Three extremely important pieces of information released over the last weeks for investors are:
The increase in US budged spending and consequently deficits.
The ECB’s public stance that they are going to print money, buy assets and do whatever it takes to prevent a recession.
The FED is ready to lower rates to keep economic growth stable.
My main concern is that we are in a Thanksgiving turkey situation and have a real turkey problem. What is the turkey problem?
The turkey is born, and fed more and more each day. The turkey thinks everything is perfect, food is coming in larger and larger quantities and there is absolutely no risk. As the days go by, the turkey’s wellbeing constantly increases. You can read more about Black Swans and turkeys in my Nassim Taleb articles.
Similarly, governments think they can spend money and not care about deficits. The central bank heads will do whatever it takes to keep things going well by printing more money and we, governments, corporations etc. all feel like turkeys. Think about it, aren’t you feeling good like a well-fed turkey and your wellbeing is constantly increasing?
There is only one minor issue, at some point in time, the butcher feeding the turkey, decides to prepare it for Thanksgiving. Similarly, the money printing game will end, it has happened a thousand times in history and currencies always debase, i.e. lose their value.
The key here for investors is not to be the turkey. Let’s start by explaining the economic fundamentals, the financial engineering provided by central banks and then conclude with how to invest so that your portfolio doesn’t end up like a Thanksgiving turkey.
Economy and monetary policy:
US budged deficits
Lower interest rates, money printing
How to invest:
Be like a government – have debt, but smart, good debt
S&P 500 to 5,000 points in 2030 but index fund investors will not be happy
Buy value like Buffett did in the last 50 years
US Budged Deficits
For me, one of the most important pieces of information over the last weeks was the ballooning of the US budged deficit.
The public debt is now 22 times higher than what it was in 1981. From my point of view, spending more than what you make can only last for a while, but sooner or later the butcher will come. Now, I know interest rates are lower and the debt cost servicing isn’t high, but interest rates can change if central banks lose control and history teaches us; sooner or later, central banks always lose control.
Lower rates, monetary easing and stimulus
Given what is going on with governments debt levels, corporate debt levels and even household debt levels, central banks have no other option to keep interest rates low, practically at zero, and promise to print as much money as necessary when necessary.
So, we have the FED saying how it will cut rates to sustain economic growth.
My conclusion is that over the longer term, money will be printed and currencies debased or better to say sacrificed. Economies and businesses will be stimulated but sooner or later this too will pass. We have to be very careful, not to be the turkey.
How to invest to not end up like a turkey before Thanksgiving
If everybody has a lot of debt, especially governments, it means all policies will help the majority, i.e. those with debt. So, let’s say you have a 30-year mortgage with a fixed interest rate of 3.5% like I have and let’s say currencies lose 50% of their value over the next decade due to inflation. This would mean that the value of your house would go up 50%, your salary too, while your mortgage payment would remain the same.
You are practically playing the same game as governments.
Secondly, the ECB and the FED say they will buy assets, which means the value of financial assets will continue to go up as it did in the last ten years. I would not be surprised to see the S&P 500 at 5,000 points with index fund investors not happy about it.
If we see inflation, which is very likely to escalate somewhere in the future because it is never linear and the FED and ECB will lose control, especially the ECB that doesn’t have any kind of coherence within. Everybody is happy to get free money from money printing, but when things get ugly, we will see for how long will Europe last.
In 1961 it looked like there will be no inflation to worry about given that inflation was at 1.2%. However, over the following two decades, inflation was often above 5% and peaked at 13.5% in 1980.
My point is that by focusing on value investing, like Warren Buffett did over the last 50 years that have had significant inflation, you can do better than what the S&P 500 offers even if it doubles in the next decade.
The S&P 500 did go up 28 times since 1981, but Berkshire did just a bit better.
The difference comes from the focus on businesses, that have moats, have pricing power and can consequently adapt to inflation. Therefore, when investing, and you have to be invested because currencies will be worthless, focus on buying value, businesses that will do good no matter what. Thus focus on risk and reward, exactly what value investing is.
The best thing if and when a stock market crash, economic collapse or recession come, is to have a strong plan. In this article I’ll share my plan and perhaps you will find good tips for your investment strategy so that you can increase your long term returns and lower your risks.
I’ve been investing since 2002 when I took advantage of the post dot-com period and I also took advantage of the 2008 financial crisis. That experience is embodied in my plan but things are not that easy.
Show you my portfolios and their crash/recession preparation
Discuss the most important things when it comes to recession proof investing
Show how crashes happen all the time and how take advantage of that
By the end of this article you should know enough to maximize your long-term investment returns by actually taking advantage of stock market crashes. It is extremely important to know ahead what might happen in order to act decisively when others sell in panic.
I have two portfolios that I manage that make things official as things are done publicly. On my Stock market research platform, I have a 100k lump sum portfolio launched in January 2019 and a model portfolio started with 10k plus 1k added every month launched in May 2018 when I also launched my research platform. I’ll discuss the strategies for each portfolio as those differ because one is a lump sum portfolio, thus no money will be added while the other is a portfolio with constant additions that makes risk management easier.
Lump sum portfolio – 100k – crash strategy
With 100k as a start and no additional investments, the key is to always manage your risks and have enough cash to take advantage of the opportunities arising when a stock or the whole market crashes.
