How To Beat The Market In The Late Stages Of The Cycle

by: Cashflow Capitalist

I present the case for a modified sector rotation strategy oriented around dividend-paying stocks.

Think of your investment portfolio like a galley-style ship, with certain stocks acting as the oars and others acting as the sails.

This strategy has beaten the market over the last twelve months by a handsome margin.

Is it possible to achieve a 20%+ total annual return in the late stages of a market cycle? Yes, it is - with sector rotation. All it takes is gradually taking profits on the more cyclical names in one's portfolio when they're running hot and shifting into high quality defensive names when they are underperforming the market. Simple as that.

I know, I know. Easier said than done. Executing this strategy well takes tremendous discipline. Especially for a Millennial like me. When all your friends are ogling over Tesla (TSLA), Amazon (AMZN), Facebook (FB), Apple (AAPL), Bitcoin (COIN), and various marijuana stocks, it's embarrassing to admit your money is in REITs, utilities, and consumer staples. It makes you sound like a grandpa. (No offense to the actual grandpas out there. I am one of you in spirit.)

But there's a time to ride the wave of cyclical names like those above, and there's a time to take profits and forego that last little bit of return.

Don't take it from me. Take it from Howard Marks. The man knows a thing or two about how to invest differently in different stages of the market cycle. His book, "Mastering the Market Cycle", discusses how to allocate investment capital for each season of the cycle. It's not about market timing, as one's timing is never perfect. It's about "getting the odds on your side."

This is not easy or natural for me. My own disposition as an investor is to buy and hold forever. I'd much prefer a slow-and-steady approach, putting away a little bit each month and not thinking about it, to constantly fretting about where we're at in the cycle and shifting investments around accordingly. Sure, I enjoy reading about the economy and researching stocks, but at heart I'm a conservative investor who would opt for relatively certain modest returns over risky but potentially high returns. If it takes me longer to get rich, so be it.

The approach I've settled on is an amalgam of sector rotation and buy-and-hold. A majority of my portfolio is in defensive, dividend-paying companies that I plan to hold forever (unless something fundamentally changes with the company, of course). If you imagine an investment portfolio as a Medieval, galley-style ship, these defensive names are the oars propelling the ship forward. Cyclical companies in technology, industrials, consumer discretionary, etc. are the sails of the ship, powering the portfolio when tailwinds are strong and favorable.

Source: Naval Encyclopedia

Unlike the oars, which can always be used to propel the ship, conditions are not always favorable for the sails to be unfurled. Sometimes, when headwinds are picking up or a storm is coming, they need to be rolled up. (For those who know much more about sailing than I do, please indulge the metaphor.)

How well has my strategy worked in the last year - a year that has been quite volatile? Quite well. Significantly better than the market, in fact.

To preface: I'm generally not a boastful person. I promise I'm not. But just this once, to prove a point, I need to show something that may seem conceited. The following chart shows the total return I've achieved in my personal stock & ETF portfolio in the last twelve months:

Author's Personal Stock & ETF Portfolio in Robinhood, TTM Total Return

Some details and disclaimers: I've concealed the size of the portfolio, because that's not really important. It's a large enough amount to be diversified among 31 individual stocks (currently) and 7 ETFs, including two ultra-short term bond ETFs that together amount to a little over 10% of the portfolio. Also, about 2.4% of the portfolio is held in cash. Almost all stocks and ETFs are (or are weighted heavily in) defensive sectors - net lease and healthcare REITs, utilities, consumer staples, and midstream energy MLPs.

Moreover, this is not the entirety of my investment portfolio. I have a Roth IRA and some additional holdings in a taxable account with Vanguard. I'm not including the returns from this portfolio because (1) the taxable portion is largely used for savings, taking advantage of Vanguard's money market funds, and (2) the Roth IRA is only invested in money markets and ETFs and I don't pay much attention to it. The Robinhood portfolio is purely for active and taxable investment purposes.

One more disclaimer: The features of Robinhood as an investment platform are game-changing. The lack of commission fees allows me to trade far more actively than in my Vanguard portfolio. This gives me the ability to make much smaller purchases or dispositions, sometimes individual shares at a time. Normally, higher turnover in a portfolio would, all else being equal, amount to lower returns as the commission fees eat into profit. This has not been the case for my Robinhood portfolio.

Also, Robinhood has no dividend reinvestment feature. So all dividends wrack up in the account as cash. This gives me the ability to reinvest dividends strategically.

Now, compare the above returns to the total return in the last year from the S&P 500:

Chart Data by YCharts

TTM Total Return from S&P 500: 9.43%

TTM Total Return from Author's Portfolio: 22.01%

How does one achieve such alpha so late in the cycle? Answer: Through the selective sector rotation strategy described above. Take profits in cyclical names (even the high quality ones) when they're riding high and shift into defensive names when they're underperforming.

The tricky part is that these two actions cannot always feasibly occur at the same time. Profits should have been taken in cyclical names in early Fall last year and should be taken right about now this year. But defensive names were doing well both of these times as well. Instead, defensive names should be picked up during late-cycle corrections before talk of an oncoming bear market or recession picks up. A large portion of the defensive holdings in my own portfolio were purchased in the spring 2018 correction and Christmas 2018 correction. Individual stocks were also purchased during sector downturns and individual stock corrections.

This is traditional value investing, but with an added ingredient: narrowing the field of investment candidates based on the current stage of the market cycle. In the last few years, this has meant narrowing the field of acquisition candidates almost exclusively to defensive sectors like REITs, utilities, consumer staples, and MLPs. I plan to do the same thing once a recession (eventually) comes, only the field of candidates will flip. At that time, the field will be narrowed to more cyclical companies in technology, industrials, consumer discretionary, small caps, etc.

The difference between late-cycle and early-cycle investing in my modified rotation strategy is that, in the early stage, I do not plan to sell my defensive holdings. I want to hold those forever and keep collecting the dividends. In the late stage, on the other hand, I do plan to gradually sell (and have already sold, for the most part) my cyclical holdings. Harkening back to the ship analogy, the oars will keep rowing regardless of the winds or weather, but the sails may be furled or unfurled.

Recently, for instance, I've been trimming or saying goodbye (for now) to some high quality cyclical companies like Cummins (CMI) and BlackRock (BLK). But I'm letting my defensive winners, like Realty Income (O) and Welltower (WELL), ride.

Now is the time, in my humble opinion, to furl the sails. But let those brawny rowers below deck keep on rowing.

Disclosure: I am/we are long O, WELL, BLK. 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.