Budget Buster

The market closure afforded the chance to get a few things done including the always budget-busting new tire purchase. They were originally going to be $950 but thankfully I thought to ask how long the old ones should have lasted. It turned out they should have lasted a lot longer than they did so the tire place took about $400 off the price.

There are two recurring themes I can tie in here. The first is that I believe the tires I get are quite ordinary. The need for tires doesn't come up often but there is never a good time for a $1000 one-off expense and tires isn't the only one that can reasonably come along. We've looked at this before  and readers have offered input along the lines of padding their budget by an extra $1000-$2000 per month, to having a separate bucket of money for one-offs that would be replenished so often and there have been other ideas too.

Someone with $800,000 who is disciplined enough to live on 4% is going to have a tough time paying for tires this month, a roof repair next month and an unexpected veterinary bill the month after.

The other tie in is living beyond ones means. While I was squaring up on my tires I glanced over to a display for a tire that cost $2000 for a set of four. These were some serious off-road tires and I know someone with a set of these on each of his two vehicles. The out the door cost for these babies would be much more than $2000. My $950 set is only $168 per tire, the rest of the expense is service provided. There can't be too many people outside of the military and jeep tour operators that need such serious off road tires but there is clearly a market for them.

We probably all have things that we spend too much on, relatively speaking, but beefy tires would seem to be a costly indulgence.

In case you didn't see this picture on Monday.

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A Useful Set of Financial Rules

Barry Ritholtz posted a list of investment rules by Morgan Housel from Motley Fool that I think is a pretty good list. As posted below with some of my thoughts;

1) Nine out of ten people in finance don't have your best interest at heart;

We all know that this is true in some magnitude, maybe it is eight out of ten or maybe 9.9 out of ten, but this has always puzzled me. Speaking for our little firm, the financial well being of everyone at our firm relies on how we treat our client base. It is in our personal interests to try to provide the best service we can and meet the expectations we set. New clients are not easy to come by and treating clients poorly would seem to be self-destructive but again Housel is mostly correct.

2) Don't try to predict the future;

There is a Yogi Berra quote in here somewhere. I believe this is an area where I have been influenced by John Hussman. He speaks in terms of weighing current positives and current negatives to make a forward looking analysis. I don't necessarily draw the same conclusions he does but there are things that occur in markets that indicate increased risks for a large decline. Any such indicator may be right this time or wrong this time but there are times where there is more front burner risk than at other times.

3) Saving can be more important than investing;

We've addressed the importance of having an adequate savings rate many times before along with the concept of living below your means; I believe the two are related. We have more control over how much we save than how well the stock market does.

4) Tune out the majority of news;

I would tweak this a little to say most news does not require taking portfolio action. I believe in making the effort to stay current but too many people react to news by making unnecessary trades.

5) Emotional intelligence is more important than classroom intelligence;

This probably refers to the various cognitive deficits and emotional quirks that we all have and not succumbing to them. If you can remember that every few years the market goes down a lot, for example, then you might be in a better position to avoid panicking when it happens. Many stock market bloggers devote time to help people understand and avoid this for good reason; people permanently impair their capital by being too fearful and/or too greedy.

6) Talk about your money;

I don't know what Housel means here, so I will guess that both partners in a couple need to be on the same page with financial matters. This either means that both need to agree philosophically or they need to figure out how to compromise effectively such that the relationship survives and that the financial plan has a reasonable chance of being successful.

7) Most financial problems are caused by debt;

I would broaden this out to say misuse of leverage which can include too much consumer debt and also misuse of leverage available in a brokerage account (margin debt, leveraging up with options, 2X or 3X ETFs and volatility). There have always been people who've blown themselves up this way and I suspect there always will be.

8) Forget about past performance;

This is one I mostly disagree with. In choosing an active manager an investor need to be on board with what that manager is trying do philosophically and looking to see whether the manager has generally met the expectation they have set. If they have, then the decision to hire them is a belief that the manager will continue to deliver against the expectation they set.

A manager who has a 20 year track record of mostly being very close to the market who then has one great year where he is 1000 basis points ahead of the market is unlikely to repeat that type of performance every year and so that would be a case where you would want to forget about past performance.

9) The perfect investment doesn't exist;

Well, I am aware of one actively managed ETF that lowers cholesterol and whitens teeth (humor attempt).

Any stock or fund you own that is doing well still has a bear case. When a stock doubles in a year then the bear case didn't matter while it was doubling but it was still there. Over the years that I have posted changes to the portfolio that we've made there have been comments disagreeing with the action taken at the time. If you've done the work and drawn a conclusion, have some confidence that you know what you are doing and can be right more often than not and for the times you are wrong, have the introspection to realize it and take corrective action.

This does not only pertain to individual stocks or narrow funds, it can pertain to a portfolio consisting of broad based products.

Thanks Morgan for the thought provoking list.
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The Big Picture for the Week of October 28, 2012

iShares strategist Russ Koesterich posted a video that was generally a support piece for iShares' suite of country funds. The topic for the video was seeking to replace income not earned from fixed  income due to low rates with higher dividends from equity exposure. I did not take the video to say that people should meaningfully change their mix of stocks and bonds so much as look for more yield from equities.

Over the course of the past week we've spent a lot of time talking about stock picking and risk tolerances and the video is a good follow on to this week's theme. Long time readers will know I am not a fan of broad based funds (except for economic reasons due to portfolio size) but I am a huge believer in the importance of international investing.

There are quite a few ETF providers that offer country funds, iShares simply happens to have the most funds. Koesterich doesn't really offer any analysis in the video, he merely points out countries where yield can be had and he notes that many countries are generally higher yielding than the US. The yield for some countries is quite high and this is worth investigating if you have not already done so.

The reason I think this video ties in with this week's theme is that the country funds offer access to most markets around the world without forcing individual stocks on someone who would rather not pick stocks. Using country funds over broad based funds allows someone to select some markets they believe are promising while avoid some they believe are not as opposed to owning them all.

