It's hard to get in touch with what you really think, much less act on it; this unorthodox portfolio is what resulted in my case.
Premise: starting valuation is the major factor in returns, and value today is in emerging markets, the world ex-US, and small caps.
Emerging markets have 40% of both global market value and global GDP while the U.S. has 25% of GDP and 38% of global market value; emerging countries have faster growth.
Consider these numbers: the shoot-the-moon portfolio is thoroughly unorthodox, but it has a form of diversification not considered in most U.S. portfolio models.
John Templeton's career provides a model of using foreign markets to apply the most important maxims including buying maximum pessimism and being different from the crowd.
“To buy when others are despondently selling and to sell when others are avidly buying requires the greatest of fortitude and pays the greatest ultimate rewards.“
“Bull markets are born in pessimism, grow on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”
“If you want to have a better performance than the crowd, you must do things differently from the crowd.” - all quotes by Sir John Templeton
Don't immediately take what I'm saying here and implement it as your personal portfolio. It's a thought piece, which means it's something which should lead you to do your own research. Then sit back and ponder. That being said, it represents what I really think about investing at this particular point in time, and I have taken the first steps in the general direction of implementing it.
Know who you are. Are you a person who has lived your life generally along the lines dictated by conventional wisdom? Don't be embarrassed if you are, or too proud either. I am generally that kind of person myself. By nature I am the bean-counter guy sitting on a high stool at a desk with a green shade, focused on copying accurately. You will recognize this unheroic character from Dickens or Melville. That's me.
But not quite all the time. I occasionally ask myself what's the most lunatic thing I might actually do. A few times I have actually done it. I volunteered for Vietnam. I got married twice, the first when I had no idea what marriage entailed and the second when I had a very good idea what it entailed. Vietnam and both marriages were the decisions of an excitable 17-year-old (except that he was 19, 23, and 57). I hit on two of three. In every case the decision involved something every paratroop knows: all you have to do is get out the door. Nobody ever jumps back up into the airplane.
When it comes to money, I have behaved like a 17-year-old twice, once when I was 27 and again when I was 45. In 1981 I bought a basket of calls one or two strikes above the market and as far out as calls went at that time. It was a totally insane thing to do with a wife and two hungry children at home, but it was a slow moment in my life and I was bored with my teaching job. I just stood up, hooked up, and jumped. It nearly ruined me, but it worked.
In 1989, just after my divorce, I scraped together $20K and bought a leveraged short on Japan via the Paine Webber and King of Denmark Put Warrants (if reasonably math-friendly read this article on them). Once again I came dangerously close to being wiped out before the tide turned and the Nikkei crashed, but I squeaked through and made enough to have seed capital for a new start. I immediately returned to my stool in the bean counting office and have stayed there since.
The reasoning behind those two trades was sound. I had strong conviction that the U.S. market was absurdly cheap in 1981 and the Japanese market was absurdly expensive in 1989. What made my actions crazy was the combination of leverage and expiration date. I did something nobody should ever do. I bet not just on what a market would do but also on when the market would do it. The fact that I survived and did pretty well was 5% skill and 95% luck.
What I'm about to do here is suggest a portfolio which should beat more conventional models soundly over a 7 to 10 year period. There's no leverage and no set expiration date. It just attempts to capitalize on global markets which are out of sync and out of whack. The world ex-U.S. is fairly cheap and emerging markets are dirt cheap. If I were a bookie, I would establish a line of about 5 percentage points annualized by which this portfolio beats the S&P 500 over 7 years.
There's no benchmark here. It's an absolute value portfolio, meaning it's an effort to optimize with no targets and no constraints. That's why there is no fixed income. Zero. I assume that anyone doing anything like this would have their cash needs covered elsewhere for the relevant time frame.
There is a place for fixed, however, and I'll explain it below. It's how to use fixed as negative leverage to dampen risk (with the same reduction of reward). I'll also suggest my two safe options for the fixed income. But, repeat, buying fixed income as part of a traditional 60/40 portfolio at this time and these rates is simple insanity.
