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The Investor's Creed & Smart Cash - Strategy

Investment Performance

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Portfolio Content Analysis

Operational Questions & Answers

Asset Allocation is an Investment Planning Tool, not an Investment Strategy... few investment professionals understand the distinction. Fewer still have discovered the power of:

"The Working Capital Model"!

The problem that most investors have is that they use the wrong number to determine their Asset Allocation in the first place. Neither Market Value nor the Calendar Year should be relevant issues!

Investing is a get rich slowly process, conducted in an uncertain environment... one that must be understood and managed in a way that minimizes the risks involved. 

The Working Capital Model accomplishes this by eliminating the need for impersonal comparisons with arbitrary and unrelated numbers and time periods. It works best with portfolios that are diversified among individual securities that are at the same time of high quality and income producing. 

All investment grade securities fit within one of these two classifications, based solely upon the primary purpose for their ownership. There are several key issues involved in successful Asset Allocation: 

• Understanding the Purpose of each Security owned, 
• Being true to the Asset Allocation Formula, 
• Knowing the Cost Basis of the securities in the portfolio, 
• Worshiping Cash Flow, and accepting the "Smart Cash" concept. Smart Cash is that which arises from earned income of any kind, including Capital Gains.

• Very simply, the purpose of any Equity Investment is the eventual production of a "realized capital gain", a profit. This profit need not be huge, but it should be "targeted" in advance as a guideline and it certainly should be above the guaranteed return in a bank account. The profit must be realized as soon as it is available, so it is helpful if Equity Investments are housed in Tax Deferred quarters. 

The Working Capital Model works best with Equity Investments that pay dividends, but this is more of a "quality assurance" element than it is a cash flow consideration. The primary purpose of Equities is profit production, quickly. (Thou shalt not fall in love with any Equity holding... ever!)

Most Fixed Income Securities represent a contractual obligation between a corporation and investors: interest, dividends on a preferred stock, returns of principal, royalties, rent, etc, will be paid at periodic intervals. Investors become creditors of the issuing entity. Obviously it pays to lend money only to corporations, municipalities, and others that have solid finances themselves. 

Typically, longer loan commitments produce higher rates of return than shorter ones and AAA Insured obligations produce lower yields than those of a lesser quality. Investment Grade falls somewhere in between, and this is where The Working Capital Model keeps investors focused. 

All Income Securities are Interest Rate Expectation Sensitive and will rise or fall in price depending on day to day perceptions about the direction of interest rates. This is expected and totally irrelevant. In fact, if an investor purchases the securities in the Fixed Income portion of the portfolio properly, he or she will be able to add to holdings when they move higher in yield, AND to sell the securities profitably when they move higher in price.

• The Primary purpose of these securities is income generation and investors should never accept or consider a lower rate of return in an effort to reduce volatility. 
• Investors should never avoid adding to the Fixed Income Asset Allocation "bucket" for fear (or in anticipation of) higher interest rates. 
• The Working Capital Model recognizes this, and works well with sound financial advice as it deflects the temptation either to transact or to sit back for the wrong reasons.

(That was a test! For a tutorial on Fixed Income Investing, click here.)

• he has analyzed his personal situation carefully and
    
• determined that this structure is most likely to achieve his long term goals.

The Asset Allocation Formula is often misused and abused in an effort to superimpose a valid investment planning tool on speculation strategies that have no real merits of their own. For example, "annual portfolio repositioning", "market timing adjustments", and shifting between Mutual Funds. To be effective, Asset Allocation must be implemented as  an on-going process that is to be tended to with every investment decision.

The Asset Allocation Formula itself is sacred, and if constructed properly, should never be altered in any respect due to conditions in either the Equity or  Income markets.

Changes in the personal situation, goals, and objectives of the investor are the only issues that can be allowed into the Asset Allocation decision making process. It operates above the whims and cycles of the markets... Income and Equity.

• To illustrate, let's start with a portfolio of $100,000 in cash. (The size doesn't matter.) We expect to invest $60,000 of this in Equities and the remainder in Fixed Income. 
• Once the portfolio has been constructed, the Working Capital total will remain at $100,000 until there are cash additions or withdrawals, and realized gains or losses. 
• Day to day changes in Market Value are ignored.

As cash increases from income and from deposits it becomes a part of the Working Capital total and is reinvested in a way that maintains the 60% to 40% Asset Allocation, based solely on cost basis. 

Thus, both investment "Buckets" are constantly growing, as is the income generated from the portfolio, while the Asset Allocation is being maintained with no unwarranted influence from current market conditions.

Note that with The Working Capital Model, Cost Basis is used for all diversification calculations as well.

• It is only fitting and proper the successful Investment Portfolio has this common ground with the successful business entity of any size. 

Performance analysis becomes much more productive and forward going because both future predicting and comparing with arbitrary indices/averages is eliminated. Year-end adjustments are unnecessary. Cash Flow analysis shows how effective the allocation formula is and helps isolate how effectively the investor is managing each investment bucket.

Investment Performance Evaluation should be a measure of the extent to which a goal or objective has been achieved. The Working Capital Model facilitates the clear analysis of goal achievement based solely on each investors unique portfolio structure. Market Value analysis, on the other hand, tells you nothing about progress toward your long term income goals or the appropriateness of your Asset Allocation.

Three specific numbers are important to long term portfolio Working Capital growth. 

• Gross Realized Earnings as a percentage of beginning Working Capital. This number should be better than the One Year CD Rate at the beginning of the year.

