Monthly Archives: September 2016

DGI Portfolio Sept 2016

The dividend growth investing (DGI) portfolio is the largest component of my active portfolio. DGI is considered an active strategy where the active part comes from stock selection rather than short term trading. As a matter of fact the intended holding period is normally very long, or even for everem> as Warren Buffet is known to prefer. I believe DGI offers the individual investor the best odds for achieving superior returns – both absolute and risk-adjusted, benchmarked to an investible index ETF such as SPY, although there may be some foreign stocks worthy of consideration. A statement like that needs to be justified of course, and “best odds” is by no means a guarantee. In this post I’ll describe why I believe DGI has this potential and the way I choose to practice it. Not everyone can copy what I do, two of the largest roadblocks being position size and skill/willingness to use options to enhance returns.

xom_bought_20160921

Diversification

Diversification is necessary to remove idiosyncratic single stock risk so that at the portfolio level only (mostly) market risk remain. This paper does a good job explaining the research despite the unfortunate title. I care more about the standard deviation (SD) than the variance (as indicated by r-squared). SD speaks to the portfolio value whose downside volatility I want to minimize. I don’t care to have a portfolio with a high r-squared fit to the market because that will also remove extra sources of return (see discussion on factors below). At any rate, it takes only dozens not hundreds of stocks to reap the vast majority of the benefits of diversification. Note also the dates cited in the article were from the end of 1990’s. If anything, the correlation between stocks have increased due to the growing popularity of indexing. In a “perfectly efficient” market – which will probably never materialize – every stock will have the same risk-adjusted, expected return (source). In a market where all participant are indexers – which is even less likely to materialize – every stock will move in synchrony and provide identical returns. Both gedankenexperiments point to less number of stocks needed to approximate the diversification of the entire market as efficiency increases.

My own DGI portfolio is a work in progress. It contains about 30 stocks right now with an eventual goal somewhere around 50 stocks. The chart below shows the current sector weighting vs. S&P 500 market weighting that is more of a guide than a target. There is a concentration in consumer staples which are the classic stable, unglamorous, capital un-intensive compounding machines. The S&P site doesn’t yet include the newly independent REIT sector. It’s not an issue as I don’t have any REITs anyway (I have them in my passive portfolio). The portfolio yield is 3%, respectably above the 2% yield for SPY but not outrageously high. Indeed current emphasis is on the “growth” part of DGI and I consciously avoid the classic dividend stocks with high yield and low growth such as telecoms. I also make a point to put the high growth, low yield stocks like Disney ($DIS) and Nike ($NKE) in taxable and high yield stocks in tax-advantaged.

dgi_sectors_20160924

Dividends and Share Buybacks

The much venerated Economist magazine recently ran a series called “Six big ideas”, the first of which was information asymmetry and signaling. My very rough summary goes like this: there is information asymmetry in markets such as in used cars where the seller knows the true condition of the car but the buyer doesn’t; or the job market where the applicant knows his true abilities but the potential employer doesn’t. The solution is for the seller to provide an additional “signal” to the buyer as an indication of quality. In this perspective, job applicants use their degrees as “signals” of their dedication and talent, which is contrary to what education is normally thought of: a means to benefit society to make workers more productive. OK fine, I recall saying to myself as I was reading this, until I came to this “Aha” moment:

Signalling explains all kinds of behaviour. Firms pay dividends to their shareholders, who must pay income tax on the payouts. Surely it would be better if they retained their earnings, boosting their share prices, and thus delivering their shareholders lightly taxed capital gains? Signalling solves the mystery: paying a dividend is a sign of strength, showing that a firm feels no need to hoard cash.

