It matters not what lines, numbers, indices, or gurus you worship, you
just can't know where the stock market is going or when it will change
direction. Too much investor time and analytical effort is wasted trying to
predict course corrections… even more is squandered comparing portfolio Market
Values with a handful of unrelated indices and averages. If we reconcile in our
minds that we can’t predict the future (or change the past), we can move through
the uncertainty more productively. Let's simplify portfolio performance
evaluation by using information that we don’t have to speculate about, and which
is related to our own personal investment programs.
Every December, with visions of sugarplums dancing in their heads,
investors begin to scrutinize their performance, formulate coulda’s and
shoulda’s, and determine what to try next year. It’s an annual, masochistic,
rite of passage. My year-end vision is different. I see a bunch of Wall Street
fat cats, ROTF and LOL, while investors (and their alphabetically correct
advisors) determine what to change, sell, buy, re-allocate, or adjust to make
the next twelve months behave better financially than the last. What happened to
that old fashioned emphasis on long-term progress toward specific goals? The use
of Issue Breadth and 52-week High/Low statistics for navigation; and cyclical
analysis (Peak to Peak, etc.) and economic realities as performance expectation
barometers makes a lot more personal sense. And when did it become vogue to
think of Investment Portfolios as sprinters in a twelve-month race with a
nebulous array of indices and averages? Why are the masters of the universe
rolling on the floor in laughter? They can visualize your annual performance
agitation ritual producing fee generating transactions in all conceivable
directions. An unhappy investor is Wall Street’s best friend, and by emphasizing
short-term results and creating a superbowlesque environment, they guarantee
that the vast majority of investors will be unhappy about something, all of the
time.
Your portfolio should be as unique as you are, and I contend that a
portfolio of individual securities rather than a shopping cart full of
one-size-fits-all consumer products is much easier to understand and to manage.
You just need to focus on two longer-range objectives: (1) growing productive
Working Capital, and (2) increasing Base Income. Neither objective is directly
related to the market averages, interest rate movements, or the calendar year.
Thus, they protect investors from short-term, anxiety causing, events or trends
while facilitating objective based performance analysis that is less frantic,
less competitive, and more constructive than conventional methods. Briefly,
Working Capital is the total cost basis of the securities and cash in the
portfolio, and Base Income is the dividends and interest the portfolio produces.
Deposits and withdrawals, capital gains and losses, each directly impact the
Working Capital number, and indirectly affect Base Income growth. Securities
become non-productive when they fall below Investment Grade Quality
(fundamentals only, please) and/or no longer produce income. Good sense
management can minimize these unpleasant experiences.
Let’s develop an "all you need to know" chart that will help you manage
your way to investment success (goal achievement) in a low failure rate,
unemotional, environment. The chart will have four data lines, and your
portfolio management objective will be to keep three of them moving upward
through time. Note that a separate record of deposits and withdrawals should be
maintained. If you are paying fees or commissions separately from your
transactions, consider them withdrawals of Working Capital. If you don’t have
specific selection criteria and profit taking guidelines, develop them.
Line One is labeled “Working Capital”, and an average annual
growth rate between 5% and 12% would be a reasonable target, depending on Asset
Allocation. [An average cannot be determined until after the end of the second
year, and a longer period is recommended to allow for compounding.] This upward
only line (Did you raise an eyebrow?) is increased by dividends, interest,
deposits, and “realized” capital gains and decreased by withdrawals and
“realized” capital losses. A new look at some widely accepted year-end behaviors
might be helpful at this point. Offsetting capital gains with losses on good
quality companies becomes suspect because it always results in a larger
deduction from Working Capital than the tax payment itself. Similarly, avoiding
securities that pay dividends is at about the same level of absurdity as
marching into your boss’s office and demanding a pay cut. There are two basic
truths at the bottom of this: (1) You just can’t make too much money, and (2)
there’s no such thing as a bad profit. Don’t pay anyone who recommends loss
taking on high quality securities. Tell them that you are helping to reduce
their tax burden.
