'Index? We Ain't Got No Index. We Don't Need No Index. I Don't Have To Show You No Stinking Index.'

by: David Crosetti

Many investors believe that benchmarking their portfolio against an Index is important.

Index comparisons, however, are more meaningful with the element of time.

Beating an index alone is not always the objective that is most important to an investor.


Before I went on my last road trip, I had an article published on August 7th, which focused on The Perfect Portfolio and how happy I was about how the portfolio had been doing year to date.

As a little back story, the premise behind The Perfect Portfolio has nothing to do with this portfolio being "perfect" in any way other than one. It was created to supplement my mother's income after CD rates fell off the table as a viable income alternative.

The portfolio was designed for two functions. First, it was designed to replace interest income from CDs with a yield that was above prevailing interest rates at the time we began the process.

Secondly, it was designed to have that income, derived from dividends, to increase, annually at a rate that was greater than inflation.

The portfolio has accomplished both of those primary goals and thus, in that regard, it is The Perfect Portfolio. Please don't read anything into that name, other than the fact that the portfolio did exactly what we wanted it to do.

Could we have accomplished the same ends with a different strategy? Perhaps. But, this is the one we chose and this is the one we will continue to use as we move forward.

What You Should Know:

There are two parts to this portfolio.

The first part consists of a group of stocks that we accumulated in 2009, 2010, and 2011. These companies are standard fare for Dividend Growth Investors.

The companies that make up this part of the portfolio are: AbbVie (NYSE:ABBV), Abbott Labs (NYSE:ABT), Colgate Palmolive (NYSE:CL), Chevron (NYSE:CVX), Intel (NASDAQ:INTC), Johnson and Johnson (NYSE:JNJ), Kimberly Clark (NYSE:KMB), Coca-Cola (NYSE:KO), McDonald (NYSE:MCD), Altria (NYSE:MO), Microsoft (NASDAQ:MSFT), Procter and Gamble (NYSE:PG), Reynolds American (NYSE:RAI), AT&T (NYSE:T), Verizon (NYSE:VZ), and Exxon Mobil (NYSE:XOM).

The second part consists of a group of companies that we have been adding to this portfolio, beginning in February of this year, 2016.

The companies in this part of the portfolio are: Cisco Systems (NASDAQ:CSCO), JP Morgan Chase (NYSE:JPM), Emerson Electric (NYSE:EMR), International Business Machines (NYSE:IBM), Qualcomm (NASDAQ:QCOM), Archer Daniels Midland (NYSE:ADM), Harley Davidson (NYSE:HOG), Monsanto (NYSE:MON), Marathon Petroleum (NYSE:MPC), Schweitzer Mauduit (NYSE:SWM), and Western Digital (NYSE:WDC).

Comment Stream:

In the pre-road trip article, the comment thread was really good and spirited, but civil. Some of the more interesting comments really caused me to give some thought to this portfolio and how we are doing with it, year to date, so I wanted to take this opportunity to look at some of those comments.

There seemed to be a couple of lines of thought that presented themselves over and over during the comment threads.

The First Line of Thought:

The first line of commentary centered on the performance of The Perfect Portfolio as compared to dividend oriented mutual funds and ETF's (exchange traded funds).

Both VIG & VYM have outperformed you YTD with expense ratios under 0.1%. The portfolios of most authors I'm reading on dividend & dividend growth investing right now are up 15%-17% YTD. It all depends to what you are comparing your returns.

NOBL and SDY are up about 14 to 18% year to date. A good year for indexers and index replicators-that's most everyone has.

The four overwhelmingly largest dividend-focused ETFs have generated a total return between 11% and 18% year to date. (SDY, VYM, VIG, DVY.) The ETFs are passive indexes, blind to valuation opinions, company research, investor goals, and Warren Buffet quotes. Note that the VYM ETF includes 427 stocks, which is 85% as many stocks as the S&P 500.

The Second Line of Thought:

The second line of comments centered around the notion that "stock picking" based on stock valuation methods is at best, a difficult task for most investors and one that would be better served by indexing to avoid the excessive PE Ratios that many stocks are throwing off, today.

David you are making claims about valuations ... "The "trick" to successful investing is to find those companies that are priced at a level that represents them being "undervalued." But then you write ..."PE, other than that, to me, is just one metric and in and of itself is relatively worthless to me." I think you're either in or you're out? Ha. Is it the KEY or is it worthless?

David, comparing to an index allows readers to observe if there's any talent or ability on display. And if your objective is income and income growth, why would you or other income investors worry about a PE of 18 vs a PE of 20. The difference would have no effect on your income? You would concern yourself with the E but not the P others will pay.

You are claiming to know when companies are undervalued, to measure that, we go back to an appropriate index, and it's about the price you pay for earnings. It's then about the total return. We can measure, and have our answer. All said, again, I love your simple approach.

The Third Line of Thought:

And the third line of comments suggested that with the market at "all-time" highs, a prudent strategy might be taking some profits off the table, or exiting the market altogether, because "losing money" is not a very attractive investment option.

As for the stocks in your portfolio, I would sell most of them now if I had them. PG, KO, VZ, T, etc. Seem to be at very stretched valuations. While overpriced stocks sometimes get even more overpriced, that is not a game I want to play. Imo you should consider at least reducing some of your winning positions with stretched valuations, and investing the money in foreign stocks, especially mining related ones.

Trying to time the market or individual stocks perfectly is very hard, however there are periods when certain stocks seem very overpriced and should be sold. Sometimes they do go up further, but on average those stocks don't do so well after becoming very overpriced.