There doesn't seem to be as many articles warning about how dangerous country fund are as there used to be, perhaps because the vast majority are actually not insanely reckless to own. During the financial crisis some other countries went down more and some went down less. The ETFs for Greece and Argentina could be thought of as insanely risky but it is difficult to believe that there have been a lot of buyers for those funds who didn't realize they were taking on a lot of risk.

In terms of owning country funds versus individual stocks the work load is probably less but many country funds have very large weightings in two or three stocks and it would be worthwhile to know at least a little about those large holdings. iShares New Zealand (ENZL) has two stocks with 15% weightings, client holding Statoil (STO) has more than a 19% weighting in iShares Norway (ENOR) and so on.

I believe as tools, country funds are democratizing for the easy access provided but they are simply tools to either be used prudently or poorly and there is no doubt that some people have been and will be burned by them for using them incorrectly.
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Of Closet Indexing and Stock Picking

Gary Kaminsky had an interesting "op-ed" that was very op, so to speak. He said when people go to a money manager they (the money managers) are going to tell you to own about 100 stocks in the name of risk management which he went on to say is a bunch of BS.

From there I think he was saying that at 100 stocks you become a closet indexer and so have no chance of outperforming. He said that top money managers never own more than 30 stocks, he learned first hand at Neuberger Berman, that he never wanted more than 30 stocks. He concluded with the "fact" that over the entire cycle, by owning a few names, that is how you make money. He said that this point was driven home countless times at a Goldman Sachs conference he attended earlier in the week.

A related question came in from Seeking Alpha founder David Jackson who asked for my opinion on the tradeoff of taking on the risk and effort to own stocks versus using broad based index funds.

It does not necessarily have to be that 100 stocks makes someone a closet indexer, that depends on the 100 stocks in question. A healthy dose of foreign stocks, small caps along with avoiding the largest 15 US stocks and I would say that the portfolio is probably not a closet index. I would further say that a portfolio of the 30 (to use Kaminsky's number) largest SPX stocks would look identical to the SPX.

The chart compares the Rydex Mega Cap 50 ETF (XLG) and the S&P 500 SPDR (SPY). That one is obviously 50 stocks, the 50 largest US stocks, not 30 but I think makes the point that picking a number of holdings is not in and of itself enough to make the argument Kaminsky is making.

Generally speaking, for accounts large enough where individual stocks make sense (economically, risk tolerance-wise or subject to any specific client mandate) we target 30-35 holdings with the mix typically being 2/3 individual stocks and 1/3 narrow based ETFs. Where the individual stocks are concerned we usually target 2-3% for each one with the idea being that with those numbers a great stock pick will be able to move the needle on the portfolio but a lousy pick won't be ruinous.

Kaminsky's comments focus a lot on beating the market or not and I think he is coming from the perspective of someone who manages the portfolio as opposed to a registered investment advisor and this is not a distinction without a difference. Most people who hire help deal with an advisor who isn't necessarily a portfolio manager and the advisor's job is to keep the client on plan, prevent them from doing stupid things and give the client a decent shot of having enough money when they need it. This does not have to involve beating the market as opposed to staying reasonably close over long periods of time. This advisor may choose money managers in the context Kaminsky means and often for these managers it is all about performances

Of course some advisors will simply use index funds or provide a portfolio of some other kind as part of the overall service they provide. Our firm is in the middle in that we have portfolio management in house that employs a certain philosophy that hopefully clients understand and believe in.

To David Jackson's question I have said many times that I believe for most people, the decision to use individual stocks boils down to time available to spend on the task and general interest in doing the task. In David's comment asking the question he talked about the work involved with individual stocks and I agree that most people will not want to put in the time needed to monitor a portfolio of stocks and the bigger point is that even if someone puts in the hours there is no guarantee that they will add value with the work they do; David's context is individual investors managing their own portfolios.

The real risks to managing a portfolio of stocks (assuming a good amount of time is devoted) are behavioral factors. A reasonably well diversified portfolio (in terms of number of holdings and concentration of various things) is very unlikely to go down 50% in a down 25% world but repeated flawed behaviors will compound to do a portfolio in over time and I can tell you that a lot of people do not learn from their mistakes or the mistakes of others.

People can make very bad decisions with broad index funds too.

My takeaway remains what it has always been which is the extent to which it starts with the end user in terms of savings rate and making some effort to learn about markets and behaviors so as to avoid or at least minimize self destructive behavior. That is the majority of the battle for people who wish to undertake this on their own.
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The Wrong Tool For The Job

Long time readers may recall that my wife and I live out in the woods on a mountain where most of the roads are steep, windy and unpaved. Recently someone moved in a little further up the mountain and one of their toys is something similar to the bike pictured above.

The bike in question that our new neighbor owns is clearly a street bike but the last mile or two (depending on how far up he lives) is steep, windy and unpaved. A couple of nights ago around 11pm he was trying to get home and couldn't quite make it up a particularly steep part of the road but that didn't stop him from trying for about an hour and a half. Finally he got towed to his house.

It certainly comes as no shock that he is now having trouble here with his bike. It is not his only method of transportation but this mountain is the wrong place for trying to use a street bike for daily use (other people have had trouble here with street bikes over the years too).

This neighbor is using the wrong tool for the job. Plug in any investing metaphor you think suitable. As for the picture of the unicycle, it would be the wrong tool here too, but I just added it for the comedic value.

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People Who Think They Are Conservative Investors

For the last couple of days we've been talking about pros and cons of buy and hold. On the Seeking Alpha version of one of those posts a reader left a comment noting that buying and holding forever does not apply to tech stocks because the technology changes so frequently.

This is an interesting comment for two reasons. The first thing is that in the past it is quite obvious that many investors have believed that tech stocks were buy and hold forever. Many names, like MSFT, INTC, DELL and CSCO, had true-wealth creating runs lasting ten years or more and cognitive deficits being what they are, many people expected that to continue for a long time.

Fast forward to today and I would say it is quite obvious that many people feel Apple (AAPL) is a name to own forever. Maybe tech should never have been considered buy and hope to hold forever  but it has been thought of this way.

I think there was a religious-like devotion with many tech stocks 12 years ago as there is with Apple and some dividend strategies today (there are probably others too). Anyone who has been reading this site for a while knows that I spend a lot of time looking out for these devotional themes and that I will often reduce or eliminate our exposure to them or discuss why they should be avoided if we don't own them.

