Investment Performance
Analysis Using the Working Capital Asset Allocation Model
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 couldas
and shouldas, 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 navigating the sea of
uncertainty, and Peak-to-Peak interest rate and market cycle analysis are much
more useful as performance expectation barometers than the DJIA was ever meant
to be. 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 in 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 thinking associated with 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 second full 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 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: Cumulative 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 Value Stocks (IGVS), and apply a 5% of Cost Basis
diversification rule, 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 the IGVSI). The Base Income just
keeps growing because Asset Allocation is also based on the cost basis of each
security class… get it? 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, tealeaves, 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. When your portfolio
hits a new high Market Value watermark, look around for a security that is no
longer an IGVS and bite that bullet.
What's different about this approach, and why isn't it
more high tech? There is no mention of the popular market indices, or comparison
with anything other than investors' personal, reasonable, goals. 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 performance 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
reason, etc. So, Virginia, it really is OK if your Market Value falls in a weak
IGVS 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 your markets. Neither the CNBC talking heads nor the
popular averages are the answer. The best method of all is to track IGVS
statistics… if you need drugs; these are better than the ones you've grown up
with. Have a nice change!
Steve Selengut
http://www.valuestockindex.com
Professional Portfolio
Management since 1979
Author of: "The
Brainwashing of the American Investor: The Book that Wall Street Does Not Want
YOU to Read", and "A Millionaire's Secret Investment Strategy"
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