BITS > AUGUST 2002

Avoiding Bear Claws

Perplexed by Performance? Focus on Portfolio Design

Portfolio management and performance are frequent subjects on NAIC's I-Club-List email discussion community. In the teeth of a bear market, watching stock prices decline can be almost disabling. These declines can also be a distraction, diverting our attention from where we're going to where we've been. In the article that follows, Mark Robertson responds to a plea for reinforcement and affirmation from a relative newcomer. Terri has experienced nothing other than the current bear market. She's tired and to paraphrase the movie Network, "She's mad and she's not going to take it anymore!" Use the portfolio discussion as a demonstration of NAIC principles in action. No investment recommendations are intended.

NAIC member Terri started investing in 1999. She admits that's she perplexed about what's transpired during her brief investing experience. She recently posted her concerns on I-Club-List, seeking guidance and reinforcement. In her words, "Discern the market? Hmmm, yes, especially for someone who began investing at the end of 1999, just when the market first began its long, continuous nosedive. Tell me again how the market is cyclical, how we invest for the long term, how we buy quality companies, invest regularly, and all those other philosophical assurances. I keep 'buying low' only to find the price goes lower and my investment disintegrates. All my blue chips have become blue dips. The faster I put money in them, the quicker they drop.

"I used to laugh at people who play the lottery, knowing that such games are nothing but a tax on people bad at math. As my losses accumulate, I'm not so sure the market is much different. At least with the lottery, you know you've lost all your money within a week of buying the ticket."

An I-Club-List community participant responded, "Are you doing your homework? In other words, completing an SSG, and then learning all there is to learn about the companies? If you have, and then applied a smidgeon of common sense -- one that I use is do not purchase if it's not in the buy range."

Terri continued her plea and provided additional information. "Yes, I'm doing the homework... as best I can. (I certainly don't try to lose my money.) For the first year of investing I was clueless, of course, but I quickly realized it. I've been involved in an NAIC club for 2 years. As for SSGs, I do them all the time, for both personal buys and for the club, although admittedly I don't understand a lot of the SSG discussions on I-Club-List. Unfortunately, my experience is that SSGs are no panacea.

"As for 'learning all there is to know' about each company, who does? Especially when huge accounting firms seem to be doing all they can to obfuscate what little we do know. I buy what I think are quality companies, whose products I know and like, which pass the SSG test, and then I cross my fingers.

"The unsettling thing I've noticed about SSGs and 'buying in the correct price range' is this: After I've already lost all kinds of money on stocks I've purchased, the SSGs tell me to BUY more of them. Among the examples are: American Express, Biogen, Exxon Mobil, Fannie Mae, General Electric, Home Depot, Intel, Merrill Lynch, Microsoft, Paychex, Pitney Bowes, Southwest Airlines, and Verizon. So far, it's been a matter of throwing more good money after bad. And the market can lose it a lot faster than I can earn it.

"Finally, I diversify. As you can see from the list, I've dutifully lost money in nearly every sector.

Click to enlarge.

Figure 1. Terri's Portfolio on June 28, 2002. The Projected Average Return (PAR) is calculated from trailing 12-month sales, sales growth, expected net margin, expected shares outstanding and expected average P/E ratio. Quality - Calculated from relative sales growth, relative profitability, financial strength and EPS predictability (ranges from 0-to-100). All sector and industry classifications are from S&P CompuStat/NAIC Online Premium Services. Sources: Value Line Investment Survey, Personal Stock Studies.

"However, here's a sad statement about my experience of our economy. One of the partners in our investment club is pressing for more socially responsible investments. Yet, in my personal portfolio, the few winners have been Anheuser-Busch (alcohol), General Dynamics (weapons), and International Gaming Technologies (gambling machines). The vices are winning!

"Although these three are my portfolio's money-makers, the SSGs on these three say Hold, presumably because the prices are now high. But they're high because they've gained in value, whereas the losers have lost value. This leads me to believe SSGs encourage us to buy losers (although NAIC politely calls them 'undervalued stocks'). While I'm still following the SSG guidelines, it's hard to do when my own gut experience says I should buy more of the winners. Or a lottery ticket."

Portfolio Discussion

We'll take a closer look at Terri's portfolio shortly, but first a few things are worth reinforcing. Any investing experience of three years or less has been confined to an extremely challenging environment. First and foremost, she's far from alone. Many investors who started investing in the late 1990s are naturally discouraged. When a bunch of investment clubs are down four percent, there's not really much feeling of accomplishment or solace in realizing that the market is down 12.5 percent. It still hurts and we all tire of declining markets.

A quick review of the portfolio makes it clear that Terri is certainly doing her homework. And from the figures she shared, she's actually some 12 percent ahead of the S&P 500 since she started investing.

As for learning "all there is to know about a company," nobody does. And that's OK, too.

Terri believes that she buys quality companies. It's also very clear that she's been doing precisely that. In a market downdraft, it becomes very important to focus on building and maintaining portfolio quality AND noting that projected returns for these companies are actually increasing. (That's why those SSGs are "pushing" those undervalued companies.)

The core attributes of portfolio design are no different than stock selection. We seek good companies at good prices. The first two elements are quality of holdings and expectations for long-term reward. Terri's portfolio delivers admirably on both counts.