One clue that I am on to something when I write about this or take action in this context is getting flamed in the comments or via email. This has been the case with solar stocks, Bank of America and most recently when we reduced our exposure to Apple a few weeks ago. In a similar context, there have been a lot of blog posts that have focused on what to avoid and how important that can be in contributing to a long term result.

In terms of isolating this devotion in a stock or a narrow segment of the market (like solar) it is not very difficult to find these and then avoid or underweight them. The more emotional others get the more likely something is happening that is worth avoiding.

With some of the emotion surrounding dividend strategies these days, the answer here is a little more complicated. Growth of dividends is a vital component to a long term portfolio success. What I think I see going on in this space is a large group of investors who believe they are conservative and may not fully understand the risk they've taken; the love of mortgage REITs is a good example.

I've written before about the love that people have for Annaly Mortgage (NLY). Recently it cut its dividend by a nickel to $0.50 and the stock has sold off noticeably although not in ruinous fashion. With so many articles out there validating the idea that because bond yields are so low, people should put more into equities and here are some with great yields and solid businesses (sticking with the mortgage REIT example but there are others) there are people taking on additional risk and they are unaware of this.

The thing with risk is there is no way to know whether there will ever be a negative consequence for a risk taken but I can tell you from comments left on my blog and my Seeking Alpha posts from four years ago that people absolutely come unglued when things hit the fan and then they forget the pain once the market recovers some (as it always does).

It seems to me that if someone is inclined to spend a lot of time arguing on what amounts to message boards about how great some sort of investment is, then that person is also a candidate to meltdown when/if there are negative consequences to that particular investment.
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Buy and Hold Still Not Entirely Dead

Yesterday's post tried to explore the extent to which buy and hold investing has evolved and maybe how it can be applied today. On a related note one of the defensive, dividend names we have owned since 2004 hit a 52 week high in the last couple of days, this level is also an all time high just slightly eclipsing the old high from mid 2008 (it is a defensive stock and so it kept going up for a while even after the market had started rolling over).

The company in question has been raising its dividend since the Pilgrims landed (slight hyperbole) and since we bought the stock the dividend has slightly more than doubled. YTD and for ten years the stock has lagged, since the market low it has outperformed and since we bought the stock it is about a push versus the S&P 500.

In talking yesterday about stories changing meaningfully for the worse, I do not believe that has happened since we've owned this particular name but of course it has not been a one way trade either. Assuming there is no meaningful change for the worse the stock will no doubt remain committed to increasing the dividend, do very well during certain parts of the stock market cycle and lag during others and hopefully at least stay close over long periods of time

In terms of maintaining a diversified portfolio the above description is what I would hope to see apply to a few of the holdings. Up a ton is a description I would also like to see on a few of the holdings. My idea of diversification is to take in holdings with many types of attributes which serves to smooth out the ride some over the course of the entire stock market cycle. Smoothing out the ride may not sound too important now when things are going very well for the stock market but I believe it matters a lot when things are going poorly.

On what is probably a related note the above stock I wrote about is obviously a dividend growth stock. Over the years I have picked on various dividend strategies but I am quite fond of dividends but it is ok to be fond of other attributes too. Simply put  it is my opinion that going all in on any single attribute makes for lousy diversification which is ok for people who don't care about diversification (some folks don't). The problem comes when people want to be diversified, think they are diversified and find out the hard way they are not.
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CNBC Earlier Today

Please click here to watch the video.
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CNBC Today

I am scheduled to appear on CNBC today shortly after the market close. Today's topic will be fire suppression in the urban interface and rural fire department management.....oh and maybe the near term prospects for the stock market in the face of a not so hot earnings season, the election and a few other things.
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Buy and Hold is Not Entirely Dead

Yesterday I noticed an article at Seeking Alpha about a stock that we have owned for clients for many years. The implication from the title (as I read it) was that the stock has been great and will continue to be great for a long time. Although the name doesn't matter for purposes of this post, I obviously hope the conclusion drawn turns out to be correct.

My thought upon digesting the title but before I read the article was that it would be great to be able  to pick one stock for each sector and have them all grow to the sky. My next thought was the folly that usually goes along with articles that try to find ten stocks to own forever.

I was not able to find any ten stocks to own forever articles from 2000 but most of us probably have a good sense of the types names that merited such praise back then. Two names that probably showed up a lot in this context back then were Cisco (CSCO) and JDS Uniphase (JDSU).

There is no doubt about how important their products are in terms of making the world function, especially Cisco, but as you can see from the chart, JDSU is down 99% from its high and Cisco is down 72% (actually from Cisco's high a couple of weeks later it is down 77%). Clearly the prices in Q1 2000 were not justified but the result for the last five years have been lousy too. In the last five years JDSU is down 33%, there was a huge spike up in early 2011 though, and Cisco is down 45%.

Back then the stories behind all the top tier tech stocks, DELL, INTC, MSFT and CSCO, were very persuasive and all these stocks were poised to grow to the sky. Chances are we all met someone who was made rich holding on to these names for ten years but then of course it ended.

This is a good excuse to remember that any stock, no matter how great it appears to be can have its story end or change meaningfully for the worse. This is not to say that buy and hold must be dead, we have quite a few names that we have owned for clients for eight years and I would be happy to hold them forever. If the story for a stock doesn't change meaningfully for the worse and you are not a trader then why not hold on to it? Fewer commissions, less in the way of tax consequences and more in the way of dividend growth are all good reasons to try to hold on for a very long time. The job then becomes monitoring the names owned and being on the lookout for serious changes which can include grossly excessive valuations.
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Sunday Morning Coffee

The Barron's interview was with Michael Hasenstab who manages the Templeton Global Bond Fund (TPINX). He had the following quote which I think framed a great way to think about risk;

I don't believe emerging markets are the new safe haven. There are risks there, but at least you are getting compensated for those risks, whereas in many of the developed bond markets, you aren't getting compensated for the risks.

