurences. That said, we may likely easily see Small Caps win out again in 2011 which is why you should retain some exposure. That said, a safer way to play a potential end to this run is beginning to increase Large Cap value stock exposure. About 40% of the S&P 500 Index is comprised of mega-caps which are companies with market caps greater than $100 billion. This group of mega-cap trades at a cheap 12.5 times earnings and also yields an average of 2.2% dividend which beats the average S&P 500 stock at 1.8%. One more fundamental consideration is that if we are indeed headed towards more of a “new normal” and overall economic growth will head towards a slower pace over the next 1-5 years, we would likely begin to see a reversion from Small to Large and from Growth to Value.
In summation, enjoy the game and don’t get hung up one just one team. This year will continue to bring us some upsets and also highlight some of the storied programs. The real winner every year in the “Investing Final Four” is the one who typically has a solid Sweet 16 showing. Take a look at your investment mix now and make sure you have a healthy dose of some of these “teams”. The beauty of the tournament is that within the 16 teams mix, you’ll find a new face like the VCU Rams and an old familiar name even with young players like the Kentucky Wildcats. The same holds true for this years investment bracket with a respective comparison in shorting US Treasuries and holding Large Cap Value.
Disclosure: I am long IVV, EWC, LQD, TBF.