I am comfortable with a max of 8 positions because it is enough to eliminate individual catastrophic risk but it still leads to long term return maximization.
However, on the cash position, I am currently 75% invested with 7 positions and 25% is in cash.
The cash is 30% of the initial invested amount of 100k where the portfolio is now already at 111k but that I attribute mostly to short term volatility as the portfolio was launched just 5 months ago.
Long-term I will be comfortable with a 20% cash balance with this portfolio. However, stocks are so volatile, especially individual stocks, that my cash balance will also be volatile. The most important thing is that you need to have a strategy when it comes to crashes and my strategy is the following:
80% invested when I can find investments that will lead to 15% long-term average yearly business returns, have a margin of safety and are generally good value investments.
I’ll increase my exposure to 90% when there are businesses that offer 20% yearly long-term business returns at acceptable risk.
I’ll increase my exposure to 100% when there are businesses that offer 25% yearly long-term business returns at acceptable risk.
I’ll increase my exposure to 120% through margin where there are businesses that offer 30% and higher yearly long-term business returns at acceptable risk, the dividend is more than enough to pay for the margin interest and there is no way to get a margin call.
The point of this all is not that I’ll do something because stocks crash, there is a risk of a recession or something. The point is that I’ll simply buy things when I can get value on the cheap, when the average cycle adjusted business return is high. The cheaper you can get value and returns, the better protected you are in case of a crash.
Plus, having a clear plan makes you unemotional when it comes to stock price movements, a crucial factor when it comes to investing.
Let me show you the business value I own because I think it will be extremely educational.
I own a lot of the energy, mining, food sector because it is something I can understand well and I feel it is something that will do well over the next decade. Plus, it is cheap at the moment as you can see from the 3rd column the average PE ratios around 10.
If you look at dividends, price to book ratios and debt to equity, you will see that there is no fixed level as I mostly invest in the long-term business outlooks and those things are not reflected into fundamentals yet.
Price to book values are all over the place but that depends what you are buying and whether the value is tangible or future oriented in the form of future cash flows. However, I believe all of the businesses I own currently trade below intrinsic value. This gives me a margin of safety.
3 Stock Market Crash Investing Factors
I have three things that I believe make investing easy, no matter the economy or stock market:
A margin of safety
The business yield
Dividends and takeovers
Margin of safety
As said, I believe all of my positions offer a margin of safety in a form or another. This means that if those stocks fall, I’ll be happy to buy more. A real investor is happy when stocks decline because he can simply buy more of the things he owns.
All my businesses have high cash flows or strong balance sheets which means it is unlikely those will ever go bust that gives me another margin of safety.
Focus on the business return
As said earlier, what makes investing easy is to focus on the business yield and not on the stock price. I try to find businesses that offer long term returns of 15% and above. This involves a lot of work to find such investments, understand them across the cycle and then buy when the risk is low and reward high.
I’ll explain what I mean by using the S&P 500. The current earnings/business yield of the S&P 500 is 4.72%. At the current level of 2,856 points for the S&P 500, the business earnings are134.8 points.
An earnings yield of 4.7% also means that expected long-term investment returns will be around that number, likely a bit higher due to inflation and economic growth. So, if you wish for safety and are happy with a 5% return, buy the S&P 500.
If you know stocks are volatile and there could be a crash coming, they you can manage your lump sum portfolio by putting portfolio exposure thresholds depending on the yield you require.
Such a strategy will allow you to be happy if stocks crash as you will be able to buy more of what you already like at a lower price. The portfolio exposure allocation depends on your personal preferences, required long term investment returns and also investing knowledge.
The most important thing when having such a strategy is that you buy more when stocks become cheaper. Thus, you will do the opposite of what most do. Stock prices will be all over the place over time, but if you know what your goal is, what are your capabilities, having such a simple plan will make investing easy and no matter what happens you will be happy.
Don’t forget the dividends and takeovers
As dividends don’t come often in most cases, dividends often seem irrelevant when compared to the daily stock market volatility of a few percentage points up or down, many disregard them. However, dividends are crucial for long term investors. If we look again at my portfolio, you can see that the yield on the whole portfolio even with the cash exposure will be around 4%.
This means that every year I’ll get at least 4% to reinvest. If stocks crash, that 4% reinvested will be of incredible importance as the returns on that will be huge. Compound that long term and you will be amazed.
Takeovers happen often and you might suddenly have 15 to 20% of your portfolio in cash. Don’t rush it, wait for good businesses to offer you the required business yield and invest when that happens.
Model portfolio Stock Market Crash Strategy
On top of the above discussed lump sum portfolio, I have a model portfolio that I started with 10k in May 2018 where I add 1k per month.
The monthly additions cumulate over time, which means the portfolio will grow and grow no matter what happens in the market. You will also see that the cash position is much smaller at just 7%. This is because I’ll be adding 1k per month for the next 19 years and that is all the risk management I need.
When I discount all the future additions to the portfolio with a 10% discount rate for the next 19 years, the actual present value of the cash to be added is 100k. This means that the current portfolio allocation is just 20%. Therefore, if you are an investor that will still be adding money to one’s stock market portfolio, you should actually beg for a crash because your money additions, alongside the reinvested dividends, will allow you to buy more and consequently increase your long-term returns.
