Single Portfolio Cannot Do Multiple Jobs - Weekly Blog #502

by: Mike Lipper, CFA

Introduction

Would you choose to go to a pharmacy that had only one medicine, a plumber who had only a wrench, or an auto repair shop that had only a screwdriver? My guess is no, you would want a reasonably complete set of tools with some being alternatives to a given general solution. Yet most individual investors and many institutional investors gather their securities investments in a single portfolio and report to themselves and others in terms of a single performance result for the most current period.

This is similar to going to an inadequately supplied pharmacy, plumber, or auto repair shop! For this very need, I have developed a different way of arranging investments. My preferred structure is based on the timespans that investments specifically need to perform in terms of cash generation and asset price performance. This structure, TIMESPAN L Portfolios®, leads to the way I examine all of the various inputs to making investment decisions including the weighting of buy, sell, and holding choices. Thus, I am continually looking to solve simultaneous equations with multiple unknowns to drive specific solutions.

TIMESPAN L Portfolios

I am using four separate portfolio structures as filters to examine inputs. (I would be happy to discuss with subscribers the various inputs as they may apply to their portfolio structures, which are mentioned.)

Current Or Operating Portfolio

This is the portfolio that must need current operating payment needs. For far too many this is their only focus. Current price performance becomes paramount to all of their investment thinking. In these nanosecond responses to news/rumors, global marketplaces speed to change directions that may be more important than the depth of thought. For example this weekend there are two inputs that can shape actions. The first is that on Friday, December 15th, the NASDAQ Composite's price broke out of a month-long constrained price pattern.

For some this may be a bullish event. For most of this year the combination of mid and small technology companies plus the well known FAANG companies were driving the major stock market indicators. For the last month while the Nasdaq was flat, the Dow Jones Industrial Average and the S&P 500 were rising.

There was a worry that if the performance leader was not moving higher, the followers would eventually stall as well. Thus, the Friday breakout could be viewed as important. This is particularly true because in the week that ended Thursday night, the only US Diversified Mutual Fund averages to decline were those of the Mid and Small market-caps, excluding the Short Biased funds, which also declined.

The second input was the volatile American Association of Individual Investors' weekly survey showed a major jump of bullish investors to 45% of their sample compared with 37% and 36% the weeks before. The progress of the US tax bill was probably the cause for the surge. I personally find this as extremely premature.

As of Sunday, I have not seen the conference committee's full draft. There is still room for some changes as both houses pass a bill. As a practical matter, until we see the implementing regulations, which are likely to be more complex than the bill itself, we won't be able to carefully apply the bill to our own taxes. Relatively soon, there is likely to be a Tax Corrections Act plus there is a good chance that tax and/or civil courts will modify the regulations.

Both of these inputs are speculative but give support to the bulls near term.

Replenishment Or Presidential Cycle Portfolio

This is an unusual portfolio device to replace the funds allocated to the operating portfolio that have been expended to meet the current needs of the account. Its time frame pivots on probable changes. These changes may be in terms of political or corporate leadership. The second element would be significant if the bulk of the investments are concentrated in companies with critical roles to their success leaders.

At the moment, this portfolio has the biggest hurdles to climb. In the normal course of market history, it is reasonable to expect to see a stock market price decline and recovery in periods of four to seven years. Currently, it appears we are building toward a peak. The very inputs mentioned for the Current/Operational Portfolio shows signs of providing the missing enthusiasm, which is present immediately prior to a peak.

One of the ways to get stock buyers to join in on the rise is to suggest that the rise is not a cyclical phenomenon but part of a long-term growth trend. We are already seeing broker's headlines declaring "Global Economy Stronger for Longer." We are also seeing earnings estimates going out to 2020-2022.

As a young junior analyst struggling to come up with annual earnings estimates, I became apprehensive when I started to see the justification for buying certain stocks on the basis of their purported five-year projected price/earnings ratios after a "hockey stick" type of growth pattern. The result did not turn out well. We are now seeing estimates that global stock markets may reach levels of $100 Trillion and at least one company expected to reach the $1 Trillion level.