There is plenty of evidence that an above average dividend yield (better yet a dividend grower, but not too high a yield which could indicate a recent stock price crash or an unsustainable dividend) correlates with above average returns.

dividend_1_20160926
dividend_2_20160926

Source

dividend_3_20160926

Source

dividend_4_20160926

Source

Rather than a choice of either “total return” or DGI as some would have you believe, above evidence suggests DGI is a path to superior total returns. Now I understand that some may have a preference for share buybacks over dividends. The former does have advantages for taxable holdings. That’s why I prefer companies that do both. Share buybacks tend to be more volatile and will be cut first in tough times as companies defend dividends. To be more effective, share buybacks need to be counter-cyclical, tough to do but a sure sign of a management with capital allocation chops. Together dividends and buybacks make up shareholder yield which is a terrific indicator for the quality of a business. One of the main gripes I have about index funds is that I want to own more of the companies with high shareholder yield but the index fund takes that shareholder yield and distribute among the whole universe of companies. By owning the stocks directly, I don’t need to do anything in the case of buybacks; with dividends, DRIP, or let the dividends accumulate to buy another dividend paying stock are both possible. The latter is my preference since I want to have control over entry points and keep stocks in round lots.

Equal Weight and Inactivity

Supposedly a popular (long only?) hedge fund construction is the “50/50”: 50 stocks with 50% in the top 10. I don’t have the time to do the research to have that level of conviction so my default construction is equal weight as much as my desire for keeping round lots would allow. It is well known the equal weight S&P500 ($RSP) outperforms the cap-weighted $SPY, 10.88% vs. 8.75% annualized since May’03, despite higher expense ratio and turnover: 0.4%, 22% turnover vs. 0.09%, 2.77% turnover. Factor analysis (PortfolioVisulizer) shows $RSP having a market factor of 1.09, both size and value factors of 0.12, and a statistically insignificant alpha of 0.4%. Proponents of fundamental indexing would argued that anything but cap-weight avoids overweighting the recently-up-a-lot stuff.

On the impact of trading activity or lack thereof on performance, one stunning example of LONG TERM holding is the Voya Corporate Leaders trust fund (LEXCX, hat tip: Sure Dividend), a fund that started in 1935 with 30 blue chip stocks at equal number of shares (not exactly equal weight nor cap weight). It didn’t buy new stocks since inception and holdings only changed due to spin-offs or mergers. The result speaks for itself:

voya_20160926

Source: Voya Investment Management

45 years (the data for the first 40 years is not available), no new purchases, the original 30 stocks turned into 22 and it handily beat both the Dow and S&P. In addition, a preponderance of academic studies suggest trading activity negatively affect mutual fund returns, mostly due the impact of trading cost (commission and slippage). My main take away is: weight quality stocks more or less equal (for sure not cap weight) and hold’em for a long, long time.

Factor Exposure

The MSCI paper Foundations of Factor Investing is a good intro to the topic. It defines a factor as “any characteristic relating a group of securities that is important in explaining their returns and risk”. Further, “the market can be viewed as the first and most important equity factor”. The paper went on to highlight value, size, momentum, low vol, yield and quality as the most important factors among the 300 or so that have been identified. Factors are important because they are sources of additional returns above that of the market. For some factors, such as value and size, the additional returns come with higher volatility so it can be argued that there is no advantage in risk-adjusted returns. But the low vol factor is certainly a slap in the face for CAMP. Academics refer to the factors that don’t fit their cherished theory as “behavioral” or “mis-pricing”. Also note that momentum which is one of the most robust and pervasive factors is totally contrary to the teachings of EMH. Still, you’ll see plenty of people in chat rooms who continue to regard CAMP and EMH the cutting-edge of portfolio theory. They are almost as bad as the academics who at first insisted it impossible to beat the market, then having found the factors, and then factors they had to call “behavioral” or “mis-pricing”, now use multi-factor analysis to RETROACTIVELY deny the existence of skill.