Stocks and bonds should offer compensation in some form for the risk taken to own them. For stocks this is some combo of price appreciation and dividends (or distributions for MLPs) and for bonds this usually means interest paid.

He also included a mention of the term fiscal risk which is something that needs to be considered much more than before the financial crisis. With a couple of exceptions, investors never gave much though to fiscal risk but now it must be the basis for any fixed income portfolio.

After a three and half year run where the stock market more than doubled it is easy to become somewhat complacent about risk, get impatient when the portfolio is not going up even more and forget what the consequence of risk feels like.

Marketwatch had a column on Friday about many of the behavioral flaws that destroy wealth and not properly assessing risk should always be part of this conversation.
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What To Do If Rates Rise

A reader asks;

Roger as asset classes go lot of pundits are warning about interest rates rising and warning to get out of bonds, or change duration mix. Have you changed your asset holdings based on these warnings
My feeling is unless economy improves interest rates are unlikely to increase significantly.

This is ground we have covered before but worth going over because of what is likely a long time table. Hopefully it is clear that buying the US ten year treasury yielding first 3%, then 2% and what has been sub 2% for many months now is buying high. People buy high with the hope of prices going higher but buying high is buying high and that takes on risk.

For many years, including the aftermath of the financial crisis buying high has been rewarded with even higher prices. I would have thought there would have been a negative consequence to years of buying high by now but that has not been the case as the Fed continues to distort markets but the intermediate part of the yield curve and farther out the curve is where the most risk is. It may be years before this matters but this is where there is the most risk.

If you can isolate the part of the market that has the most risk then it becomes very easy to figure out for yourself whether you want to take on that risk or not. It is a risk we prefer not to take but you may draw a different conclusion and may get out before the risk matters.

We own a combination of shorted dated corporate bonds with very little interest paid but we avoid interest rate risk. We own short dated foreign sovereign debt which typically yields a little more but does take currency risk. We have a couple of preferred stocks--the yield there is pretty good. And we own a few other things via funds like emerging markets that also have decent yields.

Where the risk is so obvious I would prefer to simply avoid that risk. I agree with the reader that it seems unlikely that rates will go up soon but I would prefer to not buy relatively poor fundamentals at very high prices (long dated treasuries). We have generally avoided treasuries for quite a few years now in line with the thinking outlined above.
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Grantham likes Timber

The team at GMO posted asset class return predictions for the next 7 years here. The link is only a PDF there was no commentary but the info is still worth thinking about.

Number one on the list for expected returns is timber. The PDF does not specify timberland but many times in the past he has talked specifically about timberland. This of course will get investors thinking about timber REITs and the timber ETFs WOOD from iShares and CUT from Guggenheim.

Any of those may be fine holdings but expecting a precise correlation to actual timberland is to expect too much. WOOD allocates about 60% to industrials and CUT allocates 74% to materials; those numbers come from the funds' webpages, but there are a lot of overlapping names as you might expect. Over the last four years (since WOOD's inception) the chart of both looks like the S&P 500 but have lagged that index.

Plum Creek Timber (PCL) is the most widely known and followed timber REIT. We used to own PCL for clients and sold it because I felt it was over-owned such that the correlation to the market would increase. After a short period in early 2008 when it looked very little like the market it has since tracked very closely to the Utility Sector SPDR (XLU). If you want to own the name because  you like the fundamentals and the yield then go for it (I am not implying anything wrong with the fundies) but it has lost much of the low correlation effect it once had.

GMO thinks emerging market stocks will do well in the next seven years, thinks US large cap will have zero return and that TIPS will have negative returns. There are plus or minus numbers tied to each asset class mentioned (there are others besides the ones I mentioned).

Accessing actual attributes associated with timberland even with PCL is difficult because the share prices are subject to the various emotions that all stocks are subject to. This is similar to farmland stocks. Adecoagro (AGRO) and Cresud (CRESY) have lagged badly behind the S&P 500 for the last couple of years and although they haven't looked much like the stock market, investors haven't really benefited from theme.

There is no reason to think that access to these spaces can't evolve but for now the stocks don't offer as much diversification as the concepts.
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Bill Miller Update

I meant to write this post for Tuesday but we had a structure fire Monday afternoon that kept me busy until around midnight (most posts are written the night before).

Bloomberg had a quick write up giving us the latest on once legendary mutual fund manager Bill Miller. Although he no longer manages the Legg Mason Value Trust he does still manage the Legg Mason Capital Management Opportunity Trust (LMOPX) and the fund is doing very well with a 29% YTD return through October 11.

The article notes the extent to which the fund has had this move by concentrating in banks, home builders and mortgage REITs. The Morningstar page for the fund says the risk is high and most of the related stats are not good either.

So the market is having a good year and the fund is doing very well. Any guesses what the fund will do the next time the market goes down a lot?

There are funds and managers that are very much live by the sword which is fine up to a point. What I mean by that is that many fund holders did not realize that certain managers were living by the sword, that is taking very big risks.

It is very easy to look at a stock or a fund and know whether it is more likely to go up more than the market on the way up and down more than the market on the way down. Caterpillar (CAT) is a great example of this and one I have mentioned many times before. And so apparently are funds managed by Bill Miller.

Most of the time a portfolio is a mix of holdings with various volatility profiles. Typically when it looks like the market might be on the road to down a lot we will look to reduce the portfolio's volatility by selling names that tend to be very volatile--relative to the portfolio.

Understanding what each holding is likely to do (no guarantees) in the face of a large decline should go along way to managing the amount of volatility you are exposed to.
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Wasted Emotion

Recently I visited with a long time friend and for whatever reason on that day he really wanted to talk about politics, specifically the presidential election. We have different views and based on the conversation he seems to be far more emotionally invested than I am.

Generally I view this stuff from the lens of trying to understand what various outcomes might mean for markets but I don't think it is very productive for a portfolio manager to be emotionally invested in election outcomes. I generally have preferences but don't feel the need to convince other people that my way is right as I think my friend might have been doing.

Every so often on Facebook I will post something political and often there will be dozens and dozens of comments with people arguing back and forth. The other night I posted that I thought the VP debate would be funny but that it was instead unwatchable and I mentioned my belief that Ryan is an odd pick strategically as he would seem to be an unlikely magnet for undecided voters. This drew 67 comments, very few of which were directed at me (which is fine) in which people from both sides tried to convince the other side their way was best.