So, my strategy is simple, with the lump sum portfolio, I own assets where I am happy with the business yield and if the business yield increases, i.e. stocks crash, I’ll simply increase my exposure. I’ll talk about timing the markets in a moment.
On the portfolio with monthly additions, as long as you still add cash to your investments, you should not worry about a crash, but simply add money and take advantage of crashes.
Stock Market Crash Scenarios
Extremely important topics related to stock market crashes are the following:
The markets are not linear
Stocks crash all the time
A crash can be inflationary + currency collapse
Stock market crashes are not linear, something crashes while other things go up. It is enough to compare the Shanghai Composite Index with the S&P 500 Index over the last 5 years.
Over the last 5 years the Chinese stock market has experienced two bear and three bull markets while the S&P 500 was constantly in a bull market. The message is simple, stock market crashes happen all the time. Therefore, if you are diversified you can take advantage of them by buying where and when others panic.
What is also important is that not everything crashes at the same time. The S&P 500 has been down 2.6% over the last month but some stocks have jumped 26% at the same time.
So, don’t focus on the general picture, focus on the individual positions, something will go up, something will go down, just be prepared and if something is a much better bargain, buy more of the bargain.
Stocks crash all the time
If I look at my portfolio, the average decline from 5-year peaks is 41%. I would call that a crash.
Crashes constantly create opportunities and crashes are always around us. I wish I could time the market but all I can do is focus on the business. Market timing is dangerous.
I’ve been listening to stock market crash scenarios since 2002. “You are crazy to buy stocks now” is the sentence I mostly heard in 2002, 2009 and 2012 (European crisis) when I was buying stocks heavily. However, those that stayed away from the markets, lost a lot of money on opportunity costs.
My message is that if you focus on businesses, and on the business returns and keep a strategy like we discussed where whatever happens you are fine, you don’t have to worry about stock market crashes. This is because, let’s say you own a business that has a 15% earnings yield and the stock growth at 15% when things are going good.
Even if a recession happens every 5 years and the stock drops 30%, you will still be well ahead over 10 years. Plus, no stock will behave so linearly and you would sell when others are greedy and buy when others are fearful. Thus, your returns would be even higher. If I would have listened to recession predictions in 2018:
I would have never bought a copper miner in 2018 because copper prices are very sensitive for economic development. However, I though that a miner was of great value and that even waiting 5 years for that value to unlock itself was a good deal. A recession didn’t happen, the stock got bought out and I did ok, despite all the doom and gloom around me.
A crash can be inflationary + currency collapse
A risk few discuss is an inflationary crash. Something not unlikely given the huge budget deficits most governments run. So, it is possible that we have an Argentina stock market scenario in the future. Something you can be prepared against only if you own value.
The Argentinian Merval index is up 34 times over the last 10 years while the peso is down about 93% against the dollar over the same period. So, $1,000 invested would now be around $2,450, something better than the S&P 500 did since 2008.
For me it is very simple as it has been rewarding me for the past 18 years. Simply buy value, good businesses, great assets and enjoy the returns while being patient.
I’ll keep looking, learning and constantly comparing in order to create the best maximizing return portfolio within my circle of competence.
The more I work, the more I am confident things will be ok. Any kind of crash would actually improve long-term returns even if it might look bad on my relative performance. However, I have no boss that can fire me based on a quarterly or yearly performance so I don’t have to fear that like most money managers have.
During the week I look at lots of stocks but what makes it easy for me to separate the interesting investments from the other, is the business return or the future potential business return. I look for current or even better, future double-digit yearly business returns and if a business doesn’t show that potential it is quickly skipped. This makes me an absolute value investor and not a relative investor, a very costly and risky mistake many investors currently make. As would Buffett say, we invest in businesses and not a stock that goes up and down during a day.
I am currently researching a stock list from an Asian Value investing fund with some very interesting names but also some strange decisions like the L’Occitane en Provence stock. On this stock, I wish to explain:
1) the risks of not focusing on the business yield
2) the risks of relative versus absolute investing and,
3) how easy it is to say no to an investment.
The business yield
If you are an investor in businesses, not stocks, all you care about is the yield of the business, the earnings and how the same earnings are reinvested or distributed at the end of the year. The higher the return on equity, your equity, the better. When buying stocks, your equity is the price you pay for the stock and the yield is derived by comparing the price you pay with the earnings. For example, L’Occitane is a growing company with revenues (1) tripling over the last 10 years (FY (fiscal year) 2019 revenue reached 1.42 billion EUR) and net income (2) almost doubling.
However, when I look at the net income, I see that the average over the last 5 years is around 100 million EUR. I compare it to the current market capitalization (the value of all the stocks outstanding) is 20.6 billion HKD or 2.6 billion EUR. This means that the business yield the company currently provides is at 3.84% given the price earnings ratio of 26 (100/26 = 3.84%).
That is far too low for me but then I must look at the growth the company promises. I look at the growth and see that same store growth is actually very low at 2%.
And that all of the growth the management hopes for comes from acquisitions and emerging markets. From reading a bit about the company there is a new management, the company is restructuring and it is something Warren Buffett despises, a turnaround. From the conference call transcript:
When you find words like ‘new management, new strategy, build trust’ it could be truth, but it could be also lots of baloney. Not what a value investor gets in to. So, when I see that I am already at ohhhhh.