Here's What I Know:

It is difficult to address more than one subject in a typical Seeking Alpha article. So, what I would like to do is take a look at each of these "lines of thought" relative to The Perfect Portfolio and encourage a discussion with those following the article, relative to each of the "lines of thought."

There are a lot of people who come to Seeking Alpha articles, who feel very strongly about using an index of some kind, as a "benchmark" against portfolio performance. Generally speaking, I don't use an index to benchmark my portfolio. In my opinion

But regardless of my opinion, there are some things that you have to keep in mind about indexing.

You cannot beat the market by investing in an index. The best you can do is "match" the market that you are indexing. Fees and expenses will keep you from a spot on match. But as a comparative tool, there is some value.

Indexes give you a comparative performance metric, relative to your own stock market portfolio. If you go to Johnstown, Pennsylvania, you will see signs on buildings. Those signs represent and tell you about the great Johnstown Flood and where the "high water" mark was, back in 1889. So in the same way, and index gives you a look at the high water mark for a given period of time.

The greatest flaw in benchmarking with an index, is to find an index that actually matches your own investment style and strategy, to use as the benchmark. If, for example, the stocks you hold mirror the S&P 500 Index, it might be appropriate for you to benchmark, using that index. But if you hold dividend paying stocks that happen to be in the S&P 500 Index, perhaps you would be better served by using an ETF like NOBL which is an index of stocks that make up the Dividend Aristocrats (S&P member companies that have increased dividends for 25 years in a row or longer).

But that can present an issue. Let's say that you hold stocks that have increased dividends for only 5 years in a row. What then? Again, you have to look at your portfolio to benchmark against the most appropriate "surrogate" that you can find, relative to your own specific portfolio.

Even more important when using a benchmark as a comparative tool, is to benchmark relative to the same time periods for you investment. For example, if you look at the performance of an index for the period, "year-to-date" (Jan 1-current), you have to also consider the length of time that you've held a given stock in your portfolio, relative to that time period.

So, How Are We Doing Relative To Indexing?

When we consider the portfolio as of Sept 30, 2016, we get the following results. The original holdings are up 6.90% year to date.

The new holdings are up 17.38% year to date.

The combined portfolio is up 7.83% year to date.

The Index Scoresheet Through Sept 30, 2016:

When we look at the different index investments that people like to use as benchmarks, we see the following results.

As you can see, our original stocks performed with an increase in value of 6.90%, year to date, while the indexes performed with low of 6.14% and a high of 14.67%.

When we look at the new additions of companies in our portfolio, we have an increase in value of 17.38% vs. the indexes performance that run from 6.14% to 14.67%. So, I guess you can say that the new additions trounced the indexes.

When we combine the two portfolios (the old and the new) the numbers change. The combined portfolio has an increase in value of 7.83% which has been beaten by all of the index benchmarks, except for SPY and we are very close to matching VIG.

So, there you have it.

But As They Say In the Infomercials, "But Wait, There's More":

The purchases made of the new additions did not take place on December 31, 2015 but actually have been made at dates later than that. So comparing those purchases to a year to date seems a bit counterproductive.

How have the new selections done when we look at "purchase date" through the same end date of September 30th? Glad you asked.

Our first purchase in 2016 was Cisco Systems on February 8th:

Our next purchase in 2016 was JP Morgan Chase on February 11th:

Then on March 14th, we made three purchases. We bought Emerson Electric , International Business Machines , and Qualcomm :

On April 22, we purchased two additional companies. We bought Archer Daniels Midland and Harley Davidson :

On April 28th, we purchased four additional companies. They were Monsanto , Marathon Petroleum , Schweitzer Mauduit , and Western Digital :

But What Does It All Mean?

The objectives (goals) of The Perfect Portfolio are to add income to my Social Security Benefit. Since I am going to pay taxes on the dividends paid (this is a taxable account), it seems to me that taking the dividends and paying the taxes is preferable to my own situation, rather than reinvesting the dividends and still having to pay the taxes anyway.

Secondly, The Perfect Portfolio is designed to have income from dividend payments increase annually. The target that we have set for dividend increases is 6% or better, annually. We have met that objective and with our new holding as well as some adjustments that we plan on making within the portfolio, we should be able to maintain that 6% target moving forward and even beat that target by looking at companies that are in the early stages of dividend growth (Dividend Challengers and Contenders).

Third, there is an old saying, "It's not about market timing, it's time in the market."

Our stock selections are companies that we want to hold for a long time. The original holdings are companies that we bought in 2009, 2010, and 2011. We did not purchase them in order to sell them. We bought them so that we could be partners with those companies, no matter how small a percentage that partnership really is.

Fourth, we want to have an income stream from dividends that is greater than the available interest rate from more normalized investments, like Certificates of Deposit. (The old reliable). We understand the additional risk in equities, but going back to a premise that we've shared time and time again, there is no reason to chase yield and there is no reason to purchase any company just because of the dividend. There needs to be more "there" there.

In Conclusion:

Not to belabor the point, but when we look at time in the market, comparing our results to various index investments also requires that impact of time.

While our new stock additions have handily trounced each of the major indexes, relative to the purchase date through the ending date of September 30th, the time period involved makes the comparison somewhat irrelevant.

While in recent months (year to date) our original stock selections have not, as a group, beaten all the indexes, the performance changes dramatically when we examine the purchases made in each block of purchases, starting in 2009 and through 2011.

Looking at those purchases as "units" relative to the indexes are quite illuminating and very satisfying.

Disclosure: I am/we are long ABT ABBV CL CSCO JPM CVX EMR ADM HOG IBM JNJ KMB KO MCD MON MPC PG QCOM RAI MO SWM T VZ XOM MSFT INTC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.