ITA Wealth Management

Listed below are the “Top Ten” stocks for mid-week.

• MSFT
• PAYX
• FDS
• CTSH
• INFY
• COH
• BBY
• CSCO
• WFC
• ORCL

Based on my pricing models, only MSFT, INFY, and BBY are fair value when this list was compiled. As always, this is only a group of interesting stocks and you must always do your own research.

Frequently, the “Top Ten” stocks will fall into the growth asset classes and we know from much research that over time, value outperforms growth. Keep that thought in mind when you analyze any of the “Top Ten” stocks.

Lowell Herr

Photograph: Florence, Italy

With over 100 entries on this blog, how does one go about finding the essential information. While I would like to think all entries are informative and useful, I know that is not the case. Interests differ for different investors. Here are a few suggestions.

• On the right-hand side of the blog page, you will find different categories. One place to start is to click on Beginning Investors. Then go to the oldest post and read from oldest to most recent. Unfortunately, this software does not permit me to reverse the order of the dates.
• The second hint is to use the Search option found in the upper right-hand corner of every entry page. Search for items such as Asset Allocation, Swensen, Surz, and Ibbotson & Associates.
• Two other recommended searches are Portfolio Construction and Portfolio Management. Note that any search for the recommended items will also bring up this entry.

From time to time I will post a review of the philosophy of this blog. Setting up an investment plan is something you will see me write over and over again. Also, save and follow “The Golden Rule of Investing.” When you begin to doubt your investment plan, click on the Research category and review that material.

This blog emphasizes index investing vehicles over individual stocks, although stocks are not forbidden. Stocks should not take priority, particularly in asset class were you, the investor, are not skilled in making such selections. ETFs are highly recommended over actively managed mutual funds. Value equities takes precedence over growth equities. International markets need to be part of the portfolio mix.

Take your time to read the material. The entries are not long so the total amount of reading is not all that daunting. Enjoy the photographs.

Lowell Herr

Photograph: Entering Venice, Italy

It is highly unlikely the investment club that holds the following sixteen stocks had all of them in their portfolio for five years, but if they had, here is their outstanding performance when measured against their benchmark.

• RNT - Made Money ~ +10%
• BFAM - Made Money ~ +100%
• CHS - Lost Money ~ > -100%
• CTSH - Made Money ~ +400%
• EXBD - Made Money ~ -80%
• HWAY - Made Money ~ +120%
• IIVI - Made Money ~ +200%
• JNJ - Made Money ~ -3%
• LCAV - Made Money ~ > +100%
• SBUX - Made Money ~ +10%
• SYK - Made Money ~ +65%
• TGT - Made Money ~ +5%
• UBFO - Made Money ~ -15%
• VLO - Made Money ~ > +300%
• WFMI - Made Money ~ -50%
• WRLD - Made Money ~ +110%

I consider this to be an amazing five-year portfolio. Only one stock, CHS lost money over the five years and only five failed to outperform their benchmark. There are several stellar performers in this group of stocks.

Lowell Herr

Photograph: Eze, France

Fisher Investments - Mistake #3: “Confusing income needs with cash flow needs.  Income and cash flow are not the same thing, even though many investors think they are.  In fact, the two different concepts, and the distinctions between them, are extremely important.”  While I did not have this on my list of mistakes, I do agree with Fisher.  Below are his recommendations as to how to avoid this mistake.

“Put simply, cash flow is how much money you need for living expenses and other personal uses of cash.  Income, on the other hand, is the amount of dividends and interest earned by a portfolio that, in the case of a taxable account, you will pay current income taxes on.  Here is the important difference:

“The way in which you generate income can have a tangible effect on the growth of your assets, as well as on the taxes you pay, both of which impact your ability to get cash flows.”

“It’s a mistake to think that you should get the level of cash flow you need solely from income, and never touch principal.  This is an emotional bias that for many simply cannot be overcome.  Instead, your focus should be on total after-tax return.  For example, selling stock to meet income needs can allow you to stay fully invested and create ‘homegrown’ dividends by selling selected securities.”