The rest of this article should be taken for what you can make of it. Think of it as written by that 17-year-old we all have buried inside, but supported by the knowledge and experience of a 75 year old who has followed the markets from the age of 12 (1956). Everyone should try to know at any given moment what he or she really thinks. It's amazingly hard to do that. For me, writing this article is a determined effort to make me do that for myself. Once you have done that, one task remains. You still have to decide if you are ready to stand up, hook up, stand in the door, and jump.
The Shoot-The-Moon Portfolio
Here's the new 60-40 portfolio (with numbers from Vanguard/Morningstar):
A. International Value With A Focus On Emerging Markets: 60%
- WisdomTree Emerging High Dividend ETF (DEM) - PE 8.8, PB 1.1, Earnings Growth Rate 12.3%: 15%
- WisdomTree Small Cap Dividend Growth ETF (DGS) - PE 10.7, PB 1.2, Earnings Growth Rate 13.2%:15%
- VanEck Vectors Russia Small Cap Dividend ETF (RSXJ) - 6 PE, .9 PB, 30.7% Earnings Growth Rate: 5%
- Gazprom (OTCPK:OGZPY) 3 PE, 7% Dividend Yield: 5%
- Sberbank (OTCPK:SBRCY) 6 PE, 6.6% Dividend Yield: 5%
- WisdomTree Europe Small Cap Dividend ETF (DFE) 12.3 PE, 1.3 PB, 12.4% Earnings Growth Rate: 5%
- WisdomTree International Small Cap Dividend ETF (DLS) 11.4 PE, 1.1 PB, 9.2% Earnings Growth Rate: 5%
- Vanguard FTSE All World ex-US Small Cap ETF (VSS) 14.1 PE, 1.4 PB, 11.2 Earnings Growth Rate: 5%
Rationale for the international basket: This is an international value portfolio focused on emerging markets and small caps, all ex-US. It thus combines the categories which are the cheapest asset classes in the world at the present moment. It is easy to argue that there is something wrong with almost every one of the eight choices. The general problems of emerging markets are certainly not to be taken lightly, but the opportunity seems to greatly outweigh the risks. Buying world ex-US small caps means buying hundreds of stocks you have never heard of and couldn't evaluate anyway. You have to let the statistics do the heavy lifting for you. Assets that will outperform always look like this, and you just have to take a deep breath and buy them.
The best measure of future return is starting valuation. Jeremy Siegel's Stocks For The Long Run long ago featured statistical tables suggesting that long term real return in the aggregate is more or less the inverse of starting PE. The weighted average PE of the 6 ETFs and two stocks in the basket above is a little under 9.3. The inverse of that would be a 10.8% annual real return. I'm going to use this premise for return estimates in this article. (Note that using a decimal place in these numbers misleads because they are no more than broad estimates.)
B. US Domestic Value Stocks: 40%
- Berkshire Hathaway (BRK.A)(BRK.B) PE often overstated at 20, but upon closer analysis of internal numbers (see this fine article by Sven Carlin) it's closer to 12: 15%
- JPMorgan (JPM) PE about 12.5: 7 1/2%
- Bank of America (BAC) PE about 11.5: 7 1/2%
- Delta Air Lines (DAL) PE a little under 8: 5%
- Chubb (CB) PE a little over 14: 5%
Rationale for the Domestic Basket: Domestic value stocks provide the kind of ballast for this portfolio which used to be provided by fixed income. All are more likely to protect your capital than any major class of bonds. The weighted average PE of the above 6 stocks is 11.75. The inverse of that would be an 8.5% predicted annual real return.
Russia at 15%, including two individual stocks under strong government influence, warrants an overweight because it is the cheapest of the cheap.
Expectations for the total portfolio using a weighted average return of both baskets is about 9.88%. That doubles your money in 7 years. That's pretty good, but it's just what the U.S. stock market is supposed to do every year, right? So why is it a moonshot?
The actual long term average annualized real return for the total U.S. stock market is a little less than 7%, but the chances of getting that return over the next 7 to 10 years appear slight. It's not recessions, trade wars, or slow growth, either. There is one critical variable: starting valuation. The long term average market PE is 15 or a little less, depending on your starting and ending points, and the current PE of the S&P 500 using most recent earnings reports is 22.6. Measured this way the U.S. market is about 50% higher than its long term average. If you use CAPE - cyclically adjusted (10 year average) PE ratios - the market is over 75% higher than its long term average. Market valuation is likely to shift downward toward the mean, but even if it doesn't the numbers assure much lower than average returns.
