The Hidden Fault Lines Of Your Portfolio

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Includes: ABBV, ADP, AMGN, APLE, ARCC, ARI, BA, BDX, BP, BXMT, CAH, CL, CLDT, CMI, CNP, CSCO, CVS, CVX, D, DEO, DLR, DNP, FE, GAIN, GIS, GPC, GWW, HAS, HD, HTGC, JNJ, KHC, KMB, KO, LADR, LMT, LNT, LXP, MA, MAT, MCD, MDLZ, MDT, MET, MGEE, MMM, MO, MRCC, NEWT, NHI, NKE, NRZ, O, OHI, OXY, PEP, PFE, PG, PM, PSEC, RDS.A, RDS.B, SBRA, SBUX, SNR, SO, SPG, STAG, STWD, T, TEVA, TGT, TROW, UBA, UL, UNP, V, VFC, VLO, VTR, VZ, WEC, WELL, WPC, WPG, XEL, XOM
by: Bram de Haas

Summary

Fellow contributor RoseNose has strong convictions: Real Estate and Utilities will do well.

She also has something of a nose for great management teams and put together a portfolio trading at a 17% earnings discount to the S&P 500, paying out 2x the.

Is there a catch? What would that be?

My well respected fellow contributor RoseNose recently published her 86 stock portfolio for 2017. It takes guts to publish your entire portfolio on the Seeking Alpha platform. A portfolio can be very personal. It is often an expression of someone's worldview and beliefs. Rose's definitely is or at least that's how I read it. I do think there runs something of a hidden fault line through it and that's why I want to highlight it for discussion:

Company Name

C R

curr $pr

%P/V

%P/I

CONS-Staples (14)

20.7

16

Colgate-Palmolive

(NYSE:CL)

AA-

67.36

CVS Health Corp

(NYSE:CVS)

BBB+

82.2

Diageo plc (ADR)

(NYSE:DEO)

A-

106.39

General Mills, Inc.

(NYSE:GIS)

BBB+

61.47

Kraft Heinz Co

(NASDAQ:KHC)

BBB-

86.31

Kimberly Clark

(NYSE:KMB)

A

116.43

The Coca-Cola Co

(NYSE:KO)

AA-

41.74

Mondelez

(NASDAQ:MDLZ)

BBB

45.06

Altria

(NYSE:MO)

A-

68.23

PepsiCo, Inc.

(NYSE:PEP)

A

104.56

Procter & Gamble

(NYSE:PG)

AA-

85.03

Philip Morris Int

(NYSE:PM)

A

91.84

Target

(NYSE:TGT)

A

71.44

Unilever

(NYSE:UL)

A+

40.94

CONS-D (8)

6.5

3.6

Genuine Parts

(NYSE:GPC)

A+

96.16

Hasbro

(NASDAQ:HAS)

BBB

82.87

Home Depot

(NYSE:HD)

A

133.53

Mattel

(NASDAQ:MAT)

BBB

30.47

McDonald's

(NYSE:MCD)

BBB+

120.76

Nike

(NYSE:NKE)

AA-

53.91

Starbucks

(NASDAQ:SBUX)

A

57.13

VF Corp

(NYSE:VFC)

A

53.18

ENERGY (7)

6.6

6.3

British Petrol

(NYSE:BP)

A-

37.91

Chevron

(NYSE:CVX)

AA-

116.84

Occidental Petr

(NYSE:OXY)

A

71.08

Royal-D Shell-A

(NYSE:RDS.A)

A

55.79

Royal-D Shell-B

(NYSE:RDS.B)

A

58.91

Valero Energy

(NYSE:VLO)

BBB

66.66

Exxon Mobil

(NYSE:XOM)

AA+

88.5

FINANCIAL (8)

5.4

6.9

Apollo Com R E finance

(NYSE:ARI)

44

17.06

Blackstone Mortgage

(NYSE:BXMT)

70

30.91

Ladder Capital

(NYSE:LADR)

56

13.89

MasterCard

(NYSE:MA)

A

107.76

Metlife

(NYSE:MET)

A-

54.18

New Residential

(NYSE:NRZ)

53

15.96

T. Rowe Price

(NASDAQ:TROW)

A+

75.62

Visa

(NYSE:V)

A+

82.21

BDC (6)

4.1

8.8

Ares Capital

(NASDAQ:ARCC)

BBB

16.91

Gladstone Inv

(NASDAQ:GAIN)