So it is with attitudes about investing that I see in comments on my articles that get republished at Seeking Alpha (and to a lesser extent the originals posted on the blog) and articles from other writers at Seeking Alpha. The most tangible examples are various dividend strategies and indexing but there are plenty of others too. Occasionally people leave comments that Benjamin Graham's way is the only way to make money in the markets or they will say the same about Warren Buffett.

The only way to...is a ridiculous notion as people succeed in markets with every conceivable method. People make a killing speculating with options while others permanently impair their capital very quickly speculating on options. Sell you losers? What about you can't go wrong taking a profit? Obviously people have success with Graham-style value investing but there is plenty of success to be had with swing trading. Jack Bogle says we should index invest but there are plenty of active managers who add value.

I get a big kick out of Bogle because he is very clear about his beliefs on indexing yet he has regularly called important turning points for the equity markets.

Realistically most of us will only find one method that is right for us. Maybe for you it is value investing ala Graham while your neighbor is an indexer and your co-worker is a swing trader. It is important for people to figure out what type of investor they are and it is likely that some portion of  reading that people do is focused on trying to learn a little more in order to refine their version of the method they gravitate to.

This blog is a look over my shoulder for anyone who cares to look but I have been very consistent in suggesting that people take little bits of process from various investors to create their own process.
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Sunday Morning Coffee

A Barron's roundup;

The Trader column gave a lot of real estate to Peter Andersen of Congress Asset Management and his process for screening dividend stocks. He would rather buy companies with low payout ratios and room to increase their dividends which typically means stocks with lower yields as opposed to the highest yielding stocks.

In a comment I didn't precisely follow, Andersen said (I'm paraphrasing) that there are plenty of stocks with 4% yields and, using a college analogy, those stocks are the graduates, they prefer to buy freshmen who will go on to become 4% yielders. It was implied that the stocks he is talking about will provide more total return but it was not spelled out as such.

Dividends are very important but I am not one to have the entire portfolio in some sort of dividend strategy. There are various related stats that are similar to the one I have referred to before which is that since the 1920s dividends have accounted for 42% of the total return of the market. The more yield that can be had from the portfolio then the less market volatility that needs to be taken on up to a point. If the market's total return in a given year was 2% dividends and 8% price appreciation then one way to look at is is that a portfolio that yields 3% would only need to have 7% in price appreciation to keep up with the market.

Merely keeping up with the market may not seem so hot but people with an adequate savings rate that can stay reasonably close to the market over time have a very good chance of having enough money when they need it.

The reason I say up to a point above is that a portfolio that yielded 10% would take on much more volatility than the broad market but unfortunately this would probably not become evident until a large decline had started to pick up steam but by then it would be too late.

There was an article about long term care insurance in terms of how it has evolved and what the limitations are along with a specific type of combo policy that might mitigate some of the limitations. It concluded with a strategy of using different types of policies.

I am not an insurance agent so I won't address any specifics (can't add any value) but this is something that people need to investigate and sort out for themselves--or get professional help with sorting it out.

Lastly the interview was with Byron Wien. Among other things, he is favorably disposed to emerging market equities. There was one nugget though that I really liked from the introduction paragraph.

"I'm so anxious to go to work, and I'm almost 80," says Wien. "So to be excited about going to work at that age is a blessing."

This ties in with a theme I have been writing about for years. I personally don't want to ever have to worry about social security such that I would be in a lot of trouble without it. I also believe that the sense of purpose that goes with having a job of some sort, past the normal retirement age makes for healthier aging.

It will not work out that everyone can do this which is why it is so important to save a lot. A healthy portfolio balance combined with some sort of income beyond Social Security obviously increases the odds of successfully weathering any sort of financial storm or would make for a better quality of life.
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The Big Picture for the Week of October 14, 2012

One of the bits I enjoy doing on Twitter is making fun of Jim Paulsen, Thomas Lee and Tobias Levkovich when they are due to come on CNBC. Of Paulsen and Lee I usually say something like their name? wait, don't tell me...BULLISH! And of Levkovich I usually say something like Tobias Levkovich to come on with some obscure stat that means the market is going higher.

So it was yesterday that I tweeted the above out about Levkovich and somehow this tweet made Carl Quintanilla's radar and right before the segment and he tweeted back "let's find out." So ole Tobias did not disappoint with Marshallien K which even he said was out there. If you Google it you will find it but it is obscure enough that there is no Wikipedia page on it (nothing at Investopedia either). I tweeted Marshallian K back to Carl but he did not respond to that.

It might be that I am the only one who thinks this is funny but it does make a bigger and more useful point about how unnecessarily complicated people can make investing. Whenever possible I try to make investing as simple as possible. Like many people I probably first clued into this from Peter Lynch in the 1980s (maybe he started talking about this in the 1970s?). Then I started noticing that most of the investors being portrayed as legends looked at things very simply, seeking the simplest explanation along the lines of Occam's razor (yes RW, the precise meaning is a little different).

I think a useful example here is the inversion of the yield curve before the financial crisis really ramped up. In the years before the crisis I wrote often that I would heed a yield curve inversion as being a very ominous sign for the market and the economy; banks don't do well on lending spreads which causes a lot of problems. Of course when the curve did invert in 2007 there were plenty of very smart pundits telling us why this inversion did not mean trouble--back then the Chinese were buying our debt in such a manner as to distort our yield curve.

While it might have been true that the curve was distorted by Chinese buying, the curve was still inverted which was still problematic for banks nonetheless.

The idea gains some relevance because the market has more than doubled from its low 43 months ago. Cycles tend to last four to five years so it is possible that after slightly more than three and half years that the next bear could be coming soon. Regardless of the time, as we get closer to whenever the next bear phase starts there will again be plenty of people like Paulsen, Lee and Levkovich with plenty of reasons why the market will ignore any bearish markers at the time and go higher (all three missed the financial crisis and two of the three missed the tech wreck, one was not a strategist during the tech wreck).