The explanations for this valuation include the high profit margins and growth rates of the S&P 500 top 50 companies and the low interest rates which make stocks reasonable at that price compared to bonds. Conditions like these are a moving target in the markets, and generally revert to the mean.
Compared to the U.S. market everything else in the world is cheap. Emerging markets are as cheap as they have ever been. They sometimes sell at a premium to the U.S. market, and did so as recently as 2007. The only cheap thing in the U.S. market is value, which is historically as cheap as it has ever been compared to growth. The U.S. is safer and stronger than any other economy, and is measured in the currency you will spend, but these virtues come at a high price near the end of a long bull market. Taken together, these facts explain the structure of the above portfolio. Here, for those who haven't seen it in my recent articles, is that GMO bar chart using mainly valuation to estimate future returns of global asset classes:
What are the risks? And what about diversification?
The Shoot-The-Moon Portfolio is actually more eccentric than risky. Nobody's portfolio looks anything quite like this. The 15% of the international portfolio that is Russia - Gazprom, Sberbank, and the Russian Small Cap Dividend ETF - certainly bears all the risks of an autocratic regime with corruption, an erratic currency, imperfect rule of law, sanctions, and the problems of government ownership, all factors I explored more fully in this article. A price earnings ratio of 6 and dividend yields around 6-7% more than justify these risks. The bad stuff is over-discounted in the Russian market.
Value stocks in emerging markets and other international small cap value ETFs lack the panache of current large cap market leaders, but this is factored into the low price which, as I discussed in this article, is accompanied by earnings growth that is actually excellent.
As for diversification, I have a counterargument to the obvious one. While this portfolio is in some respects highly concentrated and unorthodox, it is by another way of thinking more diversified than the standard US equity portfolio. The American markets are a few percentage points below 40% of the total global equity markets. The US basket in this portfolio actually exceeds its portion of the global benchmark.
This is also true in a comparison of relative GDP. The U.S. is about 25% of global GDP. Emerging markets in the aggregate are about 40%. Excluding other developed markets, in a universe which just includes the U.S. and emerging markets, the U.S. would have 38.5% of the GDP and emerging markets would have 62.5%
Home country bias is strongly entrenched in American investors. If you can get past it, you find an incredibly larger investment world in which to look for bargains that will outperform. Those who can't get past home country bias should read up on the late Sir John Templeton, pioneer of foreign investing and founder of the extraordinarily successful Templeton Growth Fund, the first great mutual fund to include foreign investments.
Templeton is the Warren Buffett of foreign investing. He is famous for being the first major American investor in Japan in the early stages of the Japanese resurgence after World War II. He discovered Japanese companies in the 1960s still selling at 2 or 3 times earnings versus a 20 PE at that time in the US. The Japanese post-war economy was growing at 10% annually but got no respect. At the 1970 peak, when Templeton was beginning to sell his Japanese holdings, they had reached 60% of his portfolio. By then the Japan story had become well known. Think of those numbers and that kind of audacity and then take another quick look at the numbers above.
The secret of Templeton's success was working hard to get the data on the cheapest markets in the world and then having the gumption and courage to buy them in a big way. For those of you not yet familiar with Templeton, who died in 2008 at the age of 95, you might have a look at Investing The Templeton Way by his great niece Lauren C. Templeton and her husband with a foreword by Templeton himself.
There was no asset class alien to Templeton. In a March 2000 interview with Equity magazine he let his interviewer know that he was short the major internet dot.com stocks (which were just about to crack). Asked for his advice for individual investors, he said they should not take risks like that, but he advised them to do what he was doing with most of his wealth. He was buying Treasury bonds, the most unloved asset of the moment. He bought them in the form of Treasury strips, in effect zero coupon bonds created by stripping the coupon for a future date. Zeroes and strips have much more leverage than simple Treasuries.
The rate for the long Treasury when Templeton gave this advice was over 6.5% and by the end of the year it had returned more than 30% even for straightforward Treasuries as the bond yield declined to 5.12%. I remember hearing him deliver the same advice around that time on Wall Street Week. I honestly hadn't thought of it until then but I listened and can remember the phone in the local public library from which I called my broker and bought Treasury strips.
