Time-Honored Path to Success (Part 4)
Cover Story, by Mark Robertson, Managing Partner June 5th, 2010
This month, we continue our closer look at what we do, why and how we do it ... and why our championship approach to investing works..
This month, we continue our closer look at what we do, why and how we do it … and why (and how well) our championship approach to investing works. It starts with taking ownership and a commitment to invest regularly. Our learn-by-doing investing experience naturally progresses from discovery and a boost from investing regularly to the maturity of strategic selectivity (the reality that both projected returns and quality matter) to careful design and portfolio management. How should we think of capital preservation and asset allocation decisions? What is the impact on future “shopping?”
" … a group [of investors] heeding the lessons of Graham, Babson and Nicholson has at least one leg up on the crowd and a better than average opportunity to generate exceptional returns."
Better Balance, Better Results? When your monthly cash infusions become small relative to total assets — and you have practiced a classic growth stock analysis method of investing for a few years, Nicholson urged that many investors are ready for a balanced approach to investing that embraces dynamic asset allocation based on overall market return expectations. This includes remaining “fully invested” but allowing for those times when that investment should be in cash. Build reserves for better shopping.
Our sage founders never said that we should remain fully invested in common stocks at all times. In fact, they stipulated that it would be “amateurish” and less effective to do so.
This month, we’ll take a closer look at the role of dynamic asset allocation during a lifetime campaign of successful long-term investing but first, a recap of the foundations covered so far:
1. It All Starts With Ownership. Own It.
Take responsibility and behave with a pride of ownership.
2. Invest Regularly. Imagine Success.
Investing regularly gives way to prudent portfolio management for experienced investors.
3. Embrace Strategic Selectivity.
Strategic selectivity is captured in two dimensions: Leadership quality and Projected annual returns (PAR).
4. Seek and Maintain Sufficient Overall Growth
Discover and own a sufficient number of medium- and small-sized companies.
5. Embrace Strategic Selling.
Sell (a) to improve the overall portfolio and/or (b) use a selling discipline based on core/non-core principles. Be willing to sell when your studies suggest that it’s a prudent decision.
6. Balance … and Building Reserves for Better Shopping
Most of us have been counseled that “asset allocation” is a form of market timing and it’s been enough to encourage many of us to run for the hills when the subject is broached. For the experienced investor or investment club, we’ll bring a close to this series with an invitation to think about your long-term results. Do you remember that last bear market where you doggedly remained fully invested, because … well, because that’s the rule?
The projected annual returns of your favorite purchase candidates soared but you or your club found yourselves with relatively little cash to buy some really attractive opportunities. How many times have you ridden a stock like FactSet (FDS) from $20 to $70 and back down to $30 during a swoon? If you practice strategic selling, funds are liberated (locking in gains on overvalued stocks) while creating the reserves for future buying opportunities.
The general dislike of market timing (or asset allocation principles) can be summed up by Graham and Dodd’s statement, “It is our view that stock market timing cannot be done…” However, less well-known is the fact that they continue the sentence, “with general success, unless the time to buy is related to an attractive level [of return projections], as measured by analytical standards. Similarly, the investor must take his cue to sell primarily not from so-called technical market signals but from a [decline in PAR levels] beyond a point justified by objective standards of value.”
I took some liberties to emphasize returns vs. “price chasing” but the concept is pretty straight forward and certainly consistent with our time-honored legacy. And like so many things believed by our community of long-term investors, the “rules and guidelines” have been truncated for simplicity in service to beginning investors.
Buy-and-hold is significantly different than “Buy and hold for as long as it makes sense to do so.”
As we recently covered, we know that the performance advantage of investing regularly wanes as the amount of infusions into a portfolio becomes relatively small compared to total assets, we have to be certain that we’re seeking size diversification and sticking with strategic selection to replace the missing increment.
When MIPAR Meets Occam’s Razor: Our Cash Allocation Barometer. Your portfolio cash allocation target (plus or minus, of course) should be a function of return expectations for the overall market (MIPAR). At the depth of bear markets — think March 2009 and its 20% MIPAR condition — we should have very little cash. The flip side is when MIPAR approaches multi-decade lows. Under those conditions, we’d like to have a stable of cash reserves for purchase opportunities during the ensuing correction or recession. As shown here, a simple linear relationship between MIPAR and the % of total assets committed is pretty straight forward. When MIPAR = 8%, portfolio cash equivalents should be approximately 15% of total assets.