“When compared with some dividends, as well as with interest from fixed income, selling stock may offer tax advantages, because the transaction might be taxed at the capital gains rate rather than at the client’s marginal rate.  Harvesting losses can also be tax advantageous.

Wealth Management: Mistake #3: Investors do not educate themselves as to the importance of asset allocation, and what asset classes tend to perform better than others over the long-run.  I need not go into the importances of overcoming this mistake as I have written extensively about this.  Just click on the asset allocation category and one will begin to find material to solve what I think is mistake #3.  A corollary is to use index funds or ETFs to populate the portfolio rather than build a portfolio strictly from stocks.  There is nothing wrong with using a few stocks.  However, I have yet to meet a small investor who is an ace at stock selection over the entire market.

Lowell Herr

Photograph:   The main village on the island of Katakolon, Greece.  I think this is the island where the very first Olympics were held.

Moments ago I updated the Asset Allocation-Mosaic Portfolio (AA-Mosaic Portfolio) and I see where the Mosaic has an Internal Rate of Return (IRR) of 20.1% while the VTSMX is nearly flat at 0.9%. Since I last updated the portfolio, the Mosaic dropped 4.4% while the benchmark dropped 2.2%. While I prefer not to see the Mosaic drop any points to the benchmark, the percentage drop for the Mosaic was less than it was for the benchmark.

Depending on what is available, we may add an equity ETF to the AA-Mosaic Portfolio this week. Note that one can always access the Mosaic spreadsheet from the Bivio site. I provide a link on the right side of the blog page.

Lowell Herr

Photograph: Time trial at Alpenrose Velodrome, Portland, Oregon

The asset allocation plan used to construct the AA-Mosaic Portfolio is guided in large part by the Fama-French Three-Factor Model.

• Since the performance of the portfolio is highly dependent (at least 70%) by market factors, we want a broadly diversified portfolio that covers over ten asset classes.
• The second factor is size dependent. Historically, smaller companies outperform larger companies. For this reason we skew the overall portfolio toward mid and small-cap asset classes. For example, a high percentage of our total holdings are concentrated in smaller companies. At least it is higher when the Mosaic portfolio is compared to more ‘traditional’ portfolios.
• The third factor is one of price. The Mosaic portfolio is designed to take advantage of ‘cheap’ stocks outperforming expensive stocks. Our emphasis on value over growth is how we construct the portfolio to take advantage of any inefficiencies in the market.

Overweighting asset classes in value and smaller companies does add more risk to the portfolio. Taking on this risk does not mean we are adding alpha to the portfolio. Hebner points out that managers making this sort of move are “systematically subjecting their clients to two additional risk factors - size (small company) and high BtM value (distress).” BtM is Book to Market Price or Book/Market Price.

We offset the additional risk of size and ‘cheap’ price by adding additional asset classes such as international, emerging markets, REITS, commodities, and perhaps in certain situations, bonds.

Lowell Herr

Photograph:  Gaudi window design - Barcelona, Spain

While researching the “Investment Policy Explains All” paper, I ran into this Internet source of information. Here are some of the articles I highly recommend.

• The Importance of Investment Policy: A Simple Answer To A Contentious Question
• The Truth About Diversification by the Numbers
• Getting to the Core of Model Portfolios
• Style Analysis

Start with these white papers and then pick up others of interest.

Lowell Herr

Photograph: Saint Paul, France

Fisher Investments - “Mistake #2: Misaligning investment objectives and portfolio strategy. Aligning your portfolio strategy with your objectives is a critical factor in determining long-term investing success. This may sound obvious but many investors actually employ strategies that work against their objectives.”

Fisher correctly points out that investors don’t meet their goals. “For example some persistently load up their portfolios with low coupon Treasury bonds, due to fear that stocks will drop in the short-term. Then, they often barely generate a return that’s over the rate of inflation. This reduces the odds of achieving a long-term goal of growth - especially if withdrawals are also anticipated.”