So much for the rant, the real point I’m trying to make is the typical DGI portfolio is likely positively loaded with value, dividend, quality and low vol factors; and slightly negative on size. If we take the new Nifty Fifty as representative of a DGI portfolio and compare them with the top stocks in $USMV, you’ll see plenty of overlap. Recent popularity of low vol and yield strategies probably means some future returns have been pulled forward, but to me it’s a confirmation of their long run advantage over the market.

usmv_20160926

Source: MorningStar

Option Writing

One reason I keep stocks in round lots is to be able to write options for income generation. I keep things basic: sell covered calls or cash/margin secured puts on stocks I’d like to own. Expirations are typically 3-6 weeks out when time decay is the greatest. My goal is to have the options expire worthless so I normally stay with Delta <0.2. The low commissions at IB ($0.7 per contract, no base fee) make it worthwhile even with a couple contracts at around 1% premium. Further more, I use technical analysis to select entry points: sell calls when upside momentum is nearly exhausted or puts conversely. Being selective limits the number of trades I’m in at any given time. So far that hasn’t been an issue as I’m targeting only a couple percent of additional gains annually unlike some aggressive premium sellers targeting 20% per year. Compounded over years though I expect this to be a significant source of alpha. It’s very reassuring to know that I can generate a steady income from the portfolio when planning for early retirement. For monthly reporting purposes, gains from option trades are not included in the returns for DGI.

In summary, each of the above considerations has potential to enhance returns with varying probability of delivering. I’m under no illusion that any level of performance is guaranteed but I’m also content in having maximized my chances. Time will tell what return I’ll get in the end. By then it would be too late to change course – such is the investor’s condition.

Guilty as Charged

It is something of a received wisdom in both mainstream financial media and PF blogosphere that “market timing doesn’t work”. The refrain has been used to argue against everything from DCA of a lump sum to rebalancing after a market drop. In chat rooms, “Well, that’s market timing!” is often uttered with an air of discussion-ending-finality – at least in the mind of the utterer – not unlike playground bickering among school-aged children. OK, jesting aside I do agree with the basic premise that most investors shouldn’t try to “time the market” meaning getting in an out based on some hunch or technical indicator or some guru’s prognostications. But how universal is that statement? What are the underpinning assumptions? These are the questions we must ask if we do not blindly accept everything we’re told.

I want to start by defining the term “market timing” in the broadest sense:

To market time is to stay invested when the price trend is up and to be out or short when the price trend is down.

The statement is about the desired end goal and does not in any way explain how or whether market timing is feasible. The polar opposite approach, that of the passive index fund investor, is

Stay invested in the market at all times, according to an appropriate asset allocation.

So how will these two approaches fare? The key insight is to realize the importance of the relative time scales of 1) the intended holding period (time-in-market), and 2) the characteristic time of market movements. Below is my (very poor) sketch of a long wave with period T1, a short wave with period T2, and holding period H, shaded in red.

time_scales_20160908

When T1 > H > T2, it follows that the shorter ups-and-downs corresponding to T2 are simply averaged out, while the longer trend corresponding to T1 will fully exert itself, so much as to dominate the performance during holding period H. A more pertinent range of T1 is probably up to 4 times H. A much longer T1 will make the larger wave appear as a flat baseline. At any rate, it should be clear that the investor can safely ignore shorter fluctuations especially if he is not equipped to take advantage of them, but conversely must pay close attention to longer trends and position himself appropriately (i.e. market time) lest getting caught in a prolonged downtrend.

The discussion has been kept as general as possible. The “market” hasn’t been defined. It can be any equities, bonds, or commodities, market indices or individual securities. The use of sinusoidal waveforms is not especially restrictive since any price series can be Fourier transformed. The analysis is ex post however, by virtue of completed waveforms being drawn. The latter point brings in the topic of forecast reliability which will be addressed in the future.

Holding Period

The holding period is the average length of time the investor expects to be in the market, usually determined by life events. I feel strongly that many investors overestimate his holding period. Personal finance education material will typically include a graph on compound growth over 30 years or so. In reality, no very few people invest a lump sum untouched for 30 years. The more likely scenario is making periodic contributions throughout one’s accumulation stage. If contributions are equal dollar amounts then right away the (contributed) dollar weighted average holding period is cut in half to 15 years. The far more likely scenario is the contribution grows with earning power, so that the average holding period could easily be not much more than 10 years.

