A
New Wall Street Line Dance: Performance
It matters not what lines, numbers, indices, or gurus you
worship, you just can't know where the stock market is going
or when it will change direction. Too much investor time and
analytical effort is wasted trying to predict course corrections…
even more is squandered comparing portfolio Market Values
with a handful of unrelated indices and averages. If we reconcile
in our minds that we can’t predict the future (or change
the past), we can move through the uncertainty more productively.
Let's simplify portfolio performance evaluation by using information
that we don’t have to speculate about, and which is related
to our own personal investment programs.
Every December, with visions of sugarplums dancing in their
heads, investors begin to scrutinize their performance, formulate
coulda’s and shoulda’s, and determine what to try
next year. It’s an annual, masochistic, right of passage.
My year-end vision is different. I see a bunch of Wall Street
fat cats, ROTF and LOL, while investors (and their alphabetically
correct advisors) determine what to change, sell, buy, re-allocate,
or adjust to make the next twelve months behave better financially
than the last. What happened to that old fashioned emphasis
on long-term progress toward specific goals? The use of Issue
Breadth and 52-week High/Low statistics for navigation; and
cyclical analysis (Peak to Peak, etc.) and economic realities
as performance expectation barometers makes a lot more personal
sense. And when did it become vogue to think of Investment
Portfolios as sprinters in a twelve-month race with a nebulous
array of indices and averages? Why are the masters of the
universe rolling on the floor in laughter? They can visualize
your annual performance agitation ritual producing fee generating
transactions in all conceivable directions. An unhappy investor
is Wall Street’s best friend, and by emphasizing short-term
results and creating a superbowlesque environment, they guarantee
that the vast majority of investors will be unhappy about
something, all of the time.
Your portfolio should be as unique as you are, and I contend
that a portfolio of individual securities rather than a shopping
cart full of one-size-fits-all consumer products is much easier
to understand and to manage. You just need to focus on two
longer-range objectives: (1) growing productive Working Capital,
and (2) increasing Base Income. Neither objective is directly
related to the market averages, interest rate movements, or
the calendar year. Thus, they protect investors from short-term,
anxiety causing, events or trends while facilitating objective
based performance analysis that is less frantic, less competitive,
and more constructive than conventional methods. Briefly,
Working Capital is the total cost basis of the securities
and cash in the portfolio, and Base Income is the dividends
and interest the portfolio produces. Deposits and withdrawals,
capital gains and losses, each directly impact the Working
Capital number, and indirectly affect Base Income growth.
Securities become non-productive when they fall below Investment
Grade Quality (fundamentals only, please) and/or no longer
produce income. Good sense management can minimize these unpleasant
experiences.
Let’s develop an "all you need to know" chart
that will help you manage your way to investment success (goal
achievement) in a low failure rate, unemotional, environment.
The chart will have four data lines, and your portfolio management
objective will be to keep three of them moving upward through
time. Note that a separate record of deposits and withdrawals
should be maintained. If you are paying fees or commissions
separately from your transactions, consider them withdrawals
of Working Capital. If you don’t have specific selection
criteria and profit taking guidelines, develop them.
Line One is labeled “Working Capital”, and an average
annual growth rate between 5% and 12% would be a reasonable
target, depending on Asset Allocation. [An average cannot
be determined until after the end of the second year, and
a longer period is recommended to allow for compounding.]
This upward only line (Did you raise an eyebrow?) is increased
by dividends, interest, deposits, and “realized”
capital gains and decreased by withdrawals and “realized”
capital losses. A new look at some widely accepted year-end
behaviors might be helpful at this point. Offsetting capital
gains with losses on good quality companies becomes suspect
because it always results in a larger deduction from Working
Capital than the tax payment itself. Similarly, avoiding securities
that pay dividends is at about the same level of absurdity
as marching into your boss’s office and demanding a pay
cut. There are two basic truths at the bottom of this: (1)
You just can’t make too much money, and (2) there’s
no such thing as a bad profit. Don’t pay anyone who recommends
loss taking on high quality securities. Tell them that you
are helping to reduce their tax burden.