Just another one for the record. On top of the new management, the company that made about a billion in profits over the last decade, suddenly decides to make an acquisition of a cosmetics brand and pays $900 million for a company with $40 million in EBITDA.
All of the above is simply too risky, it might work, I hope it works for them, but it might also backfire as that kind of corporate actions often do. The plan is to scale the brand, a totally new brand, in China.
It could happen it might not, too much risk and the actual business yield is below 4%. Enough for a value investor. So, let me finish this with why are other investors investing in this? Well, they do so because they are relative and not absolute investors.
Relative vs. absolute investors
This is a concept well described in Seth Klarman’s book Margin of Safety and L’Occitane is a great example. A relative investor looks at the company and says:
“I have a great global brand growing at double digit rates that just made a potentially transformational acquisition trading at a PE ratio of just 26. A fair valuation in this market should be 40, thus the stock is undervalued by 30%.”
This might be true and the market might revalue the stock, or re-rate it as the lingo goes, in case it shows faster growth in the future and improving margins. However, as a value investor you want both future growth and good earnings or value already there, not in some future promise. Also, the fact that the stock was much higher in the past, means absolutely nothing. Actually, it confirms that it was overvalued in the past and the market is slowly but surely re-rating it.
That is it, this is how I mostly spend my time, looking at companies that are not that interesting but from time to time, there is something interesting. To finish with a nice quote that summarizes this:
“Whatever you do, do it with all your might. Work at it, early and late, in season and out of season, not leaving a stone unturned, and never deferring for a single hour that which can be done just as well now.”
That is how bottom up value investing is done. You exclude more than 99% of businesses you look at and with time it becomes a fast process. Buffett says how it takes him 5 minutes to read through a business. Therefore, the more stones you turn, the better are the investments you will find.
Well, the FED will protect you as much as it can and as in Europe, they will do whatever it takes to keep the situation calm. As long as we don’t have inflation things will be good. Plus, it is hard to have inflation when there is so much supply of everything due to the same low interest rates.
However, lower interest rates just postpone the inevitable, which is that the economy is always cyclical and after all it all boils down to productivity. Policy can influence growth in the short term, prevent crises, which also means you can’t time a crisis. Nobody knows what kind of recession will come next and when it will strike.
Postponing means that you might make 20% per year for 5 years and then lose just 20% in one year when there is a recession. The point is that even if it all looks terrible in the form of high debt, low interest rates, it might go on for a decade, or inflation might change things. Therefore, try to find both good investments and protection in case of inflation. The best investments will always be quality.
Global economic situation
On a possible global recession, and something to keep in mind also when watching the specific country growth rates, on one side we will have the slowest global growth since the financial crisis but on the other hand, global growth has been 3% compounded over the last 10 years.
The average since 2000 is probably 4%. This means that over the last 20 years, despite the global financial crisis in 2009, the global economy more than doubled. It will probably double again in the next 20 years and there will probably be one or two recessions. Keep that in mind when investing.
What did stocks do over the last 20 years? Stock doubled!
I would say, passive investors should expect their money to double over the next 20 years, perhaps a bit more than that with significant ups and downs during the period.
How to invest for the long term?
If you want higher returns, from these levels I think one can easily beat the S&P 500 and other indexes because it was a hard thing to do from 1982 when the PE ratio was 7, thus the return 15%. Now that the return is around 5%, by looking at businesses that offer more, you can do that over the next 20 years. What is the difference?
$100 * 1.05^20 = $265
$100 * 1.1^20 = $672
$100 * 1.15^20 = $1636
My mission is to help those who want more than 5% per year.
The message is simple and I will never get tired of repeating it because it is so important:
Invest in value that will give you a good return over the long time, that will benefit from the fact that the global economy will probably double over the next 20 years and that gives you a margin of safety.
You might buy an airport, fertilizer stocks that we will discuss on Sunday or who knows what. But keep those things in mind. The global economy will double in the next 20 years, no matter the news. Some businesses with quadruple, some will go bust, looking long term, you have a chance to find those that will quadruple.
Long term investing is the most important advantage we have. It allows us to take advantage of the irrationalities that emerge from Wall Street’s and everyone’s focus on the short term.
I received this very interesting comment from a subscriber as I bought my 5th stock for my lump sum portfolio which is now 50% invested. So, I invested 50% of my portfolio over the last 3 months that might surprise people scared of the upcoming crash or recession.
I have 3 points to answer this question:
I can’t predict the future, nobody can
Nobody knows what will happen with the market, we have the last two crashes in our mind that were close to 50%, but that doesn’t mean it will happen again. Nobody, and I mean nobody knows.
A recession is always around the corner
There are recession predictions for 2019 and 2020, but the same could had been said in 2018, 2017, 2016, 2015, 2014, 2013, 2012, 2011, and especially 2010 and 2009. There are many out there that have been waiting on the side-lines since 2009 or they just got in in the last few years. No need to mention the missed opportunities.
For example, my largest position in January 2018 was Nevsun Resources.
In January 2018 there were fears about China slowing down leading to a copper crisis etc., fears of a recession and market crash over the next two years with Ray Dalio saying there is a 70% chance for an U.S. recession. I would have been better in cash than investing in a copper miner, right?
