4 Things You Must Do To Protect Your Portfolio From The Next Crash

by: Dividend Monk

Over the past five years, the stock market has pretty much never stopped increasing:

Source: Ycharts

Between June 20th 2012 and June 20th 2017, the S&P 500 total return is getting us a very nice round number of 100%. In other words, the stock market doubled in value over the past 5 years. We are talking here about a compounding return rate of almost 15% per year during this period. Unfortunately, while the market doubled, the average P/E ratio keeps going up, leading me to think there is some bubble growing up:

Source: Factset

In the light of both graphs, it seems obvious the market is going all the way up for the wrong reasons. There isn’t enough value being created at the moment to justify such hikes in price. Does it mean you should sell your stocks and wait on the sideline? This would probably be the biggest mistake you could make. However, this doesn’t mean you have nothing to do to protect your portfolio from a potential crash. Here’s a list of what I’m doing now on my own portfolios:

1. Review your asset allocation to spot any discrepancies

This is a common step that is often ignored by DIY investors. Did you know the biggest source of losses in portfolios are related to asset allocation? Each time I came across an investor who lost lots of money, the common theme was the same: The bulk of their investment was in a single industry. As the stock market rose, some industries did better than others. If you haven’t done much trades in the past year and simply looked at your portfolio growing, chances are you are over weighted in some industries.

Therefore, my first step to review my portfolio is to create a simple Excel pie chart using the company name, sector and current value. Within a few minutes, my pie chart is ready and I get a clear view of what my portfolio looks like:

Source: DSR portfolios returns

You can then easily determine if your asset allocation makes sense or not and identify over weighted sectors where you will need to make transactions.

2. Review each holding with your initial investment thesis

To facilitate the selection of companies to trade, I then review each of my holdings and look at my initial thesis. Each selection in my portfolio has been made based on my 7 dividend investing growth principles. This is a set of seven investing rules based on decades of academic studies and my own experience as an investor. Principle 6 focuses on the importance of having a strong investment thesis before making any purchases. Once you have identified the reasons why you think a company should be part of your portfolio, it makes it easy to follow it throughout time. Each year, I review my investment thesis to make it still make sense today. As an example, here’s my investment thesis for Lockheed Martin (NYSE:LMT):

One of the reasons why I like LMT so much is that it evolves in a quasi monopoly. They obviously have lots of competitors, but LMT has become THE defense company the U.S. government goes to when it comes down to jet fighters for example. Lockheed Martin has done what BlackBerry did a few years ago by controlling the market. Fortunately for them, it is a lot harder to copy an F35 than a smartphone!

LMT clients are closely bonded to them for several reasons. First, the trust between both the client and the company is quite important in this case. We are talking about military defense, you will not change your supplier in a heartbeat! Second, the switching cost for their clients would be incredibly high. Lockheed Martin benefits from several long-term contracts guaranteeing a steady income flow. Those contracts are not easily broken. Plus, LMT owns a unique experience in military defense products and services.

It seems LMT is surfing through the perfect storm. As conflicts are rising around the globe, the Congress accepted Lockheed Martin to seek out for international opportunities. This means the company could enlarge its international sales by doing business offshore.

Source: The Dividend Guy Blog

As long as LMT will go along with my thesis, I will hold onto this stock. If the business model changes or the industry is not the same anymore, I will not hesitate to pull the sell trigger.

3. Use a proper valuation model

My third step is to use a valuation model that will help me making my trading decisions. In my opinion, the investment thesis weights a lot more than any valuation model. The main reason being is any kind of valuation model is as good as your assumptions. Unfortunately, it is very easy to make mistakes.

I use a double stage dividend discount model. As a dividend growth investor, I rather see companies like big money making machine and assess their value as such. I think the company will reduce slowly its dividend growth rate compared to previous years as it is clearly unsustainable. Here’s an example of metrics I used to value 3M Co (NYSE:MMM), another of my favorite holdings.

And the calculation results:

Source: Dividend Monk Toolkit Excel Calculation Spreadsheet

The Dividend Discount Model doesn’t own all the answers, but it is a very powerful tool to asses the value of a stock while it is included in a complete investing process.

4. Make trades, but don’t panic

I know, the temptation of selling your stocks with profit and waiting on the sidelines for the next market dip is very seductive. However, as we never know how Mr. Market’s mood swings will affect our portfolio (we could definitely see another bull market for the next 3 years), I'd rather have most of my money well invested and cash dividend payouts every month.

The key is to make light changes, tweaks, to your portfolio to make sure your money is well invested. This is not a time to panic nor to sell everything you hold. I personally did one trade so far in my portfolio as one of my holdings didn’t meet my investing thesis anymore. I might do another one but that’s about it. It’s never a good move to panic or make massive move with your portfolio.

Disclaimer: I hold LMT & MMM