Starting at the bottom line, we build and maintain our portfolios to deliver an annualized return of 15 percent or more over the long haul. Some stocks will surge in price, temporarily reducing their expected returns. The reverse is true, too. Taken as a group, we generally try to maintain that 15 percent target over time. In Terri's case, the projected average return is estimated at 15.2 percent as June 2002 ended. This result is the average result of Stock Selection Guides prepared on all of the holdings based on Value Line estimates of growth, profitability and valuation.

Quality is important. I've used my quality scoring system (based on relative sales growth and profitability expectations, financial strength and EPS predictability) to generate a quality rating for each company in the portfolio. The rating ranges from 0-to-100 and 20 percent of Value Line's 1700 companies have quality ratings greater than 65.0. Therefore, the average company in Terri's portfolio garners at least an "A-" (65.5) rating for quality. Taken as a whole, the companies in the portfolio have outstanding quality characteristics.

How "frisky" is the portfolio? We can measure the aggressiveness of a portfolio by checking the average sales growth rate and expected P/E ratio. The more ambititious a portfolio is, the higher these two indicators will generally be. The sales growth forecast for Terri's holdings is 11.7 percent. NAIC investors, depending on how frisky they are, will generally average 12 percent plus or minus a few percent. Younger risk-tolerant investors may design a portfolio for 14-16 percent. Investors who've reached critical mass or have a low risk tolerance probably ought to consider 8-10 percent. (Individuals fitting this description would probably also want to design a higher dividend yield for stability and income.) The average expected P/E ratio is 21.4x, a little assertive, but certainly not overly aggressive.

The average financial strength of the companies is "A" and the average EPS predictability is 67.7. The EPS predictability is fine but it could be a little higher and companies with higher EPS predictability might merit extra attention when adding new funds. Again, the majority of these companies have strong balance sheets and favorable business outlooks.

The portfolio size diversification is probably better than average. Many NAIC investors seem to get a little top heavy and concentrate too much on accumulating large companies. In this case, Terri's distribution is probably a little better (more emphasis on medium and small companies) than most NAIC investors. Future shopping efforts and monthly contributions probably should keep one eye on the smaller companies and pay special attention to opportunities in this range of company size.

Terri's right about the "distribution of losses across all sectors." (Grin) The sector distribution is well diversified -- again probably more so than the average NAIC portfolio. She owns a bit of information technology but it's not overly concentrated. Future shopping and weeding might seek to displace some of the information technology holdings and seek sectors like healthcare and consumer staples.

Holdings By Industry

The list of companies includes industry diversification. It's usually a good idea to spread the holdings out over a number of industries and the portfolio does a pretty good job of this. The portfolio includes both Home Depot and Lowe's and Terri might want to try to pick a winner to stay with in order to avoid any accusations of building a Noah portfolio. (2 of everything.) There's also a couple of aerospace companies and perhaps an extra pharmaceutical. All in all, the diversification looks pretty good by both sector and industry.

Conclusions and Recommendations

The market is cyclical because the economy is cyclical. We're getting a solid reminder of that right now. We do invest for the long term, regularly selecting quality companies at good prices. You've been doing all of this and you're outperforming the market. When the market turns, you're positioned well.

Terri is right about the SSG. It's not a panacea. But SSGs can be powerful guides and have been so for over fifty years. Build conservative assumptions about forward-looking growth rates and profitability and use reasonable estimates of P/E ratios. Concentrate on quality companies that are leaders within their industries. Good companies will secure leadership positions in either sales growth (market share), profitability and in many cases, both. Pay special attention to companies that continue to capture market share and maintain or increase their profit margins. Quality is important. Focus attention on the forecast of returns that are delivered and use them to build and maintain the portfolio.

The top 20 holdings account for only 74.1 percent of the portfolio. Diversification is actually attained at as little as twelve stocks, so long as they're distributed among different industries. I think that 12-20 total stocks should work well for most clubs and individuals. As such, I'd watch for opportunities to reduce the number of holdings.

Weeding a portfolio down to 20 stocks or less could well be one of the most powerful educational exercises that NAIC investors ever undertake (if their accumulating has produced a bloated number of holdings). I can't recommend what Terri should do with the portfolio. But I can describe what I'd do if it were mine. For more on this, see Pruning a Portfolio.

Incidentally, what's missing from the portfolio displays so far?

Right. There's no mention of purchase prices and gains or losses. It doesn't matter where the prices have been (with the exception of capital gains considerations). It only matters where the holdings are poised to go. Investors may find that it helps to "ignore" price history when evaluating portfolios during bear markets. It's more important that we focus on expectations for the holdings.

But the biggest recommendation would be to think differently about "throwing good money after bad," because Terri is clearly not doing anything close to that. Summon courage and resist the temptation to surrender. Leave the lottery tickets for someone else.

Readers can access NAIC's I-Club-List by going to www.better-investing.org and clicking on Community. Follow the links on the right side bar.

Mark Robertson is director of online resources and senior contributing editor for BetterInvesting. He serves as a member of BetterInvesting Magazine's Editorial Advisory & Securities Review Committee. Mark can be reached at Robertson_Mark@comcast.net.