The portfolio value weighted average would be much shorter than the the working career since the highest value occurs just before retirement. The whole process of saving for retirement is aptly described by Michael Kitces as Save For Decades, Then Quickly Double Your Money And Retire. Indeed the sequence of return risk applies to the final years of accumulation as well as early years of retirement but the awareness for the latter is much greater. A more in-depth article from Kitces contains this gem:

kites_retirement_date_risk

This topic is pertinent to me as I plan for my own possible retirement in 10-12 years. The withdrawal stage is a completely different animal from accumulation where volatility is exacerbated – a mathematical fact. Although one can identify a “dollar” that stayed in the same asset across the retirement threshold, that “dollar” would be subject to different risk-tolerance and likely different allocation rules. The psychological difference may be even greater. I speak from personal experience as I once left my well-paying job to pursue my own business ideas and also became a STHD for three years. I was to contribute my share of living expenses from savings and investment income during this time. My timing was awful as I quit my job in mid 2007. When the Great Recession rolled around, whatever investment plans I had didn’t survive losing the equivalent of 3-months’ expenses in one day. For me retirement is such a clear demarcation that I consider 10-12 years as my maximum holding period. By the earlier reasoning, as the holding period shortens more market oscillations will need to be carefully negotiated because there is less time to recover.

Shorter Duration Fluctuations

I have a very small allocation (several % of my active portfolio) for swing trades lasting days/weeks/several months. I’m also a premium seller for options 3-6 weeks out. But for the majority of my accounts, I consider the following events “noise”:

  • Intra-day movements
  • Movements related to Fed/central bank meetings, GDP, ISM, employment numbers
  • Quarterly earnings
  • Relative sector movements – example will be sectors like utilities or biotech falling in/out of favor. This is actually a borderline case as far as my ability to take advantage of the ups and downs. Relative movements can last anywhere from six months to a year or more that in theory can be recognized through technical analysis. However, I don’t have a dedicated space for this kind of trading. It’s natural for me to “buy low” in my DGI portfolio, e.g., industrials, some staples and financials of late, but since they are intended as long term holds, I’m not looking to “sell high” at the end of the same cycle.

Longer Duration Trends and Cycles

Now for that I cannot ignore:

Mass Extinction Events
– Ha, just trying to see if you are paying attention! The point is not whether there is a 60 or 26 million year cycle to extinction events (in either case we’re safely outside of the danger zone), but whether there is any cycle that will upend the widely held belief that should just sock away money in a TSM index fund and forget about it.
Long term global growth
– No I’m not being facetious. Long term growth cannot be taken for granted; one only has to turn on the TV or read the newspaper to see pain and suffering, gloom and doom everywhere. The thing that gives me hope for humanity’s future is that we’re still expanding our knowledge and using it to make our lives better. In fact knowledge is being expanded and disseminated faster than ever before. As long as that trend is still in place, I’m willing to overlook how destructive some people can be.
Armstrong cycles
– I read Martin Armstrong everyday. You will have to distill what he says into actionable advice but he is the real thing.
Long term market forecast
– There is a multi-year equity price forecast model that I have verified and assimilated. It’ll inform my investment/trading plan for the next 3-5 years. With a model like that it’s important to note the “tracking error”, i.e., what it advises differently than simply stay invested. For now there is none and the model is not at all concerned with the equity valuations (ie. CAPE) that many are worried about, notwithstanding some churning into 1Q’17.
Recession watch
– The next recession/bear market will likely be severe and take a decade or more to recover from in real terms. Even though none is visible on the horizon one will almost certainly hit within 10-12 years. The best case scenario will be to grow my portfolio enough before that happens so that I can dial back on risk exposure. That’s something I’ll monitor.
Macro cycles
– There are three long-term trends that I can point to concrete actions I’ve taken or will take in response:

  • Long term interest rates might finally tick up. I don’t profess to know when or by what catalyst, but the majority of my fixed income allocation in my passive portfolio in stable value funds that has little principal risk.
  • The rise of the East relative to the West. So far I haven’t done enough analysis on individual EM stocks. For now all I have is an overweight in EM in the passive portfolio.
  • I have a healthy allocation (~15% overall) to precious metals. The long term expected return of PM is only to keep up with inflation but it can act as a hedge against government folly, of which there is abundant supply. I have been in PMs since 2002 and held through the correction from 2011, though the tide has turned since early this year. My target price for gold is $3500-5000/oz for this cycle, after which I expect to keep only a few coins.