41

8.56

Hercules

(NASDAQ:HTGC)

BBB-

14.41

Monroe Capital

(NASDAQ:MRCC)

37

15.77

NEWTEK Busines

(NASDAQ:NEWT)

39

16.68

Prospect Capital

(NASDAQ:PSEC)

BBB-

8.58

HEALTHCARE (8)

8.6

6.1

AbbVie

(NYSE:ABBV)

A-

63.79

Amgen

(NASDAQ:AMGN)

A

156.78

Becton Dickinson

(NYSE:BDX)

BBB+

167.89

Cardinal Health

(NYSE:CAH)

A-

75.33

Johnson & J

(NYSE:JNJ)

AAA

116.3

Medtronic

(NYSE:MDT)

A

72.87

Pfizer

(NYSE:PFE)

AA

33.48

Teva

(NASDAQ:TEVA)

BBB

35.1

INDUSTRIAL (6)

5.3

3.6

Boeing

(NYSE:BA)

A

159.1

Cummins

(NYSE:CMI)

A+

138.72

W.W. Grainger

(NYSE:GWW)

AA-

231.5

Lockheed Martin

(NYSE:LMT)

BBB+

257.85

3M Co

(NYSE:MMM)

AA-

178.23

Union Pacific

(NYSE:UNP)

A

103.19

TECH (2)

2.3

1.5

Automatic Data

(NASDAQ:ADP)

AA

103.11

Cisco Systems

(NASDAQ:CSCO)

AA-

30.23

TELE-COM (2)

7.9

8.3

AT&T

(NYSE:T)

BBB+

41.32

Verizon Comm

(NYSE:VZ)

BBB+

53.26

UTILITIES (9)

14.6

13.2

CenterPoint

(NYSE:CNP)

A-

25.36

Dominion

(NYSE:D)

BBB+

76.9

DNP Fund Inc.

(NYSE:DNP)

10.4

FirstEnergy Corp.

(NYSE:FE)

BBB-

31.13

Alliant Energy

(NYSE:LNT)

A-

37.8

MGE Energy

(NASDAQ:MGEE)

34

64.6

Southern Co

(NYSE:SO)

A-

49.01

WEC Energy

(NYSE:WEC)

A-

58.78

Xcel Energy

(NYSE:XEL)

A-

40.92

REAL ESTATE

Healthcare (6)

7.2

11.2

Care Capital Prop

(NYSE:CCP)

BB+ 55

25.35

Welltower

(NYSE:HCN)

BBB+

68.45

Nat Health Inv

(NYSE:NHI)

47

74.45

Omega Health

(NYSE:OHI)

BBB-

32.67

New Senior Inv

(NYSE:SNR)

78

10.13

Ventas

(NYSE:VTR)

BBB+

63.05

REAL ESTATE

Misc (11)

10.8

14.5

Apple Hospitality

(NYSE:APLE)

27

20.07

Chatham Lodging

(NYSE:CLDT)

45

20.23

Digital Realty

(NYSE:DLR)

BBB

104.04

Lexington Realty

(NYSE:LXP)

BBB-

11.05

Realty Income

(NYSE:O)

BBB+

59.84

Simon Property

(NYSE:SPG)

A

186.83

Stag Industrial

(NYSE:STAG)

BBB

24.41

Starwood Trust

(NYSE:STWD)

BB 57

22.45

Urstadt Biddle

(NYSE:UBA)

0

23.93

W.P. Carey

(NYSE:WPC)

BBB

61.25

Wash Prime Grp

(NYSE:WPG)

BBB-

10.71

87 Total

100

100

Source: Rose Portfolio

When I reviewed it I immediately thought:

  • Aggressively betting rates won't be raised
  • U.S. Ftw
  • Attempts to limit volatility
  • Lots of bets but expressing the same ideas

Which is completely fine with me if that's what you want to bet on.

But after reading the comment section I got the impression the author nor many of her readers are aware they are looking at a very aggressive portfolio that is expressing an extremely strong conviction that rates will rise less than expectations.

I ran the portfolio through the Morningstar X-Ray tool to get a clearer understanding of the portfolio. I wanted to equal weight every position but the tool is a bit of a hassle so the weight assigned to positions actually varies from 1.02% - 1.34%. Rose's actual portfolio has different weightings and Morningstar's conclusions may not be applicable but they will do for discussion purposes.