Well, all depends on value, if you find it, even if a recession happens, your returns are delayed by a year to 3. The point is that if you buy value, you will survive those bad years and get ahead after the crash. So, I, as a selective investor, simply buy when I see value and when I am happy owning the business. It has rewarded me very well in the past no matter the possible crashes. And yes, I lost money in 2008, but it is not comparable to what I made from 2009 onward and from 2002 to 2008.
Index fund investors
For those who invest in index funds, just invest on a monthly basis, just dollar cost average and forget about stocks, don’t even think about it, you will get your returns whatever they will be, own your home, invest in another property, diversify and you will be well off. Your wealth doesn’t depend on the market, but mostly on you and you not doing stupid things like most did, I.e. selling in 2009 march.
3) Highest possible return long-term
I know if there is a recession my portfolio will get hit, but I also know that the highest possible return I will get is when I buy value when I see it. So, in good years I will have great returns, in a bad year, I don’t know how I will do. There is a nice passage in the book Margin of safety by Seth Klarman discussing how when you buy value, real value, it often offers downside protection as it is already depressed in price and the price can’t go much lower. All my current 5 stocks trade below book value, mostly tangible book value, have high earnings yield and potential. So whatever happens, I am a happy owner, owning assets and that gives me a margin of safety.
To explain in an easy way what margin of safety investing is, I’ll make the next video article apple.
I sold Alacer because it is not a value play anymore, it is more of an exploration play now.
What the market didn’t see last year was positive growth, what the market is missing now, might be a negative in the form of lower future ore grades.
However, there are still 3 catalysts that could push the stock price higher; a dividend, more exploration success at Aldrich and, as always, higher gold prices.
In 2018 I did a comprehensive analysis of gold miners, I spent more than a month on them and deeply researched about 40. I wasn’t pleased with what I found but Alacer Gold (ALIAF) (ALACF) looked good. We can say it was my favorite gold miner in 2018 as it was not just a bet on gold, but a value play with a nice business proposition thanks to the Copler sulfide project.
Since then things have changed, most significantly the stock price increased as the market noticed what ALIAF has been doing.
As the exploration results led to a new resource that will feed the old oxide plant, the management increased guidance and said ALIAF could become a 300k to 400k ounces producer.
However, the path towards such high production levels is long and the ore grades of the sulfide ore aren’t really indicative of higher, sustainable future production. But this doesn’t mean there are no catalysts for ALIAF or that it now is a bad investment. The catalysts that could push it higher in 2019 are a dividend or buybacks, new successful exploration results and higher gold prices.
For me, when the stock price increases and reaches my intrinsic value, the risks are higher and the rewards lower so I prefer to find other, less risky value investments with a margin of safety.
You can hear more about why I sold in my video discussion.
Over the past years, I’ve been making some macroeconomic videos, I like the mental exercise, analysing the long-term risks etc. However, I must say, all that ‘mumbo jumbo’; GDP, economy, debt, trade wars, employment, housing etc. hasn’t helped me at all when it comes to investing. I am subscribed to an economic newsletter from the Wall Street Journal and in the last 4 weeks there were two positive and two negative headlines all about the US housing market, so funny.
The fact is that companies are living beings that adapt to circumstances, grow and change over time. By looking at the business, not the economy is actually where I get my investing value. As I am really pushing on the research, more and more of it will be business specific and less macro. Although macro is fun to look at, discuss and you can talk about it for eternity, talking about it doesn’t really help your portfolio.
For example, the S&P 500 has been flat since January 2018.
The point is that nobody could have predicted where the S&P 500 could have gone, it could have been up 20% or down 30%. It is all a guess, no matter how much macro you study. The point is that we have to focus on the business, nothing else.
I’ll take this opportunity to discuss the real news and news that could be important for your portfolio.
Extremely important news 1: your long-term investment returns are driven by earnings
Earnings are the key, not economics
In 1999, S&P 500 earnings were 58.55 points. Today we are at 130 points. That is an increase of 122%.
How did the market do? Well, the S&P 500 was at 1282 points in 1999 and now it is at 2757 points, up 115%.
Earnings are up 122% and the market is up 115% over the last 20 years. In the mean time we have had the dot-com bubble crash, the great recession, a European crisis, Japan not growing anymore, a commodity boom and bust etc. Who knows what will we have in the next 20 years, but no matter what happens, good businesses will do well. Another thing that helps very much with determining stock market returns are valuations.
Keep an eye on valuations because the market is extremely differentiated
In 1999 the S&P 500 was at 1282 points with earnings of 58.55 that leads to a PE ratio of 22. Thus, the earnings yield is approximately 4.5%.
1282*1.045^20= 3091 points
According to the valuation, investors could have expected a return of 4.5% based on the valuation they were paying in 1999. The return was even a bit higher when you add the dividends of just below 2% per year.
There will definitely be market crashes in the future but you can’t time them. Let’s say there is a crash of 30% 6 years from now but in the meantime, the S&P 500 grows at 5% per year. This would say that from the current 2757, the S&P 500 would go to 3694 points. If then it crashes 30%, we would be down to 2585 but by waiting for the crash you would have missed on the dividends so you wouldn’t be ahead. However, as we spoke that earnings are key, you can invest for higher than 4.5% returns by investing in earnings and taking advantage of the volatility.
