2016 Investment Candidates Delivered 10% Alpha And 2017 Tactical Investing Considerations

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Includes: BRK.A, CHL, CVX, DJI, FXI, JPM, MKL, RDS.A, SPY, VFIAX, VWO, XOM
by: Tim Butler

Summary

Eight early 2016 investment candidates delivered a 22% return on investment a year later and a 10% alpha.

Distinguishing long-term investments vs. speculative trades.

Some speculative trading in a retirement account can be a good thing.

Helpful ratios for a taxable investment account concerning sell discipline.

A year ago, I wrote an article here on Seeking Alpha citing two high-quality companies and six bottom-fishing candidates for investment. 2016 had started with the Dow Jones Industrials (DJI) down 900 points and the S&P 500 (NYSEARCA:SPY) down 100 points in the first four trading days of the year.

The eight investment candidates were: Berkshire Hathaway A (NYSE:BRK.A), Markel (NYSE:MKL), Exxon (NYSE:XOM), Chevron (NYSE:CVX), Royal Dutch Shell A (NYSE:RDS.A), iShares China Large Cap Fund (NYSEARCA:FXI), China Mobile (NYSE:CHL) and Vanguard FTSE Emerging Markets Index ETF (NYSEARCA:VWO).

Now, a year later, the eight investments produced a 10% alpha and 22% return on investment, including dividends, equally weighted, as shown in the table below.

Ticker

07 January 2016

10 January 2017

Dividends

Inv Appr

ROI w Div

BRK.A

$194,100

$242,079

0.0%

24.7%

24.7%

MKL

$841

$897

0.0%

6.6%

6.6%

XOM

$76

$86

3.8%

13.1%

16.8%

CVX

$83

$115

4.7%

38.5%

43.2%

RDS.A

$42

$54

4.5%

29.5%

34.0%

FXI

$32

$36

2.1%

13.3%

15.4%

CHL

$51

$54

3.5%

6.8%

10.3%

VWO

$30

$37

3.2%

22.9%

26.1%

Average

22.1%

S&P 500

11.9%

Alpha

10.3%

Source: Yahoo Finance, Vanguard

For the underlying investment reasoning in early 2016 on Berkshire and Markel, I quote from the article published January 10, 2016:

"Berkshire at 1.3x book value, with Mr. Buffett's buyback policy at 1.2x book value, is a genuine bargain and great long-term investment candidate. Markel's consistent, long run, 20-year historical and 2015 outperformance makes it a solid investment candidate for the future, and it's the best of the baby Berkshires."

The investment rationale for the oil companies, China and Emerging Markets was that oil was unlikely to stay in the (prevailing in January 2016) $25-30 per barrel range for the long haul, and that the oil companies, China and Emerging Markets had already been severely price discounted, creating attractive bottom fishing opportunities. The results a year later: all eight investments were up, with six producing a positive alpha.

It turns out that the 22% Return on Investment and 10% Alpha produced over the last year by these 2016 eight investment candidates matched my 2016 investment return on my retirement account. Even better, longer-term investment horizon returns have produced a consistently positive alpha:

31 December 2016

1-Yr ROI

5-Yr ROI

10-Yr ROI

15-Yr ROI

S&P 500

11.9%

14.6%

6.9%

5.2%

SEP IRA

22.8%

18.4%

9.7%

7.3%

ALPHA

10.9%

3.8%

2.8%

2.1%

Source: Vanguard, Vanguard 500 Index Admiral Shares (MUTF:VFIAX), SEP IRA year-end brokerage account statements, unaudited. Note that the S&P 500 15-year return is based on the inception date for Vanguard's VFIAX mutual fund of November 13, 2000.

For Seeking Alpha readers looking to 2017, who are self-directed in making investment decisions, and manage their own individual and retirement accounts, as I do, I want to share a few tactical investing points, suggestions or methods, based on my own experience over the last decade, and I do look forward to your comments.

Distinguishing Long-Term Investments vs. Speculative Trades

In considering a purchase investment decision, I find it helpful to distinguish, be and remain keenly aware as to whether I am making a long-term investment, or a speculative trade. An investment is a year at a minimum, probably 3-5 years, and perhaps, forever. A speculative trade might be as little as a week, normally weeks to months, and typically less than a year.

Berkshire and Markel are examples of investments, which I do not intend to sell. Speculative trades on the upside include stocks, covered call options to generate income, and LEAP call options for levered capital appreciation. On the downside, and rarely, inverse indexes, protective puts, and naked puts where I would be happy to be executed at the lower price.