A passive indexer will no doubt look at what I’ve written and call me a “market timer”. To which I’ll proudly reply, “Guilty, as charged!” It’s an admission with considerable thought and qualifications: I’ll apply my timing methods to those multi-year to decade long trends using the models/indicators I have vetted. The goal is both risk control and return enhancement. The process will be documented in this blog – only time can tell how successful I’ll be.

Passive Portfolio September 2016

As discussed in the post on my overall portfolio construction, approximately 40% of the total is designated as “passive” which I define as following a relatively static asset allocation and utilizing low-cost index funds as much as possible. It is not the intent of this blog to teach the basics of passive investing. There are plenty of free resources available, among them the Bogleheads forum and Wiki pages. The asset allocation in my passive portfolio is given in the table below.

Passive_20160904

The salient features are:

  • The high level breakdown is 45% equities, 40% fixed income and 15% alternatives.
  • The equity percentage would be considered “very conservative” by most in the personal blogosphere where the standard recommendation is “100-120 minus age”.
    • The domestic/international split is roughly equal, in-line with the actual cap weighting. Today VTI has a P/E ratio of 19, VXUS 15 and VWO 13. Thus the expected returns are higher for international/EM.
    • REITs are implemented with VGSLX/VNQI. I count them towards the equity allocation while some count them towards alternatives. A good argument can be made for either approach. I would have preferred the mutual fund version of the international REIT index, VGRLX, were it not for the 0.25% purchase fee. Also note that the P/E ratios for VNQ/VNQI are 34 and 14 respectively, again underscoring the cheapness of international markets.
    • Domestic equities are implemented through a combination of large cap blend (VINIX and similar investment trust for S&P 500), and small/mid cap blend (VSMAX, VIMAX, VEXAX). The convoluted choices are due to the availability of funds in certain accounts: VINIX and VEXAX in my 401k, similar investment trusts in my wife’s 401k, VSMAX and VIMAX in my HSA. There is an overweight of the small/mid caps when market weight is only about 20%. In general I’m a believer of the factors research, but limited in fund access.
    • International equities are implemented through a combination of total international index funds (VTIAX and similar investment trust) and emerging market index funds (VEMAX). Since VTIAX already contains about 15% emerging markets I’m imparting a much greater overweight in EM than in small caps in domestically.
  • The 40% weight in fixed income is mostly in stable value funds. My wife’s 401k has an excellent one yielding over 3% currently, whereas mine has one that yields just over 2%, compared with current treasury yields of 2.28% for 30-yr and 1.6% for 10-yr. I keep a small percentage in total bond market, but otherwise happy to take the yield while avoiding any principal risk.
  • I have 15% allocated to precious metals (PM) which is probably the most controversial decision. I won’t go into the reasoning here since PM/gold deserves a separate series of posts on its own. For now I’ll only say that I have been heavily influenced by the ideas behind the Permanent Portfolio. PM_passive is meant to contain only physical bullions but still has a sliver of mining companies that I’ll reposition gradually.
  • The table also contains target and current weights. I have a relaxed rebalance limit of relative ± 30%, but allow myself the discretion to rebalance at any time. In fact I did just that last month when the PM sector was entering a correction.

Overall this is a very conservative portfolio that is meant to serve as a stable foundation. I plan to review the allocation on an annual basis. I do not foreseen any drastic changes; any tweaks will be small and take effect gradually.