• Gross Realized Capital Gains as a percentage of the Cost Basis of Securities Sold. This percentage should be right around the profit taking target you've set for yourself. You may also want to determine the Average Holding Period of each sold security. Shorter holding periods enhance portfolio working capital growth. It is important to set a reasonable target, one that can be achieved frequently throughout the year. Three 8% gains may not be exciting, but they can produce more revenue than one 20%er!

• Growth in Working Capital as an annual percentage.  A negative number in this area is totally unacceptable and should (almost) never occur. If it does, the portfolio manager (investor) has: (1) allowed too much risk into the security selection process, or (2) realized losses on older holdings that could not be given up on too quickly. The actual growth rate will be somewhere between the target profit taking rate for equities and the average yield for fixed income... thus, it depends upon the asset allocation (the size of each bucket), which depends on the age, circumstances, and risk tolerance of the investor. Hey, is this easy or what.

Similarly, because of the disciplined investor's dedication to the profit taking purpose of the Equity Allocation of the portfolio, large amounts of Smart Cash will accumulate with broad advances in the Stock Market. (Smart Cash is defined as cash that results from the realization of profits plus income generated by securities in the portfolio).  

• This is not a hedge on anything, and not some form of market timing. It's simply profits earning some compound interest until new opportunities arise. [Yes, Virginia, compounding is still an important growth provider.]

Rising markets require GREED CONTROL just as surely as falling markets demand protection against FEAR... the two heads of the ole Uncertainty Monster!

While the Media and your buddies drool or cringe, respectively, your Working Capital focus keeps you on target, looking for higher yielding, quality, income securities and/or quality equities that have fallen from grace with the Market. 

Smart Cash is only "smart" if it doesn't burn a hole in your Asset Allocation. 

• Knowing that excessive amounts are the result of profit taking should encourage investors to avoid the purchase of high priced old favorites, hot new issues, and the best performing funds. 
• When the FEAR head is talking to you, The Working Capital Model will be whispering in your other ear to get that Equity Allocation back where it belongs with lower priced quality issues... possibly the same ones you recently sold for profits. 
• Typically, more speculative investor types will not be able to control their greed and will fall from Asset Allocation grace by changing and by outthinking themselves. 

This is the moment of truth. Be disciplined, don't invade the fixed income portion of the portfolio under any circumstances. Tolerate excessive cash destined for Equity Investing. Don't look at the calendar or the Market Averages for help.

 A focus on Working Capital Model Asset Allocation really works if you allow it to throughout changing conditions in all markets. 

• It also aids in the understanding of what happens to those Trading Profits that just don't seem to move , dollar-for-dollar, to the bottom line. Trading takes place within the ebb and flow of both the stock and the bond markets, which may or may not be moving in the same direction.
  
• Although your realized gains, and other income, are very real, they are not directly related to the portfolio's Market Value. This is corrected in Working Capital analysis, where the one-for-one relationship remains valid.

The following is a slightly edited excerpt from Chapter Seven of: The Brainwashing of the American Investor, 2nd Edition.

• Now I realize that this approach is totally different than anything you’ve ever dealt with before, but in one fell swoop it surely eliminates all of those nagging ifs, ands, and buts, that make standard bottom-line market-value analysis totally useless (to the investor).  
  

• I created the Working Capital method of portfolio performance evaluation many years ago (1975), when it became evident that a trading strategy was quite a bit different from most styles of investment management.  It shows you where you are and allows for meaningful comparisons with where you’ve been. As a kicker,  it allows for an instant and accurate appraisal of Asset Allocation. 
  

• Working Capital is defined as the actual Cost Basis of the securities in the portfolio as opposed to their current market value. This concept is also consistent with the retail store approach towards equity investing which was discussed earlier. Income of any kind, including realized capital gains, and deposits increase your working capital while withdrawals and realized capital losses alone decrease it. Current market value is not a factor. Since you will constantly monitor the age of the securities in the portfolio the tendency to hang on too long to nonproductive assets is also avoided.
  

• The total Working Capital will always be more than the Market Value of the portfolio, unless the bulk of the portfolio is invested in fixed income securities. (AND then only if interest rates have moved down since the time the  Income securities were purchased.) This is both expected and accepted because it is easy to understand without having to sift through a dozen research reports that try to explain an array of unknowables about the economy and the company’s management team. However, the closer the broad market gets to truly high ground, the narrower the difference between working capital and market valuations.
  

• Is this clear? Working Capital doesn’t change as a function of market value. It grows through the addition of cash from deposits, dividends, interest, and realized gains. It decreases when losses are realized and when cash is withdrawn from the portfolio. The day-to-day changes in market value that you used to worship can now be thrown out into the street with the other garbage! 

We are replacing our profitable investments (merchandise we have sold at our store) with new ones that have potential for future profit (inventory on the shelves). Thus our current portfolio value will not “catch up” until new buying opportunities dry up. If you have nothing to buy, Smart Cash builds up (compounding at money market rates) while profit taking continues. 

Always Remember: The Investor’s Creed

My intention is to be fully invested in accordance with my planned equity/fixed income asset allocation. On the other hand, every security I own is for sale, and every security I own generates some form of cash flow that cannot be reinvested immediately. I am happy when my cash position is nearly 0% because all of my money is then working as hard as it possibly can to meet my objectives. But, I am ecstatic when my cash position approaches 100% because that means I’ve sold everything at a profit, and that I am in a position to take advantage of any new investment opportunities (that fit my guidelines) as soon as I become aware of them.