You will probably be much better off seeking out the simplest explanation whenever possible.

We recently got back from our annual pilgrimage to the Grand Canyon. In the above picture a mule train went by near the South Rim.
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10/11/12

A reader pointed out this article at Seeking Alpha about the Norway Government Pension Fund--Norway's sovereign wealth fund.

The article has several bullet points discussed including one about avoiding inadvertent indexing. The idea here was not to avoid indexing but to avoid paying an active management fee for what amounts to an indexed portfolio. Chances are you've heard the term closet indexer. This refers to funds or managed accounts that quack like some broad based index.

There are at least two reasons why a manager would look a lot like an index. One of which is something called career risk. The idea here is that it is ok to be wrong if you're wrong in the same way as everyone else. I think a good example of this was the extent to which many well known managers were overweight financial stocks five years ago. Another example would be being overweight tech stocks 12 years ago.

Another reason would be size. When a fund has many billions in AUM it becomes difficult to stray from the index because it can't really buy small stocks, it would have to buy half the company to move the needle for the fund.

The above chart is an actively managed, global equity fund (name and symbol removed) that charges a fee that is well within the range of normal for an actively managed fund. The fund's result is in blue and its Morningstar benchmark is in orange. I doubt the fund's marketing is "we're going to look just like the index but charge you a lot more!"

Looking like an index now and then is inevitable but the in my opinion that does not have to mean a result like the above chart. I would note this does not have to be about performance in terms of a fund manager saying they will beat the market every quarter or every year. I would think that any manager would have some sort of philosophy and they need to articulately convey that to anyone who is thinking of hiring them so that there is not a mismatch in expectations. For example we are not worried about beating the market for a given quarter (without looking how'd you do in Q2, 2010?) but their are investors who do need to beat the market for the quarter so that person would be a bad fit with our firm as an example.

To be clear, indexing is a valid way to invest. It may not be right for everyone, no method is, but it is valid. The point being made is that no one should pay 1.5% for what amounts to an indexed portfolio. Another point of differentiation to make is an active strategy using index funds. There are managers having success with active strategies that use passive funds.

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No Post Today...

...but a (hopefully) cool picture of the entrance to Yellowstone National Park from Silver Gate. MT.
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Now Everyone Hates Apple?

A little over a month ago we reduced our position in Apple (AAPL) by virtue of swapping half of our core technology ETFs into a tech ETF that does not own Apple. This had the effect of reducing our exposure from about 4% to about 2%.

There was no fundamental bear case to make at the time but there was a pretty good list of sentiment indicators that we've all seen before in terms of analysts competing for higher price targets as the stock kept going up, the stock getting constant attention on stock market television, a lot of excitement about the coming product launch and the stock having become the largest company in the world (click through on the above link for more details on these things).

Since we made the swap the stock went down a hair, then up a few percent and now most recently down a few more percent (the stock was $675 when I started placing trades in late August).

Now things seem to have changed some. It is still talked about a lot on stock market television but now it seems like a lot of pundits hate the name all of a sudden which speaks to the psychology of the market.

The point of this post is not about Apple specifically as it is too early to be right or wrong with the trade. The point here is the list of sentiment based indicators isolated in more detail in the previous post. I didn't write that post and place that trade because I hadn't seen those things come together many times before. Often I talk about the details of various market events being different but that the behaviors tend to repeat over and over.

Reducing a position when the sentiment becomes cultish or euphoric will not be the worst trade you ever make.
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Fixed Income Allocations

Barron's had an article about the increasing popularity of emerging market debt. The article makes it seem like interest in this space is new but I seem to recall Bud Fox pitching the space early on in the first Wall Street movie.

Included in the article was a quote from a money manager who "recommends allocating as much as 35% of fixed income to the category." A big part of the story here is of course that things like treasuries, money market funds and investment grade US corporates pay very little interest by historical standards. If ten year US treasuries paid 6% there would be less interest in emerging market debt--that is not a commentary on fundamentals so much as an opinion that people would be plenty satisfied with that yield.

If you can accept that this is about yield then I would submit there are plenty of places to get yield without allocating 35% to any single segment. There are plenty of things that yield, 4-6% that don't take on absurd risk. Keep in mind that we live in a zero percent world so the more that is allocated to things that yield 4-6%, or higher, the more risk that is assumed.

We have exposure to emerging market debt through the PowerShares fund that has symbol PCY. Depending on the client we target 5-10% of the portfolio to the space with this fund. We have room for a little more exposure to the space but not much more IMO. The yield shows 4.75% but we've had it for a while and so our yield is a little better than that. There are other EM bond funds that yield more of course but going for yield at any cost, as indicated above, increases the risk assumed.

For many years I've written about our use of preferred stocks. Many clients own two different issues at a 5% target weight each. We could find ones that yield in the sevens but are quite comfortable in the high five-low six area.

We have used individual issues of foreign sovereign debt for many years now. Some countries provide very good yield and some don't yield as much. Individual issues can be difficult to access because of the minimum order sizes associated with the space but there are ETFs that offer the exposure too. Some clients own the WisdomTree Australia New Zealand Debt Fund (AUNZ) which shows a distribution yield of 3.46% (of course that is a backward looking number, it may yield more or less in the future).

Most clients also own the most boring closed end fund I know of, it is a very generic go anywhere fund. The name isn't that important as there are plenty that don't use a lot of leverage, don't trade at a gross premium to NAV and aren't that volatile. Some closed end bond funds can be nauseatingly volatile. Too much exposure to this space will cause tears on the next big downturn.

The above are just some of the spaces where yield can be had. Other spaces that we don't own but have yield available include high yield (junk), floating rate loan funds and various parts of the mortgage market.

We only do a little with muni bonds. Individual issues tend not pay too much but of course levered closed end funds pay a lot. We also have TIP exposure but that is not about the yield.

The other really big chunk of the fixed income portfolio is short dated, investment grade corporate debt. Here we use a combo of ETFs and individual issues and the yield is not very good. The more of a fixed income portfolio in this space the less risk that is likely being assumed. The balance between this space and the above categories is of course up to the end user.