The market is extremely differentiated and volatile – learn about the business
Earnings and volatility
If I look at the top 10 positions of the S&P 500, the PE ratios vary extremely and I can tell you that returns will vary extremely over the next 20 years.
Therefore, it is extremely important to look at try to understand where could your investment be in the next 20 years. This doesn’t mean that if a company falls out the top 10 it will be a bad investment. However, you can avoid buying companies with too stretched price to sales ratios and extremely high earnings valuations where the actual business doesn’t justify.
The point is that when you follow a company for a few years you begin to understand it much better than the media does, you understand its natural cycles and how to invest around those.
This allows you to take advantage of volatility. It is pretty simple if you have a long term view.
How to take advantage of volatility
The easiest was to take advantage of volatility is to rebalance your positions in relation to the earnings yield those offer.
The only problem is that you have to move your focus away from the news and future expected earnings and simply focus on the real current business earnings. Just 6 months ago, Apple’s stock was above $232 only to fall down to $142 in January and now rebound to $173. Apple’s earnings didn’t change that much, so if you focus on the earnings yield you can buy more when the earnings yield is higher, PE lower, and less when the yield is lower, thus the PE ratio higher.
I didn’t buy Apple, but in the summer of 2018 I invested a bit in Brazil because I did find an interesting business there.
I didn’t sell yet, but the increase in price gives me a nice thing to think about and see how it fits my portfolio. The point is that it is all easy when you invest in businesses. Which leads me to the most important news of all:
Invest in the business, be an owner
Invest when you are happy with the business earnings
By focusing on the earnings and not on the news, investing becomes easy. What is your required investment return?
4.5% – buy the S&P 500 and forget about it
7% – buy good businesses when their PE ratios are around 14
10% – same but at PE ratio of 10, or higher ratios buy with some growth
15% – look at good businesses in distressed sectors, value investments and take advantage of the market’s short term focus. This implies a lot of work but it is possible to find such opportunities.
Forget about news, focus on the business reality, the long-term reality
Earnings are the drivers of your investment returns, be a business owner
Focusing on earnings will allow you to take advantage of the market’s irrationality, or better to say volatility
News, economy, stock market crash, recession, GDP, Trump – not adding value to your investing, so focus on the business and that is what we do here, so please SUBSCRIBE!
A month or something ago, I was contacted by an investor that had just set up a portfolio with an investment bank. He told them that his risk tolerance is minimal and that he would like some capital appreciation in the long term. He asked me to review the portfolio and that is what we are going to do now.
Here is the video version, while those who prefer reading, can find the article below.
$13 million-dollar investment bank managed stock market and bond portfolio review:
US equity portfolio exposure & issues
International equity portfolio exposure
Fixed income portfolio
General banking fees and value for money
Discussion about fees and risk reward opportunities
Risk and reward
What would I do differently?
Stock market and bond portfolio review
Here is how the portfolio has been structured:
US equity is 22.74%, international stocks 25.52% and as the requirement was low risk, 48.5% has been placed into US fixed income. This has been done by putting the money into 3 different bank funds (more about bank fees later). The yearly management fee is 0.9%.
Let’s start with US equity exposure.
US equity portfolio exposure
The portfolio positions are listed from the largest to the smallest. The client automatically replicates the positions held by the 3 funds within his account.
The largest position is Advance Auto Parts (AAP). I don’t know whether the fund bought the stock at the bottom in February of 2018 or it was a long term holding as the unrealized gains and losses in the above table go back to when the portfolio investment was made, which is February 2018.
AAP, has had free cash flows between $300 and $500 million per year over the last 10 years on a $10 billion market capitalization. I would expect the return there to be around 4% in the future. Auto parts are a competitive business but can be recession proof.
The next position is Comcast (NASDAQ: CMCSA), a company that recently won its bidding war and acquired Sky Plc for $38.8 billion. The all cash offer will put more pressure on Comcast’s balance sheet that already has $114 billion in liabilities. Plus, Sky Plc has had operating cash flows of around $2 billion per year in the last 10 years. This makes it a stretched acquisition as the interest on the debt will be close to the $2 billion of free cash flow coming from Sky.
Intercontinental Exchange (NYSE: ICE) is another stable company with high free cash flows and a potential return of around 4 to 5%. Free cash flows are $2 billion on a $42 billion market cap.
Danaher is the 4th largest US portfolio position (NYSE: DHR) is another stable company with $3 billion in cash flows on a $70 billion market cap.
Progressive Corp Ohio (NYSE: PGR) is an insurer and Kroger (NYSE: KR) is a grocer with similar characteristics as the above businesses. All have dividend yields of around 2%, stable business models, we can call them recession proof business models, and price to cash flow ratios of around 20 that should lead to a return of around 4 to 5%.
If we look at other portfolio positions, those mostly replicate the above. All good companies and fairly priced by the market. The portfolio also holds Google or better to say Alphabet (NASDAQ: GOOGL), American Express (NYSE: AXP), Mastercard (NYSE: MA) and we could easily say that the US equity portfolio reflects the client’s wishes: safety and quality.
US equity portfolio potential issues
I have two issues I want to discuss. The first is the value added in relation to the charged fee and the second is the fund management cost environment and investment process which is possibly even more important than fees.