Line Two reflects "Base Income", and it too will always move upward if
you are managing your Asset Allocation properly. The only exception would be a
100% Equity Allocation, where the emphasis is on a more variable source of Base
Income… the dividends on a constantly changing stock portfolio. Line Three
reflects historical trading results and is labeled “Net Realized Capital
Gains”. This total is most important during the early years of portfolio
building and it will directly reflect both the security selection criteria you
use, and the profit taking rules you employ. If you build a portfolio of
Investment Grade securities, and apply a 5% diversification rule (always use
cost basis), you will rarely have a downturn in this monitor of both your
selection criteria and your profit taking discipline. Any profit is always
better than any loss and, unless your selection criteria is really too
conservative, there will always be something out there worth buying with the
proceeds. Three 8% singles will produce a larger number than one 25% home run,
and which is easier to obtain? Obviously, the growth in Line Three should
accelerate in rising markets (measured by issue breadth numbers). The Base
Income just keeps growing because Asset Allocation is also based on the cost
basis of each security class! [Note that an unrealized gain or loss is as
meaningless as the quarter-to-quarter movement of a market index. This is a
decision model, and good decisions should produce net realized income.]
One other important detail No matter how conservative your selection
criteria, a security or two is bound to become a loser. Don’t judge this by Wall
Street popularity indicators, tea leaves, or analyst opinions. Let the
fundamentals (profits, S & P rating, dividend action, etc) send up the red
flags. Market Value just can’t be trusted for a bite-the-bullet decision… but it
can help. This brings us to Line Four, a reflection of the change in "Total
Portfolio Market Value" over the course of time. This line will follow an
erratic path, constantly staying below "Working Capital" (Line One). If you
observe the chart after a market cycle or two, you will see that lines One
through Three move steadily upward regardless of what line Four is doing! BUT,
you will also notice that the "lows" of Line Four begin to occur above earlier
highs. It’s a nice feeling since Market Value movements are not, themselves,
controllable.
Line Four will rarely be above Line One, but when it begins to
close the cap, a greater movement upward in Line Three (Net Realized Capital
Gains) should be expected. In 100% income portfolios, it is possible for Market
Value to exceed Working Capital by a slight margin, but it is more likely that
you have allowed some greed into the portfolio and that profit taking
opportunities are being ignored. Don’t ever let this happen. Studies show rather
clearly that the vast majority of unrealized gains are brought to the Schedule D
as realized losses… and this includes potential profits on income securities.
And, when your portfolio hits a new high watermark, look around for a security
that has fallen from grace with the S & P rating system and bite that
bullet.
What’s different about this approach, and why isn’t it more high tech?
There is no mention of an index, an average, or a comparison with anything at
all, and that’s the way it should be. This method of looking at things will get
you where you want to be without the hype that Wall Street uses to create
unproductive transactions, foolish speculations, and incurable dissatisfaction.
It provides a valid use for portfolio Market Value, but far from the judgmental
nature Wall Street would like. It’s use in this model, as both an expectation
clarifier and an action indicator for the portfolio manager, on a personal
level, should illuminate your light bulb. Most investors will focus on Line Four
out of habit, or because they have been brainwashed by Wall Street into thinking
that a lower Market Value is always bad and a higher one always good. You need
to get outside of the “Market Value vs. Anything” box if you hope to achieve
your goals. Cycles rarely fit the January to December mold, and are only visible
in rear view mirrors anyway… but their impact on your new Line Dance is totally
your tune to name.
The Market Value Line is a valuable tool. If it rises above working
capital, you are missing profit opportunities. If it falls, start looking for
buying opportunities. If Base Income falls, so has: (1) the quality of your
holdings, or (2) you have changed your asset allocation for some (possibly
inappropriate) reason, etc. So Virginia, it really is OK if your Market Value
falls in a weak stock market or in the face of higher interest rates. The
important thing is to understand why it happened. If it’s a surprise, then you
don't really understand what is in your portfolio. You will also have to find a
better way to gauge what is going on in the market. Neither the CNBC "talking
heads" nor the "popular averages" are the answer. The best method of all is to
track "Market Stats", i.e. Breadth Statistics, New Highs and New Lows. . If you
need a "drug", this is a better one than the ones you've grown up
with.
Change is good!
Steve Selengut
sanserve@xxxxxxx800-245-0494
http://www.sancoservices.comProfessional
Portfolio Management since 1979
Author of: "The Brainwashing of the American
Investor: The Book that Wall Street Does Not Want YOU to Read", and "A
Millionaire's Secret Investment Strategy"