A Matter of Balance

Cover Story, by Mark Robertson, Managing Partner December 1st, 2012

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We know what is important. Discover high-quality companies. Own them if and only if they go “on sale” -- a condition easily detected by monitoring long-term return forecasts.

We know what is important. Discover high-quality companies. Own them if and only if they go “on sale” — a condition easily detected by monitoring long-term return forecasts. Last month, we introduced our Core Diem demonstration portfolio. This month, we’ll introduce the Balanced Budget demonstration portfolio. Core Diem will remain focused on the best-of-the-best companies and those that seem well-positioned to suitably scoot. But we also know that growth diversification is an important component of the overall framework of successful long-term investing. Cy Lynch inspired a thought-provoking answer to a long-standing question this month … and it’s worthy of considerable exploration and potential implementation.

The question came as they often do. From the back of the room … and in something of a hushed inquiry.

“If the long-term performance of the Value Line 1700 companies is that good (as shown here) then why don’t we invest directly in that?” — Bashful Student.

Ken Kavula and I have fielded that question several times. And the answer has generally been something along the lines of the fact that there’s no directly investable approach to doing that and very few of us want to invest in 1700 companies. Value Line has a mutual fund (VLIFX) — but the management approach is based on their timeliness rating and frankly, has been fairly ineffective. (The 10-year annualized relative return is -2.9%)

But Cy Lynch asked a simple question, expanding on some of his work (and warnings about “marquee bias” when it comes to a number of index funds) in his fund research. What would be wrong with using a group of investable equally-weighted exchange-traded funds to emulate the Value Line 1700?

Introducing Balanced Budget

No, we didn’t say introducing a balanced budget. That’s almost unimaginable when watching the sideshow that is Washington D.C. these days.

Our Balanced Budget is a play on words. The demonstration portfolio will be a form of asset allocation. The allocation will be based on — and driven by — the allocation recommendations published in the Value Line Selection & Opinion each week. As shown here, the allocation to “cash equivalents” is 30-40%. This doesn’t change very often. The last shift took place back in April 2012 — a slight increase in the recommended allocation to cash equivalents. So Value Line provides the “budget” when it comes to the distribution over time of stocks vs. cash equivalents.

The “Balanced” part is in homage to the guidance provided by George Nicholson Jr. (grandfather of the modern investment club movement) in his invitation to experienced investors. His advice? After gaining suitable experience, investors should become informed about balanced investing. Balanced investing includes core investing but also leaves room for cash reserves and speculation (also known as non-core investing) in the form of general market securities.

The common stock component will be largely based on the Value Line 1700 — using the method suggested by Cy.

It’s not an exact match. But there’s been an equally-weighted version of the S&P 500 for several years. It’s the Guggenheim S&P 500 Equal Weight (RSP). Guggenheim has recently added the S&P 400 MidCap Equal Weight (EWMD) and the S&P 600 SmallCap Equal Weight (EWSM) exchange-traded funds.

No, it’s not perfect. And you know how we feel about classification by capitalization. (It’s lame) But until Wall Street reforms to focus on growth it’s the best we can do for now. So these funds provide an investable coverage of 1500 companies. With Value Line at 1700, there’s clearly a few differences. For one thing, Value Line has a number of international ADRs that are not included in the S&P 1500.

Not Just For Clubs

Nicholson’s suggestion was clearly not just for clubs. In fact, the time horizon for forecasts is always five years, but the life expectancy of an investment club is “infinite.” Think about it. This provides logical support for 100% fully-invested at all times, etc. For clubs, adopting non-core (balanced) investing is an attempt to achieve incrementally superior performance. But when it comes to individual investors, none of us have infinite expectancy. And some investors have capital preservation objectives that can be wholly consistent with balanced/asset allocation principles. We’ll be doing more with this subject. What seems right for you?