By spreading across various segments, versus concentrating 35% in something like emerging markets, there is a chance that not everything will go down at the same time. 2008 was an outlier in this context as markets stopped functioning normally. Diversifying risks by allocating smaller portions to many segments can work when markets function normally. A repeat of 2008 in terms of market ceasing up is a low probability event but large price declines in specific segments are not quite as outlying of an event.
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Sunday Morning Coffee

Barry Ritholtz linked to an article that was fun read but was weak in terms of supporting the primary thesis (if I understood the primary thesis). It was a lighthearted age warfare piece where the 34 year old son was the voice of one generation blaming his 63 year old father as the voice for another generation. Blame was placed on all sorts of economic and social issues and concluded with the 63 year old father saying to 34 year old son that one day the child of the 34 year old son will blame him (the 34 year old) for all that is wrong with the world.

The goes around comes around conclusion might mean that age warfare was not the actual premise of the article.

The idea of age warfare is evolving as a theme and while I think it can be productive to look at past behaviors/mistakes and try to learn from them I don't think blaming a previous generation for today's problems is anything but a copout. The debt that has been incurred over the last 10-20 years (or any other timeframe you care to think about) will be a burden for some lengthy period of time but the impression I took from the article was something of a woe is me, how will we ever succeed mentality.

Many aspects of being an adult in this country are different than they were in 1980. Similarly being an adult in 1980 was different than being an adult in 1950 and so on, things are always changing. It seems plausible that 2012 is a more difficult time to be a productive adult than it was in 1980 however I have to think it was more difficult still in 1935 versus 1980 or now.

However I do not necessarily think the idea of difficult times is a byproduct of the financial crisis. I am 46 years old and so I might be in the age cohort that has it worse than their parents (I am talking in generalities, I personally have nothing to complain about). Assuming 46 is a part of the age cohort in question, I noticed that when I was in my late 20s a lot of people my age had not yet found their way professionally.

When I was 18 someone said to me that you start making money in your 30s and 40s. I think that presumes that you've slotted into some sort of career track by your late 20s but if people who are today in their 40s got a later start for whatever reason then some of the complaints in the above linked article have been 15-20 years in the making. I would submit that things changed (as they always do) and recognition and adaptation was somehow hard to come by for a particular age group.

As I read the article it seemed like the 34 year old author wanted society to solve the problems that his generation is having. No one will care more about your problems than you will and there is no better solution to your problems than the one you create. There will always be something of a social safety net but hopefully it is obvious that the less reliance on that safety net the better off we'll be.

What happens if there is means testing for social security and what if people with a lot less money than you might think get tested out of a large chunk of what they think they will get? That is a problem that I think is very much a real possibility for people today who under the age of 50. Someone who is today 40 years old has enough time to at least partially mitigate that outcome.

This really is a bootstraps post. People who figure this stuff out for themselves will be much better off in the long run.
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Understanding the Moment

The other title I had in mind for this post was Our Long National Nightmare is Over.

Yesterday on the AdvisorShares Alpha Call Michael Young, the call's host, was planning to tease me about the season that the Red Sox had but not surprisingly I found something applicable to investing here.

One of my older brothers is a bigger sports fan than I am. Shortly after the Red Sox won the 2004 world series, which came on the heels of two Super Bowl wins for the Patriots (we are from Boston), I proclaimed that this is our decade and that we should enjoy it while it lasts. The Sox and Pats won one more each and then a little later the Celtics and Bruins won championships too. While we're at it the Boston College mens hockey team won four championships, Boston University won one and even the Boston Cannons won a Major League Lacrosse championship.

In pointing out in 2004 that this was something special I believe I had some understanding of the moment.

So it is with investing. The late 1990s was one kind of moment where everyone involved was making a lot of money without having to do much work. It turned out badly for most folks for not realizing that it was a unique moment that would end. The market is having a different kind of moment now that I talked about yesterday on the Alpha Call.

In the last 42 months the S&P 500 has more than doubled. In that time there has been little to no natural economic growth and little to no natural economic recovery. What I mean by that is that whatever economic growth has occurred has come from the Fed's having the accelerator pressed all the way to the floor and that much of the stock market's price appreciation has come from the Fed trying to steer people into more equity exposure.

To the extent the above is true (I believe it is) then it makes sense to think about what may happen if the equity market ever decides to stop playing along with the Fed's policy. I don't know if that will ever happen but if the market has doubled on what are still lousy economic fundamentals (I believe they are lousy for being artificial) then participants need to understand that and realize that the consequence could be painful. This is not a prediction just a realization of what the rally has been built on and that the Fed thinks things are still weak enough that we need zero percent rates until at least 2015.

The national nightmare bit at the top is also a Red Sox reference as the team fired beleaguered manager Bobby Valentine yesterday. His hiring was an obvious mistake right out of the chute, went south right away and now is finally over although along the way the team was completely gutted and so we may be in for a period of rebuilding. When he was hired I commented that giving him the job was "truly a black swan."
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AdvisorShares Alpha Call Today

I will be participating in the AdvisorShares Alpha call today at the market close.

The dial-in instructions as follows;

1-800-977-8002 Code: 777534#

I hope you can listen in.
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The Debate

Last night's Presidential debate was very entertaining. I think Romney cleaned Obama's clock in terms of being more specific (not to say he was very specific) and bringing many more facts to the table. While I would prefer Romney, I still don't think he can win Ohio however.

On a far more important note Miguel Cabrera won the triple crown, the first player to win it since Carl Yastrzemski did it in 1967. This is a very neat thing for baseball fans.
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Speaking of Which...

Yesterday's post was about no one being able to be correct with every single holding in their portfolio all the time and that occasionally a holding will get blindsided, more correctly the person with the holding gets blindsided.

Right on cue one of the stocks we own for large accounts and the fund we subadvise got crushed. MSCI (MSCI) finished the day down 26.8%, although it had been down a little more earlier in the day, on news that Vanguard will be switching away from MSCI indexes for several traditional funds and several ETFs (22 in all).