National Association of Investors founder George Nicholson advised that, with experience, we reach a point in our investing journey when we should consider a balanced approach to investing.
The balance is struck between core and non-core investments. For the classic growth (core) component, we do everything we’ve learned about high-quality growth investing during our first few years of investing. Nothing changes.
How much could/should be committed to the non-core component? As with many things investing, the answer is individual specific based on time horizons, objectives, etc. But for a baseline, Nicholson suggested a 75%/25% split between core and non-core.
That 25% could include non-growth investments (cyclicals, special situations, etc.) with exceptional price appreciation potential and serves as a stash for “cash” or cash equivalents. The core component of your portfolio is managed with all of the beginner’s guidelines and rules, much like a well-managed growth fund.
Cash Allocation Barometer
So how much cash is appropriate?
Answer: It depends. It depends on market conditions. Think back to March 2009 and the historical high levels that we observed for MIPAR (and our “back up the truck” commentary at the time.) With forecast returns at elevated levels, it makes sense to assertively invest perhaps including some promising emerging smaller companies in the mix.
The flip side was observed during summer 2008 with return forecasts near historical lows. We argue that it is prudent to create a sufficient number of cash reserves for future buying opportunities under those conditions. As the accompanying figure suggests, it could be a pretty straight forward connection between MIPAR levels and recommended cash positions.
Q: But isn’t “hiding” in cash a breach of the “rule” that we remain fully investing?
A: No. Not at all. In fact, most of the investing public would see the cash allocation recommendations discussed here to be very aggressive. In sharp contrast, many/most of us would feel “overly conservative” with 15% in cash at this time. Look no further than Value Line’s current recommendation of 35% in cash equivalents. Assets invested in cash equivalents are still fully invested. In fact, to remain 100% invested in common stocks at all times is a path to weaker results. Reserves are important for the transitions from periods of overbought (low return forecast) conditions to the opportunities presented by corrections.
Tin Cup Unit Value: Traditional vs. Balanced Analysis. In this cursory analysis, the return for the Tin Cup model portfolio would have been improved by 2.5%/year for the trailing five year period by implementing the return-driven allocation principles discussed in this article. A traditional (fully-invested) Tin Cup has actually recovered to pre-bear market levels while using a total return bond fund for cash equivalents buffered the downside during the bear market. A 100% allocation to stocks (based on MIPAR) during 2009 delivered powerful returns from a better “base.”
Echoes of Tin Cup
The Tin Cup model portfolio has been fully invested in common stocks since its 1994 inception. The performance of Tin Cup was actually pretty good during the 2000-2002 bear market and we’ve pointed out previously that our mechanical investments in stocks like AutoZone and Wolverine Worldwide bolstered the results during a pretty difficult period fairly dramatically.
Tin Cup has performed extremely well over the last year or so and is back to pre-bear levels and continuing its ascent to $1,000,000. (Knock on wood.) And that was without any cash allocation strategy.
To us, the natural question when it comes to dynamic asset allocation is “What is it potentially worth?” It’s an important question. Nicholson counseled that the strategy could lead to situations where the cash reserves could be deployed to make “sizable purchases of general market securities at favorable levels.” But he also counseled that (1) it’s not for beginners and (2) it should be regarded as optional. “The application of this strategy is very difficult and will require good judgment and prudent attention.” (Original emphasis, not mine) It is important that only a moderate part of your portfolio be used until you have established a record of successful results and understanding.
Pieces of Our Relative Return Advantage
According to sources like DALBAR, the average investor achieves a relative return that generally trails the general stock market by five percentage points. Our quest to outperform general stock market benchmarks by an equally large ADVANTAGE (5%) is built on the solid foundations of (1) ownership and optimized expense ratio, (2) investing regularly during the early years, (3) embracing the strategic selectivity of projected returns and quality, (4) prudent portfolio design and management featuring strategic selling and now (5) it appears that an incremental advantage can be pursued using a balanced approach to long-term investing. Patience. Discipline.
We see enough promise to continue to explore this dynamic (projected return-driven) asset allocation strategy.
Our time-honored path is centered on seeking superior returns, and the peace that comes with piece by piece.
Mark Robertson
Mark Robertson is founder and managing partner of Manifest Investing, a source for research and portfolio management focusing on strategic long term investors.