Wealth Management - Mistake #2: Many investors are too conservative at an early age. While I did not originally list this as my number two mistake, I did have it on my list of eight mistakes. Therefore, I am in agreement with Ken Fisher when it comes to mistake #2.

Let me illustrate this mistake with a real example. Husband and wife saved identical amounts during their working years. The wife’s savings were divided almost equally between a portfolio of bonds and stocks. The husband’s portfolio contained only stocks. Upon retirement, the husband’s portfolio was worth approximately twice that of the wife. This example of one of the reasons I tend to shun bonds.

Upon retirement, will you have a pension? Do you know the approximate monthly payout from that pension? If one can retire on a pension and social security, then the portfolio need not include bonds. One can read more about this position in William Bernstein’s second book, “The Four Pillars of Investing: Lessons for Building a Winning Portfolio.”

Summary: Plan to live longer than you might expect and do not be too conservative when constructing your portfolio.  The AA-Mosaic Portfolio follows this advice.

Lowell Herr

Photograph: Entering the port on the island of Katakolon, Greece

Prepare for more bad news when it comes to selecting individual stocks. I found a portfolio of seventeen stocks that had a Projected Annual Return (PAR) of 17.6% on May 1, 2005. Of these seventeen stocks, two are no longer in existence so the following data comes from the remaining fifteen.

The first bit of analysis was to find what asset class each stock occupied. Since there were a number of core holdings, I decided to use Vanguard’s ETFs as the benchmarks. This posed one problem I will describe later. A second problem is that Yahoo does not have a three-year comparison option. I could go with either the five-year option or the two-year option even though this example portfolio was not recommended five years ago. I am familiar with all these stocks and I know them to be high quality companies. Therefore, I chose to go with the five-year comparison as most of these stock would have been recommended five years ago. Since the Vanguard ETFs are not five years old, the comparison graphs for the ETF is matched at some percentage starting point other than zero. In other words, the ETF is normalized with the individual holding so the final percentage spread is a fair comparison over the period of comparison. Here are the results.

• WEN - Lost Money ~ > -100% (The spread between WEN and its VB benchmark was in excess of 100%) Correction: WEN is now a mid-core holding according to Morningstar.  Using http://www.nasdaq.com and a three-year comparison, WEN is outperforming VO, the mid-core benchmark.
• BBBY - Lost Money ~ -75%
• CAH - Lost Money ~ -50%
• FIC - Lost Money ~ -80%
• HMA - Lost Money ~ >-100%
• MO - Lost Money ~ >-100%
• LLTC - Lost Money ~ -15%
• LOW - Made Money ~ -45% (Even though LOW showed a five-year price increase, it under performed its VV benchmark by ~45%)
• UNH - Made Money ~ -10%
• CECO - Lost Money ~ >-100%
• MAS - Lost Money ~ -60%
• CVS - Made Money ~ + 200% (This is the first stock to outperform its benchmark.)
• SNV - Lost Money ~ -100%
• PAYX - Made Money ~ -40% (Another stock that made money but under performed its benchmark.)
• SYK - Made Money ~ +30% (The second stock to outperform its benchmark)

What is the message conveyed by this data and analysis?

Lowell Herr

Photograph: Advertising shingle in Saint Paul, France

While looking for “sin stocks” within the different asset classes, attention was drawn to the fact that there is a significant overlap between value and core holdings. The same duplication occurs between core and growth ETFs. In other words, stocks held in all the core holdings are spilling over into either value or growth ETFs. For this reason, I am seriously considering eliminating VV, VO, and VB ETFs. If these core or blend ETFs are removed from the portfolio, the other value and growth U.S. equity ETFs will need to be realigned. Before I make this semi-drastic move, I will lay out a new asset allocation plan for the AA-Mosaic Portfolio.

Lowell Herr

Photograph: Street vendor in Barcelona, Spain