I'll guarantee you of one thing, though. Templeton wouldn't give small investors or anybody else that advice today. A very nice man, he might offer you a bicycle to ride as fast as you can away from bonds and clear your head in the process.
As for the domestic side, it truly is a ballast provider in place of bonds. Bonds have close to zero return but significant risk in the event of a sharp rate reversal. I am familiar with the arguments that are made for bonds at these rates but they strike me as tortured in their reasoning.
The only people who have any reason to own bonds at current rates are institutional money managers operating with a mandate to do so. There are of course people in Europe and elsewhere buying sovereign bonds at a negative rate, but individual investors who do that should go straight to the religious institution of their choice, get down on their knees, and pray for a global depression because only that will save them.
Berkshire Hathaway is the diversified core on the domestic side. It has plenty of single company and key employee risk, but on the other hand it has very deep high quality management and almost 100 high quality wholly owned subsidiaries of a variety of sizes and industries. And it's selling at a discount to fair value (see my last piece). It's growing at about 9% annually.
And there's JPM, BAC, and CB - way too much concentration in financials. But it's inescapable if you're following the discipline of value. Banks are the cheapest major area in the market. DAL is even cheaper in the unloved airline sector. Where is maximum pessimism more likely to be found in the US than in an airline selling under 8 times earnings? As for Chubb, it's a little less cheap, but it's a wonderful conservative plodder with good growth prospects for an insurance company thanks to its hard-driving CEO Evan Greenberg.
What You Don't Own Is Important
What you don't own is an important part of portfolio construction. Here are a few things I urge you not to own and the rationale for not owning them:
- The FANG stocks - Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Alphabet (GOOG)(GOOGL) and other large cap growth stocks. The big money has already been made in these stocks. End of story. Some may eventually settle into respectable growth and grow themselves into their current valuation but the long term returns are likely to disappoint.
- The leading Chinese large cap growth stocks such as Alibaba (BABA) and TenCent (OTCPK:TCEHY). Same reasons as #1. The value funds above exclude them for valuation reasons and in the process reduce the amount of China found in cap weighted indexes by about one third.
- Slow growth consumer stocks with large dividend payouts - Coca-Cola (KO) being an example. They are ridiculously expensive for their operating results, being bid up by reachers for yield, and are at severe risk of valuation contraction. They are probably the worst hidden risk in the U.S. equity market.
- Growth in general. Growth has ruled for an unprecedented 10 years. It may continue to rule for a while, but eventually the music will stop. The value funds and companies in the above portfolio have sufficient growth, priced so that it will produce real investment return. I looked hard at India and Israel funds, but they were too expensive for the growth they offered.
- Bonds of any kind. From the present valuation they will provide 2% at best until my grandchildren are well into middle age. Lower quality bonds are particularly dangerous. At around 4.5% on the Treasury 30-year bond you can look at bonds again.
- The S&P 500, which is heavily weighted to expensive and risky categories #1 and #3.
- Don't own things just to diversify. It makes no sense to diversify by buying things that are overpriced, overhyped, and risky. Concentrate on things with the predominant evidence in their favor. Concentration is fine, as Buffett and Munger say, if you know what you are doing.
The above categories are likely to drag down portfolio returns despite the fact that some of them are fine operating companies. The starting valuation from their present prices is a factor which makes them the riskiest parts of the market.
If you accept the principles behind the Shoot-The-Moon Portfolio but are uncomfortable with the potential volatility and short term drawdowns, you can do what hedge funds do but in reverse. They buy what looks like safe easy return (emphasis on looks like) and ramp it up with leverage by borrowing money cheap. You should instead buy a portfolio which has strong fundamentals and value, and if it makes you nervous reduce the risk with a safe cash reserve. Think of it as inverse leverage. Nothing fancy. You can currently get about 2% by doing this.
Here are my two choices for fixed income ballast along with the rationale:
- Vanguard Prime Money Market Fund (1.90% yield) or Municipal Money Market Fund (1.15% yield). Divide the Muni Fund yield by .6 if you are in the top tax bracket and choose whichever is better - the Prime Money Market or the tax equivalent result of the Muni Money Market. They are currently about even. If rates go up, both funds will track rising rates with a short lag. If rates go down, ditto in the wrong direction but they will remain a good parking place for safety capital.