It appears as though Vanguard might save a little money on licensing which if correct would allow it to more easily remain competitive with ETF providers like Schwab who are probably willing to operate their ETFs at a loss. The bigger reason might be to allow for differentiation in its Emerging Market ETF (VWO) and iShares Emerging Market ETF (EEM) which for now both use the same index. (thank you IndexUniverse for the above info).

IndexUniverse also devoted quite a few pixels to quotes from people at iShares about doing more business with MSCI. The revenue loss from these Vanguard funds although not de minimis is pretty small and does not merit a 30% decline in the share price (the stock was down that much during the day) in my opinion.

The arc thus far is not a new one. Bad news that catches the market by surprise causes the stock to overreact, the question then is what happens next. One typical path is that after the panic the stock then quickly retraces a meaningful chunk of the decline. If the trading yesterday is the overreaction I believe it was then a snapback as described above seems very plausible. We'll see.

In terms of impact on the portfolio it was quite small. The NAV of the fund we subadvise was down 0.28% yesterday versus lift of 0.09% for the S&P 500. Any client accounts may have been more or less. The rest of the portfolio had a good day coincidentally or the NAV would have had a bigger drop.

This is exactly why I target relatively small weightings for individual stocks. From here the stock will either be a good hold or a bad hold but it is not a realistic concern that the company will cease operations. For now this was merely a bad day for the portfolio but not even that bad. Time will tell whether this was a hiccup or a mistake but the as I write about quite regularly the consequence, if it really turns out to be a mistake will not be ruinous.

As a another follow up from yesterday the 30 for 30 documentary about broker athletes was fascinating. It did get around to Curt Schilling's troubles up to a point but surprisingly gave Lenny Dykstra's story very little time but maybe that one will be an entire mini-series.
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No One Wins Them All, and That Is Ok

One purpose of this site is to let anyone so inclined look over my shoulder at the moves I make in the portfolio I manage for separate accounts and the exchange traded fund we sub-advise. When a decision is made to by or sell something I post about it a day or two later--obviously I don't announce a trade here before I place it for clients.

As I say frequently, an actively managed portfolio is a series of decisions and hopefully more of those decisions will turn out to be correct than not. A byproduct of these posts disclosing trades is that people often point out some risk or other form of drawback to stock or the trade. If you write openly you should expect various forms of criticism and after eight years and counting it is not a surprise.

The point here today is not to try debate any commenter on Seeking Alpha but to point out that in buying or selling something there is a risk of being wrong. In selecting a stock to buy there are pros and there are negatives. Every great stock that has ever existed had or today has negatives. When a decision is made to buy something, then hopefully whatever the analytical process was, found the negatives, the big ones anyway, and took those negatives into account.

However much research goes into picking a stock it is not likely that every little thing that exists can be found but hopefully the big ones can be. Any investor who routinely gets blindsided probably needs to figure out another way. Getting blindsided occasionally might be an occupational hazard however that fits in with no one being able to be correct every single time.

Unrelated, there is a potentially interesting 30 for 30 documentary on ESPN tonight about the extent to which so many professional athletes squander their millions. It will be interesting to see if the timing worked out that Curt Schilling gets any mention. His story is that he saved up a bunch of money and put it all (so he has said) into a video game company that he ran and then the company went bust. Aside from putting a lot of people out of work (tragic on a societal level) he did not hold back a little bit of a personal cushion just in case. He worked this summer for ESPN as a baseball analyst and while I'm sure that pays well I doubt it will replace the tens of millions he lost.
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Investment Lessons from John Templeton

Barry Ritholtz posted Sir John Templeton's 16 Rules For Investment Success as follows;

1. Invest for maximum total real return
2. Invest — Don’t trade or speculate
3. Remain flexible and open minded about types of investment
4. Buy Low
5. When buying stocks, search for bargains among quality stocks.
6. Buy value, not market trends or the economic outlook
7. Diversify. In stocks and bonds, as in much else, there is safety in numbers
8. Do your homework or hire wise experts to help you
9. Aggressively monitor your investments
10. Don’t Panic
11. Learn from your mistakes
12. Begin with a Prayer
13. Outperforming the market is a difficult task
14. An investor who has all the answers doesn’t even understand all the questions
15. There’s no free lunch
16. Do not be fearful or negative too often

Barry also include Templeton's writeup on each of the 16 Rules that would be worth clicking through to and reading. A few of them are of particular interest that I wanted to expand upon.

Starting with number nine and monitoring your investments; not all news that comes is story-ending or thesis-altering even if the stock has a big reaction. For anyone using individual stocks or narrow based ETFs, if a lot of time can be spent on the holdings then there is a better chance of knowing when news does create a sell catalyst and when it doesn't. No one can be perfect of course but this does fall under the heading of managing the portfolio.

Not panicking has been a recurring theme in blog posts over the years. Unfortunately too many investors succumb to emotion and do the wrong thing at precisely the wrong time driven by some sort of emotion (usually fear or greed). This is very difficult to first come to and some people never come to realize this aspect of investing. I've told the anecdote of one former client who would call me in an absolute panic during market corrections of varying sizes and often my end of the conversation included reminding him that he had been through more of these than I had but he never came to understand this point.

Every investor has made mistakes and will make mistakes in the future. In addition to learning from mistakes I would add not letting the consequence of any mistakes have a ruinous impact on the portfolio. If a mistake is unavoidable and there is no way to know which future purchase will end up being a mistake then this makes the argument for smaller position sizes.

Number 14 is probably my favorite one. Included in Templeton's writeup on this one is the need to continue learning. The chance to keep learning is one of the reasons why the job is so fun. The world continues to evolve as do many aspects of investing. The need to learn creates work that needs to be done but for people who enjoy this, the task becomes easier. Chances are anyone spending time on a site like this does want to learn but we know that most people do not have this interest and so long term investment success could be tougher to come by.

I would sum up that a financial plan, whether it includes equity market participation or not, is a life long endeavor. I believe the Templeton list orients to the long term investor. Set and forget has not been applicable for a while and is unlikely to come back anytime soon. If that is correct then the work requirement embedded in Templeton's thoughts stand up today even though he wrote the list many years ago.

The picture is from our hotel room in Boston and is unlike any picture of Fenway I've ever seen.
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