Line Two reflects "Base Income", and it too will
always move upward if you are managing your Asset Allocation
properly. The only exception would be a 100% Equity Allocation,
where the emphasis is on a more variable source of Base Income…
the dividends on a constantly changing stock portfolio. Line
Three reflects historical trading results and is labeled “Net
Realized Capital Gains”. This total is most important
during the early years of portfolio building and it will directly
reflect both the security selection criteria you use, and
the profit taking rules you employ. If you build a portfolio
of Investment Grade securities, and apply a 5% diversification
rule (always use cost basis), you will rarely have a downturn
in this monitor of both your selection criteria and your profit
taking discipline. Any profit is always better than any loss
and, unless your selection criteria is really too conservative,
there will always be something out there worth buying with
the proceeds. Three 8% singles will produce a larger number
than one 25% home run, and which is easier to obtain? Obviously,
the growth in Line Three should accelerate in rising markets
(measured by issue breadth numbers). The Base Income just
keeps growing because Asset Allocation is also based on the
cost basis of each security class! [Note that an unrealized
gain or loss is as meaningless as the quarter-to-quarter movement
of a market index. This is a decision model, and good decisions
should produce net realized income.]
One other important detail No matter how conservative your
selection criteria, a security or two is bound to become a
loser. Don’t judge this by Wall Street popularity indicators,
tea leaves, or analyst opinions. Let the fundamentals (profits,
S & P rating, dividend action, etc) send up the red flags.
Market Value just can’t be trusted for a bite-the-bullet
decision… but it can help. This brings us to Line Four,
a reflection of the change in "Total Portfolio Market
Value" over the course of time. This line will follow
an erratic path, constantly staying below "Working Capital"
(Line One). If you observe the chart after a market cycle
or two, you will see that lines One through Three move steadily
upward regardless of what line Four is doing! BUT, you will
also notice that the "lows" of Line Four begin to
occur above earlier highs. It’s a nice feeling since
Market Value movements are not, themselves, controllable.
Line Four will rarely be above Line One, but when it begins
to close the cap, a greater movement upward in Line Three
(Net Realized Capital Gains) should be expected. In 100% income
portfolios, it is possible for Market Value to exceed Working
Capital by a slight margin, but it is more likely that you
have allowed some greed into the portfolio and that profit
taking opportunities are being ignored. Don’t ever let
this happen. Studies show rather clearly that the vast majority
of unrealized gains are brought to the Schedule D as realized
losses… and this includes potential profits on income
securities. And, when your portfolio hits a new high watermark,
look around for a security that has fallen from grace with
the S & P rating system and bite that bullet.
What’s different about this approach, and why isn’t
it more high tech? There is no mention of an index, an average,
or a comparison with anything at all, and that’s the
way it should be. This method of looking at things will get
you where you want to be without the hype that Wall Street
uses to create unproductive transactions, foolish speculations,
and incurable dissatisfaction. It provides a valid use for
portfolio Market Value, but far from the judgmental nature
Wall Street would like. It’s use in this model, as both
an expectation clarifier and an action indicator for the portfolio
manager, on a personal level, should illuminate your light
bulb. Most investors will focus on Line Four out of habit,
or because they have been brainwashed by Wall Street into
thinking that a lower Market Value is always bad and a higher
one always good. You need to get outside of the “Market
Value vs. Anything” box if you hope to achieve your goals.
Cycles rarely fit the January to December mold, and are only
visible in rear view mirrors anyway… but their impact
on your new Line Dance is totally your tune to name.
The Market Value Line is a valuable tool. If it rises above
working capital, you are missing profit opportunities. If
it falls, start looking for buying opportunities. If Base
Income falls, so has: (1) the quality of your holdings, or
(2) you have changed your asset allocation for some (possibly
inappropriate) reason, etc. So Virginia, it really is OK if
your Market Value falls in a weak stock market or in the face
of higher interest rates. The important thing is to understand
why it happened. If it’s a surprise, then you don't really
understand what is in your portfolio. You will also have to
find a better way to gauge what is going on in the market.
Neither the CNBC "talking heads" nor the "popular
averages" are the answer. The best method of all is to
track "Market Stats", i.e. Breadth Statistics, New
Highs and New Lows. . If you need a "drug", this
is a better one than the ones you've grown up with.
Have a nice change!
Steve
Selengut
sanserve@aol.com
800-245-0494
http://www.sancoservices.com
Professional Portfolio Management since 1979
Author of: "The Brainwashing of the American Investor:
The Book"