US investors are not blind to all of the risks in today's marketplaces. Their aggregate response to these risks is to invest outside of this country. The largest single net flows this year are into International/Global Equity mutual funds and ETFs, with the latter being driven by institutional owners. Perhaps it is warranted as most markets are selling with price/book value prices below those in the US. (There may be less massaging the book values than the reported earnings.)

Endowment Or Post-Decline Portfolio

I believe it is reasonable to assume that there will be both a stock market decline and a recovery, which eventually will lead to much higher price levels. There are two keys to benefiting from this prediction. The first is the careful management of assets going into the peak and recovery cycle and the second is to benefit from the probable change in market leadership.

The endowment period is probably as long as the youngest decision maker is in that position, but likely more than ten years.

Typically, new leadership comes from overlooked companies and sectors that have gone through major structural changes during the peak/decline cycle. This is often the type of period where prior momentum plays lose ground to contrarian plays. I have two examples of this thinking. The first could be Britain. Because of necessity, the UK comes out of BREXIT stronger than when it entered the divorce procedures. As is often the case, the winners could be centered in the mid and small-cap domestic-oriented companies.

The second good endowment prospects are what we used to call "warehouses." These were not physical warehouses, but stocks that would not lose much value in a decline and had reasons to have a better than historical experience in the future. Today there are two, somewhat controversial, opportunities of interest. The first is the oldest warehouse for more than a century, AT&T (NYSE:T).

While in truth it is the recast Southwestern Bell along with a number of acquired former Baby Bells. I am not attempting to guess the final result of the proposed merger with Time Warner (NYSE:TWX). My interest is focused on the likely leader in the Fifth Generation internet, which could well be dominated by AT&T as the technological and capital leader. The declining value of their long lines infrastructure could be reversed.

The other warehouse that is even more controversial is General Electric (NYSE:GE), which was the first large company I analyzed. The slimmed down current company is essentially being rebuilt around its capability with engines. The power business, particularly in the conversion to the use of natural gas, should be a major plus. The aircraft engine business is very attractive in terms of the parts and services involved. What are labeled their healthcare products are in reality supplying the mechanical/electronics patient movement businesses.

I view both of these stocks as substitutes for ten-year US Treasury Bonds, which currently yield 2.4% and AT&T yields over 5% and GE 2.7%. The income from the bonds is fixed. I suspect that the two warehouses will raise their dividends at least equal to published inflation if not higher. Further over time their pension expenses will decline through pension risk transfer contracts with Prudential Financial or other insurance companies. Also I expect that the number of employees and their ages will decline easing their retirement expenses.

Legacy/Future Generations' Portfolio

The nice part of managing money for this portfolio is that I won't be around to see whether it works or not. I hope it does work because it will be important for my grandchildren, great grandchildren and their beneficiaries. This is the most challenging portfolio. While some of the future winners will be leaders from today, some will be a surprise. It is in the latter group that I am focusing on in the beliefs that there will be some changes, which will lead to good investments.

The first idea is that much of what we invest in today is anchored in the so-called permanent or physical world. In future generations, I think we will be living in more fluid situations. Even today's tax bill may be driving to praising liquidity over permanence. Individual ownership of real estate could give way to greater rentals. With the growing retirement capital gap, we may need to increase savings and get higher returns on our capital as we live longer and more expensively. My guess is that we will see more century and longer bonds, possibly perpetuals.

The second idea derived a bit from the first is that business and industry structure can and will likely change. We are already entering a phase of vertical as distinct from integrated mergers. The recently proposed merger of Aetna (NYSE:AET)* into CVS/Caremark (NYSE:CVS) is being analyzed as a process to lower the cost of drugs. I see some other, more important long-term advantages. First, as a data-hawk, the idea of putting the aggregate data in terms of medicines with health and life insurance statistics could have enormous advantages to the companies and could well provide better healthcare for patients.

There is perhaps an even bigger potential advantage to the proposed merger. CVS is used to their customers coming to them. Aetna has to go out to get their insured through direct or agent sales efforts. With the increase in marketing and sales supported technology, the dollar levels of future sales could expand materially.

* Shares personally owned