For this article I'll try to stick to objective observations. Take note Morningstar takes the S&P 500 as a benchmark which isn't something we should blindly accept but Rose employs it herself too so let's roll with it.

First observation: there are no bonds which is great as those would make the portfolio even more vulnerable to rate hikes and I think it's about the worst asset there is but it is a high conviction bet, if wrong the portfolio will suffer.

Rose runs a portfolio without a clear style designation which is fine. I'd say there is a value bent (which I view as a very good thing) but Morningstar thinks it is mostly a core portfolio because the largest allocation is in core large caps. If you view the table below you'll see the total allocation towards value beats the allocation towards core. There is also a clear preference for large companies visible:

rose1.jpg

Source: Morningstar, edited in green by author

Something that surprised me is how strong the management teams for the portfolio companies are. I'm not sure if Rose emphasizes this or it is correlated with another selection criteria but Morningstar rated many management teams as Exemplary and most Standard. While rating only one (AT&T) as Poor.

Source: Morningstar

When we review the stock stats, the value bent is also clearly reflected with the average stock in the portfolio trading at 16x prospective earnings which is a 17% discount to the S&P 500 average, P/B is also quite a bit below the S&P 500 but that's less surprising due to the high conviction sector bets.

The portfolio pays out almost two times the yield on the S&P 500 which is quite a feat to pull off while Rose is giving up virtually nothing in terms of projected EPS growth. It can be partially explained by the poor RoA figures which suggest the companies in this portfolio are highly leveraged.

rose2.jpg

Source: Morningstar

The portfolio contains 94% U.S. stocks. The few stocks that are located outside of the U.S. are oil majors which don't behave all that different from an Exxon or Chevron I would imagine. As an aside, I'm fine with oil majors (RDS over Exxon) but having so many does unbalance the energy bet a little bit. The tilt towards large caps does mitigate the U.S. bias to an extent as large caps tend to make a sizeable chunk of their money globally.

rose3.jpg

Source: Morningstar

The portfolio is heavily into cyclicals although this is offset by an increased exposure to defensives. The extremely large bets on real estate and utilities are conscious choices but greatly increase the likelihood of a large future deviation from the S&P 500. You may want to read this white paper on utilities by Horizon Kinetics.

One reason I'm writing this article is that I question whether some readers understand how aggressive this portfolio is. Not just because of the 95% U.S. allocation, the 100% stock allocation, the 60% allocation towards large caps or the 25% allocation to real estate but also because of the huge underlying bet on FED rates not getting hiked as much as the market expects them too.

The massive allocations towards utilities, Business Development Companies and REITS are all expressing this view as these are sensitive to rate hikes. Not to mention the defensive high yield plays which are often viewed as bond alternatives and could behave that way as well.

There are very few holdings that offset this view. There are a few financials but mostly of a type that don't benefit much from rate hikes like Visa, Mastercard and T Rowe Price.

It's perfectly fine with me if you put it all on red, expecting red.

But if you are trying to create something of a "traditional" income portfolio (admittedly a tremendous challenge these days) while diversifying vigorously, paying attention valuation, paying attention to credit rating and the quality of business you may still inadvertently be betting on red without realizing.

Diversification, after all, is not how many different things you own, but how different the things you do own are in the risks they entail.

-Seth Klarman

The end result is a portfolio that's extremely dependent on the U.S. It's vulnerable to rate hikes especially in combination with credit availability drying up. The high leverage mainly through BDCs and REITs is a major cause. Something that worries me is how U.S. large caps have been subject to the major share of ETF flows:

With ETF's having exploded in popularity and money mostly going towards U.S. large cap this may be distorting valuations:

The evidence is mounting that passive investing has increased the valuations of the stocks going into the index as well as the correlation of the constituent stocks.

Many people find safety in familiarity but if the above characterization is correct, overweighting large cap creates vulnerabilities.

A portfolio like this may very well outperform in most years based on its positive characteristics like a value factor bent and carefully selected quality stocks at a good price. The leverage at the company level also helps, as well as the tailwinds of the ETF inflows.

Unfortunately, I would also expect it to blow up (-50% or worse) under the wrong circumstances and I wouldn't want that to come as a total surprise to anyone.

Think you might have some hidden fault lines in your portfolio? Send me the ticker symbols and preferably also weight of your holdings and I'll pick out several portfolios to write about, which will also give you the benefit of wisdom of the crowd as the most valuable feedback is often found in the comments. I'll publish portfolios without names.

Disclosure: I am/we are short SPLV.

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.