Some Speculative Trading In A Retirement Account Can Be A Good Thing

A professional colleague recommended to me about 10 years ago, that if I was going to trade (i.e., speculate), it should be done primarily in a non-taxed retirement account, precisely because the retirement account is not taxed until retirement. The math made sense immediately. However, my gut instinct was to be conservative with my retirement account, and therefore, not speculate by trading.

It took me years to overcome this gut instinct. Writing short-dated, out-of-the-money covered call options is fundamentally conservative. Moreover, in a retirement account, if the trade goes bad and the underlying stock is called away, there are no capital gains taxes to be paid, and one can buy the stock back the next Monday morning. Buying select LEAP call options, which leverage your investment, are likely to produce outsized returns to the upside or downside. However, they are more conservative than using margin debt for leverage in an individual account.

So I have come around to the view over the last five years, that some speculative trading in my retirement account can be a good thing. I reviewed the numbers for 2016 in my retirement account. 31% of the gains for the year came from speculative trading, while 69% came from long-term investments. Stated differently, but equivalently, 7% of my 22.8% return on investment for 2016 came from speculative trading, which is roughly three quarters of the alpha.

Helpful Ratios For An Individual Taxable Investment Account Concerning Sell Discipline

If you keep a spreadsheet to track your investment portfolio positions, here are two ratios to be added as columns, which I find helpful in managing my individual taxable investment account, particularly where I have long-term embedded capital gains:

  1. Yield On Cost (%) - defined as (Current Annual Dividend Rate Per Share) divided by (Cost Per Share).

  2. Breakeven Price Per Share, If Sold Today ($) - defined as (Current Price Per Share) minus (Position Paper Capital Gain or Loss in Dollars times Effective Capital Gains Federal + State Combined Tax Rate divided by Number Of Shares Owned).

I'm well aware that the first is simple, while the second is more complex. So I will walk you through both ratios with an example.

Yield on Cost tells you your current annual dividend yield, based on your historical cost per share, and can be helpful in reminding you of the actual dividend yield you are receiving this year on your position, in contrast to the current commonly cited dividend yield, which is based on today's price per share.

For example, JPMorgan Chase's (NYSE:JPM) current dividend is $1.92 per share per year, with a current dividend yield of 2.2% based on a recent price of $86 per share. However, since I bought JPM in December 2011, my current Yield On Cost is 5.7%. I find this Yield On Cost figure helps in deterring me from any considerations about selling.

Breakeven Price Per Share, If Sold Today - is even more helpful, even if the math is a little more complex, because it tells you the after capital gains taxes Price Per Share that you are actually receiving, if you sell today, notwithstanding the currently quoted price per share you are seeing on your screen.

Estimating your Effective Capital Gains Federal & State Combined Tax Rate is not easy, but it is a worthwhile exercise. Consider calling your accountant or doing your own research. The calculation is easier for investment positions which you have held for more than a year, because the long-term capital gains rate applies to the federal portion of the contemplated gain. Differences in income levels and state tax rates complicate the calculation. In general, for long-term holdings of more than a year, the Effective Capital Gains Federal + State Combined Tax Rate will be somewhere in the range of 15% to as much as 28% depending upon your state and income level.

Again, an example may be helpful to see and understand the benefit of the Breakeven Price Per Share, If Sold Today. Let's say JPM is trading at $86 per share, as it has been recently. Let's say I'm contemplating selling. The Breakeven Price Per Share, If Sold Today calculation instantly tells me that, in my case, because I have sizable long-term embedded capital gains since I bought JPM in December 2011, I would actually be receiving $78.15 per share after paying the capital gains taxed. The $86 price quote I see on the screen is really $78.15 for me after tax.

If JPM does not fall below $78.15 I lose money if I sell it at $86. JPM would have to fall well below $78.15 to make it attractive for reinvestment. Thus the benefit of the Breakeven Price Per Share, If Sold Today calculation is that it aids me in my sell discipline decision making, as does the Yield On Cost calculation.

To be clear, I remain invested in JPM. I have not and will not trade the stock in the near term. The example given was to illustrate the benefits of the two ratios, specifically in developing one's sell discipline. Comments welcomed, and happy long-term investing.

This is not investment advice. Instead, it's commentary on historical stock market returns and tactical investing methods. Do your own research and make your own decisions.

Disclosure: I am/we are long BRK.A, BRK.B, MKL, JPM.

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.