Investment fees and value added
The first issue with the US equity portfolio part might be that there are 26 positions. If we look at professor and 1990 Economics Nobel prize winner Sharp’s seminal work on risk: Risk, Market Sensitivity, and Diversification, published in the Financial Analysts Journal in 1972, we see that as soon as you pass 20 positions in your portfolio, the risk equals the market’s risk.
We have seen that the expected returns from a price to cash flow standpoint will be around 4 to 5%. However, if we look at the top positions of the S&P 500, their price to cash flows don’t differ much from the ratios of the analysed portfolio and the businesses in the S&P 500 can be considered of quality too.
Microsoft (NASDAQ: MSFT) has a cash flow yield on price of 3.75%, Apple (NASDAQ: AAPL) of 8%, Amazon (NASDAQ: AMZN) of 1.8% but we might argue that in 10 years, AMZN might have higher cash flows than Kroger. Berkshire (NYSE: BRK.A, BRK.B) is a diversified portfolio focused on US equity by itself, it holds great businesses and it has a price to free cash flow ratio of around 4%.
This leads me to the question, is the 0.9% yearly fee our friend is paying for the above portfolio justified? One can buy the S&P 500 for a yearly fee of 0.04% which is 22.5 times smaller than what is being paid to the investment bank or there is always the option to simply buy Berkshire and let Buffett and his fellows manage the money at no cost practically.
To conclude on the investment fees, I don’t think that in this case, paying a yearly fee of 0.9% adds any kind of value given that the stocks might look a bit more conservative than the S&P 500 but such bet is based on past performance and not part of a strategy. In this digital era world, one might argue that Amazon is more defensive than Kroger.
Investment fund behavior
The thing when it comes to banks is that there is a lot your bank is not telling you.
Aside from the 0.9% yearly management fee, the bank makes money as they buy and sell through their own broker, perhaps they are even the market maker for the security, they pay for research, marketing costs, administration etc. that might not be included in the first fee you pay but might be included in the costs of the second fund that you actually don’t see. In this case, as the clients owns the positions directly, only the brokerage, custodian and market maker fees come into account, but that is still something extra.
Investment fund management process
Now, there is another thing when it comes to investment funds that is not discussed much. When things go well, all is good, but when things go south, some clients might want their money back. The investment manager is put into a tough spot because he then has to make investment decisions based on external inputs which might not be in the best interest of other clients. For example, if I manage a $1 billion portfolio, there is panic in the markets and clients want to cash in on $300 million. Liquidity usually dries up on the market too at such moments and you cannot sell your positions easily, especially your bond positions. (Remember that the positions discussed above are part of a much bigger fund)
The investment manager has no option than to sell the most liquid assets which might be the best assets to hold in the long term. Further, an investment manager has to be invested 100% all the time. Investment managers, collecting a fee of 0.9%, don’t have the option Buffett has. Buffett has $114 billion dollars practically lying on Berkshire’s bank account waiting for a market panic so that he can buy stocks on the cheap. (Buffett’s cash is invested in short term US Government Treasuries with an average maturity of 4-months – can be considered as cash)
This is something few think about when things go well, but crucial when things go south. Our friend has no influence on that and unfortunately this is where things often go wrong with funds managed by investment banks. An investment manager has to do as ordered, not as he wishes or what would be in the best interest of the client.
International stock portfolio overview
The international part is 25.52% of the whole portfolio and has a total of 68 positions. Since the inception of the portfolio, the performance of the international part has been really bad as almost all the positions are down with some like Ryanair (LON: RYA) down 34%. This is nothing strange given that international stocks and emerging markets have really suffered during 2018.
The largest position is Medtronic (MDT), followed by Unilever (UN), Compass Group (CMPGY), Aptiv (APTV) and Ryanair (RYAAY). There is a little bit of everything there with Tencent (TCEHY), BHP Billiton (BHP), the Indian Icici Bank (IBN), the Russian version of Facebook – Yandex (YNDX) and some interesting Chinese stocks like 58.com (WUBA) or South American payment processors like Cielo SA (CIOXY).
Now, Medtronic (NYSE: MDT) – the world’s largest medical device company makes most of its revenues and profits from the U.S. healthcare system but is headquartered in Ireland for tax purposes. Thus, this is not an international stock but goes under the international portfolio. Free yearly cash flows have been around $4 billion over the past 10 years and the market cap is $120 billion.
Nevertheless, holding 69 stocks doesn’t move the needle and we can expect them to perform equally as the market does. Therefore, one can simply buy the Vanguard Total International Stock ETF (VXUS) for a fee of 0.11% per year.
If I compare Vanguard’s top 10 positions and the portfolio we are analysing, I see that Royal Dutch Shell pls (NYSE: RDS) is in both portfolios, same as Tencent (TCEHY), Novartis (NVS), Roche (RHHBY) and Taiwan Semiconductor (TSM).
So, a portfolio I am paying 0.9% to be managed has 5 positions that are also in the Vanguard Total International stock ETF top 10 positions with a management fee of 0.11%.
Let’s see if there is more value added in the bond portfolio.
US fixed income portfolio
48% of the portfolio is placed into a bond fund and the holdings are the following.
The majority of the bond portfolio is in US Treasuries, 18% of it, with maturities ranging from 2021 to 2026. The yield on those is less then 2% or around that. Then there is a bunch of other corporate bonds with yields between 1% and 4% on average and maturities ranging from 2022 to 2028 on average.
