Create Your Own Conglomerate, Part Deux

Back in June I argued investors should create their own conglomerate by assembling a diversified portfolio of high quality companies.  Michael Crook of UBS provides a potent factoid validating this strategy. He calculates:

“After accounting for inflation, $100 invested in US equities, US corporate bonds, US Treasury bonds, and US Treasury bills in 1932 would now be worth $30,790, $1,252, $810, and $156, respectively. That is equivalent to excess performance for equities of over 2000% over eight decades.”

Roll that around in your brain for a moment: $30,790 versus $156 – $1,252.

Bottom line: Over time you can become wealthy investing in stocks, but not in bonds or cash.  Very long term, it really is that simple.  Naturally, there are short-term exceptions.  Equities perform poorly in certain decades (1930s, 1940s, 1970s).  And bonds are a great investment occasionally, such as the early 1980s when nominal yields were sky-high (15-20%!) and inflation was about to plummet.

Timing Is Not That Important . . .

. . . if you are saving for retirement out of income, because you can invest regularly without making bets on when the market will rise and fall.  And if you accumulate significant savings by the time you retire, you can raise some cash and—to the extent you need to dip into capital rather than live off dividends and Social Security—sell stock in years when the market is strong, and use cash in years when stocks are weak.

. . . . But the Cult of Over-Diversification Makes This a Fairly Good Time to Buy Stocks

Yes, it would have been better to plunge into stocks four years ago.  But now is still a decent time because investors remain skeptical about stocks, leading to excessive diversification.  At the end of long bull markets, you get a cult of equities.  At the end of the 30-year bull market in bonds we got a cult of bonds, with PIMCO’s Bill Gross arguing bonds would continue to outperform stocks, which were a “Ponzi scheme.”  (Stocks are up 27% since Bill shared his insight with the world.)  Now we have a cult of over-diversification:

  •  A New York Times article by Gretchen Morgensen notes that “alternative investments” (hedge funds and private equity) “now account for almost one-quarter of the roughly $2.6 trillion in public pension assets under management nationwide, up from 10 percent in 2006, according to Cliffwater, an adviser to institutional investors.  Investments in public companies’ shares, by contrast, fell to 49 percent from 61 percent in that period.”
  • Ivy League endowments similarly have their funds spread across many asset classes, with modest amounts in domestic equity (see my Dec. 22, 2012 post).  Like pension funds, they have too much in costly, opaque, poorly performing hedge funds.
  •  A top wealth management firm is telling clients willing to accept “Moderate Risk” to have only 34% of their money in stocks / 46% in bonds.  Even “Aggressive” investors are advised to be 55% stocks / 33% bonds.

Five years from now, much higher allocations to equities will be conventional wisdom—which will be a bearish sign.  But as institutions raise equity allocations over the next few years it will be positive for stocks.

How to Assemble your own Conglomerate

  •  Gradually assemble a collection of 30-40 high quality companies that are expanding their earnings.
  • Most should pay dividends that are growing at a decent pace.  I like dividends because most large firms can pay them without hurting their EPS growth, which boosts total return.  And there is the all important “sanity factor.”  When the stock market freaks out, as it does from time to time, investors can stay sane if their dividend checks remind them they own shares of real businesses—not merely pieces of paper whose price just fell 30%.
  • Be well diversified across sectors.  Most true stock market disasters occur when investors become enamored of one sector that gets too popular and expensive, and then collapses as you get lower PEs on lower earnings—energy in 1980, tech in 1999.
  • It is fine to own some smaller fast-growing stocks IF you understand the business and growth prospects, and to own some foreign stocks if they are great companies.  But don’t try to “allocate” between regions or bet on currency movements.
  • In general, sell your losers not your winners, unless a stock becomes hideously overvalued and too large a part of your portfolio.  (But keep in mind that, as Peter Lynch pointed out, much of your return will come from a few great stocks, which can only happen if you own them for a long time.)
  • You can limit risk by rebalancing—for example, maintaining a 15% cash position.
  • Have enough cash or very safe short term bonds so you don’t get scared and sell at the bottom of bear markets.  (This is the main reason most individuals vastly underperform the mutual funds they invest in.)
  • Don’t try to time the stock market.  You own companies for the long term.  In rare periods of extreme over-valuation, such as 1999 when the trailing PE of the S&P 500 was 28x, shift some assets to cash or to cheaper, lower-beta stocks.  This only happens every fifty years or so.

This advice is more radical than it sounds . . .

No trading.  No market timing.  No allocation across stocks, bonds, cash, gold, industrial commodities, private equity, hedge funds, real estate, art, rare baseball cards, etc.  “Risk” is not defined as short-term price volatility but permanent loss of capacity to generate free cash flow.  (According to Wall Street’s conventional definition of “risk” as “Beta” — or stock price volatility relative to the market — General Motors and Citigroup were “less risky” in 2007 than Nike or Starbucks.  Oops.)  You have to accept that occasionally the quoted value of your portfolio will go down a lot.  But this doesn’t matter unless you need to sell stock (which is why you should keep enough cash to weather bear markets, both financially and psychologically).

Don’t Buy High-yield Stocks Because “I need the income.”

In an interesting Barron’s interview, American Funds’ James Rothenberg was asked whether and why he owned too many bank stocks before the financial crisis.  His answer:

Yes, we did.  We have a lot of funds for which current yield was, and is, a very important part of the objective.  And there were only a few places where you could get significant yield.  One was financials, one was oil, one was utilities, and there was a smattering of other things.  So we were naturally drawn to the financials because on earnings they looked cheap, relatively speaking.  The problem was that t heir earnings weren’t real, as we now know. (emphasis mine)

I am not second-guessing Mr. Rothenberg; I, too, got burned badly in certain financial names in 2008.  But, what is flawed here is the thought process of investors thinking, “Well, I need income.  I only want stocks with high yields.”  That logic dramatically narrows your choice of stocks. You are likely to end up in companies with high dividend payout ratios, mediocre growth, and perhaps high financial risk.  (Which describes many utilities these days.)

Even if you value income, you want to own growing businesses.  You should evaluate stocks not just on dividend yield but also EPS growth, using the “PETR Principle” described in my April 30, 2013 post.  It simply involves dividing the PE ratio by an estimate of total return, defined as (dividend yield + long-term EPS growth).  Doing this properly requires an understanding of the business and its future growth, which is why you may need an investment advisor.

Copyright Thomas Doerflinger 2013.  All Rights Reserved.


About tomdoerflinger

Thomas Doerflinger, PhD is a prominent observer of American capitalism – past, present and future.
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