- Vanguard GNMA Fund (2.51% yield). These mortgage pass-throughs have a duration of about 2 years (duration being a weighted average of time until you get your money back). They are U.S. Treasury insured. The incremental yield over Treasuries of equivalent duration comes from the prepayment option that allows mortgagees to refinance when rates fall and drag down the overall portfolio yield. Nothing is perfect, but Ginnie Maes are pretty consistent.
The amount of your fixed income holding position will depend upon how risk averse you are. Let's say you want a 20% reduction in risk. You put 20% of total portfolio into a combination of the two above instruments. You then reduce each individual position in the Shoot-The-Moon Portfolio by 20%. For example, the two Berkshire Hathaway and the two WisdomTree Emerging Market Dividend portfolios, each at 15%, would each be reduced to 12% of the total portfolio. JP Morgan, at 7 1/2% would be reduced to 6%. Etc.
The expected return of the total portfolio drops from 9.88% to 7.94%, but that will still be far better than most conventionally constructed portfolios. Maybe you'll sleep better.
Now you know what I really think. So do I. Setting it down on paper clarified a few things for me - a practice I recommend to everyone. The Shoot-The-Moon Portfolio is what I really believe I should do. I am lucky to have a pension, so I can afford to take risks despite my advanced age without worrying that I will end up eating cat food or have to stop buying blueberries for my cat. Will I actually do it? I'm going to continue thinking while getting there in stages.
I have a high level of conviction about this particular piece of analysis, but it's something less than 100%. I remind myself that I am sometimes wrong. Events could take place which would make this approach vulnerable, although most of the visible ones would damage a U.S. equity portfolio as much or more. That includes a deep global recession or trade war.
The most serious risk to this portfolio is persistent strength in the U.S. dollar over many years into the future. That would be an unprecedented occurrence, but strange things occasionally happen. We find out the reasons later.
I currently own the four stocks in the domestic basket in my personal portfolio which contains about a dozen stocks. Some of the stocks I already own are presently at full value, so I wouldn't buy at today's prices or suggest that you do so. I can't sell either because the positions are well over 50% in embedded capital gains, and cap gains taxes would take me down close to their buy range. That said, what I already own in U.S. stocks is going to be my domestic portfolio for the foreseeable future. I'm not buying more at this point.
Having been entirely in U.S. stocks for 10 years, I began buying the two WisdomTree Emerging Dividend ETFs and the two Russian companies, Gazprom and Sberbank a few weeks ago. I will continue buying them as a ladder of CDs fortuitously bought last March and December begin to roll off. I had this in the back of my mind when staggering CD maturities out to 2023. The smaller tranche, from March, will start rolling off next month and the proceeds will go into the emerging market value instruments above. I should mention that I am not entirely without emerging market experience having held Brazil and India CEFs during the latter stages of the dot.com crackup and for about a year into the recovery. They tripled. And I sold early.
As fixed assets roll off the books over the next four years and I reduce a large muni bond position, I plan to continue redeploying capital in this way barring a sudden adjustment in relative prices of U.S. versus emerging market assets (like a U.S. crack-up, which I don't predict). When the international percentage of my portfolio reaches 30%, sometime next year, I will do a close reexamination of both the original premise and valuations. I may write a follow-up article at that time.
When taking a large position, especially one that is a pivot in basic approach, I believe that buying in stages is a good approach. It takes a bit of courage to do even that. It's one thing to know what you know, and another thing to push the final button.
About Vietnam. Nothing in my life has had a greater positive impact. I realize that I was extremely lucky, and many others did not have the same experience I did. The army was the perfect training ground for me. It taught me that by some very important criteria I wasn't as special as I had thought I was. It taught me to pay attention to details or risk paying for sloppiness with really bad consequences. It taught me that the quality of the people around you matters tremendously in who you become and how things work out. It taught me that it is a good idea to be cautious and careful when possible. It also taught me that you can calculate, prepare and plan all you want but a good bit of what happens is still a matter of luck. It also taught me that every now and then you just have to stand in the door and jump.
Disclosure: I am/we are long BRK.B, JPM, BAC, CB, DAL, DEM, DGS, OGPZY, SBRCY. 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.