Now, the first thing is that if 9% of the total portfolio is in Treasuries, why would you ever have to pay any fees on that as with a $13 million dollar portfolio you can simply buy them yourself. Or, if you want, the Vanguard Treasury ETFs has a fee of 0.07%.
Secondly, the investment grade US corporate bond ETF from Vanguard, offers much higher yields for minimal fees.
On a portfolio of 66 bonds, 60 excluding the Treasuries, I simply don’t see any difference except the huge fees. The intermediate corporate bond ETF, has a yield of 4.35% and is managed by Vanguard.
Conclusion – portfolio management and risk reward
The holder of this portfolio hoped that I can manage part of his portfolio and perhaps create an all-weather portfolio for his holdings. I declined because my current investing focus accepts a little bit more risk as we are focused on long term return maximization which isn’t what the goal of this portfolio is. I am completely devoted to what I do and creating another portfolio alongside building mine would be impossible. On the all-weather portfolio, I am partly working on it, but an all-weather portfolio focuses first on neutralizing risk and not that much on maximizing returns. You cannot get high, Buffett like returns with an all-weather and that is why I cannot focus my whole work around it and this portfolio. I takes at least a year of hard work to build a portfolio.
Secondly, if I would have to manage the money as required, the way explained above would be one way of doing it. I cannot charge $117,000 per year for the above as the investment bank is doing, I simply can’t. Well, you have it above for free.
What we actually did is that we have created a smaller part of the portfolio to follow my portfolio that I manage on my Stock Market Research Platform. This should add a bit more diversification as it is focused on absolute value and not that correlated to markets. Plus, there are some hedges too.
Portfolio risk reward
Now, what we still have to discuss are the risks of the above portfolio in relation to the rewards. We have seen that the yield on Treasuries now should be around 3%, and the return on equities could be at 4%, up to 6% on the international portfolio. Given the 10-year maturity of the bonds, that is what the holder can expect, deduct 2% inflation and you have a real return of about zero on the bond portfolio which would be closer to 2% with Vanguard.
50% of the portfolio is in stocks and given that the number of stocks held is 90, one should expect equal to market returns, US equity markets and international equity markets. The biggest risk here is a contraction in valuations. If global investors start to require a 6% investment yield in place of the current 4%, that could lead to a decline of 50% on global stock markets and a similar decline within the equity portfolio. Also, as bonds are priced in relation to interest rates, I would expect a significant decline in the bond portfolio too.
Thus, the upside is limited but the downside is pretty big. This is because there is no strategy behind the discussed portfolio, it is over diversified, there are no hedges in place, no real diversification as we have seen bonds and stocks move in correlation during the turmoil of the last few months.
What makes me sad is that most pension funds are managed in the above way with outrageous fees. In a video on Canadian pension funds I discussed how fees go up to 2% per year for practically nothing. This is outrageous and the first thing I would tell people to do is to start educating themselves about what can be done when it comes to investing their hard-earned money.
Perhaps, individual stock picking the way I do it will not be for most, but lowering a management fee from 2% per year to 0.1% makes a hack of a big difference within a portfolio. Actually, it makes almost a 100% difference on a long-term portfolio over 30 years based on current market return expectations.
If all that you change in your financial life and investment portfolio is that you get a lower fee or even eliminate fees, the above is how much it affects a $1 million portfolio over a 30-year period and 4% market returns per year. The differences are staggering.
From a general perspective, an approach like the one discussed above offers no strategy, it is a purely market following and extremely diversified investment. Thus, such a general approach certainly doesn’t deserve to charge a 0.9% fee. The lack of alpha, the lack of an investment strategy, a portfolio that resembles an index is just part of what is not good in story we discussed up till now.
The following chart shows how there are different investment strategies and the one discussed today is probably the most obsolete. However, banks still manage to sell it to clients due to a lack of financial education.
My opinion would be that the investor should first create a clear strategy about what is the goal for his funds and then put that goal into a risk and reward perspective within a well-diversified portfolio based on a well-balanced strategy.
Such a strategy is what we focus on so if you enjoyed this kind of investment educational content shared above please follow, subscribe, like and share.
About the author: Sven Carlin, Ph.D. is passionate about investment research and value investing. He also manages the Sven Carlin Stock Market Research Platform based on long term value and business investing principles.
Politics aside, it is important to have a clear investing perspective on how can our portfolio positions be affected by Brexit.
For now, markets are pricing in more pain for Europe, than Britain.
There are some stocks that should be avoided and some that shouldn’t be impacted at all, on the contrary.
Brexit is a very hot topic in Europe nowadays. However, it is important to separate your investing perspective from whatever might be your political views. I sit down with Niche Masters Fund with head investment manager, Peter Barklin, and discuss his very interesting, objective investing perspective, on the potential implications of Brexit for us as investors.
Just as an interesting note from the video, European stocks (VGK) (IEUR) have been hit harder than UK stocks (EWU). This shows that the Brexit isn’t just all bad for Britain and that we must carefully weigh the pros and cons.
1:40 Brexit for investors
3:27 What to own
5:08 Brexit benefits
7:04 Brexit and Europe
10:05 Portfolio positioning
11:29 Brexit risk perspective