Yogi Berra it was reported to have said that you can see a lot by observing. The distinguishing characteristic of most investors, be they institutions or individuals, is that they thrive on information. However, most investors devour what is served up to them and don’t take the time to observe how the information is served up to them. This week’s blog will focus on two critical streams of information driving the portfolio allocation of many investors. My purpose in displaying how I look at these factors is to illuminate how to look deeper than what is served up, not to suggest that you adapt the way I think.
When reviewing investments, most investors start with a listing provided by an advisor, broker, or custodian. The way the information is arrayed often directs our thinking and therefore our actions. We don’t realize that the array reflects how the producer of the portfolio organizes their information flow, often to reduce their liability. When was the last time you were asked how you’d like your investments shown to you? When was the last time your agent asked what other critical information would be useful to you in making decisions?
During this lazy summer, with the aid of the computer and forced companion in isolation, I’m creating an information matrix giving a different viewpoint. The different view will probably show you how to think about investments and give you a more complete picture, like when your investments will be depleted after meeting various significant expenses.
The following discussion is my first pass at creating an investment framework. It will probably evolve from more thinking and hopefully from the reactions of some of our thoughtful subscribers. I am not recommending this structure for anyone. I’m challenging you to develop your own thinking from a similar exercise.
Once a second investment is added to your first, a portfolio is created. The ability to meet future payments will likely result from the performance of the portfolio, not just a single position. That is true even if the money comes from a position, as it is chosen from the list of available choices. Most investors are collectors of investment opportunities of a different nature. Thus, I find it useful to group investments in different categories based on some common theme rather than looking at a portfolio in alphabetical order.
For this first exercise, I created five categories or buckets. In this case, the buckets are based on their desired usage and not necessarily their investment characteristics. The five are Capital Preservation, Capital Appreciation, Long-term Hedges, Future Merger & Acquisition candidates, and Expenditures. These terms have specific attributes for me and reveal a great deal regarding my thinking, as described below:
- Capital Preservation requires a belief that these assets will grow reasonably in value over time relative to inflation, purchasing power (currency risk), sustainability through economic cycles, and after-tax benefits. Assuming none of the positions fail to meet the continuing criteria they will be part of my estate. Because the criteria changes over time, the portfolio is also likely to change. For example, a major change in tax regulations could cause some of the holdings to move out of the Capital Preservation bucket. (Notice, I did not specify stocks, fixed income, or public/private investments. Each of these could qualify in the right hands.)
- The Capital Appreciation bucket includes holdings, which over an investment cycle, are expected to do better than the appropriate index. The bucket includes both positions doing well and some fallen angels, where there is hope for recovery. Some fallen angels with large losses should be held until they can be used to offset large realized gains. Because of the inclusion of both fallen angels and some leveraged holdings, I do not expect them to be considered “trust quality.”
- Long-term Hedges are those positions likely to rise when specific Capital Preservation issues are falling. They can be competitive with the Capital Preservation items, e.g. Morgan Stanley (NYSE:MS) vs. Goldman Sachs (NYSE:GS), or an economic trend contrary to a Capital Preservation holding, like Jet fuel oil vs. airlines.
- Future Merger & Acquisition holdings would be good companies with attractive products and market share, possibly with an aging senior management with estate problems and weak middle management. Amazon (NASDAQ:AMZN) or Tesla (NASDAQ:TSLA) could be examples.
- Expenditures would include available cash in various currencies and instruments. The currencies result from fund and individual security distributions, where their initial purpose was to be a small reserve for future purchases of investments in those currencies.
In the table below is the current percentage commitment to each bucket and the current number of holdings.
Clearly, there is little relation between the level of commitment and the number of holdings in each bucket. To emphasize that point, adding the single most heavily owned position in each bucket would represent 42% of the total portfolio, demonstrating the power of compounding winners. The large number of holdings represent a behavior pattern of investing in a number of companies when entering a new industry or sector. It also reflects the retention of a number of fallen angels, either due to a belief in an eventual recovery, or the desire to reduce the tax impact of selling large winners.
What would you do with this portfolio instead of one heavily invested in financial services, that is globally diversified with an Asia-heavy focus and a substantial Canadian commitment? I am not suggesting the unconventional display above is superior, it is just different and might add to your decision-making capabilities.
There are any number of other buckets you can use to group your investments. The following is just a sample for both individuals and institutions, and it is far from exhaustive.
Sample Allocation Categories
Pre and Post Retirement
Acquisition of Major Real Estate
Major Family Event
Large Educational Bills
Death and Inheritance Issues
Credit Rating Protection
New Buildings or Laboratories
Funds for strategic acquisitions
Balance sheet to repel a raid
Sufficient Flexibility to Pivot
So far, in the second quarter of this year, most companies reported materially larger declines in operating earnings than in revenues, excluding some tech companies. Under normal conditions, this would indicate the company has lost control of its costs and should be sold. However, as with everything on our march to a series of “New Normals,” our experience and training may prove to be wrong.
Many companies claim their staff is their most critical asset. (I disagree and believe their customers are their biggest asset, followed by their people.) Most successful companies are labeled as skilled or non-skilled, regardless of their existing employees bringing them to their recent former highs. Instead of slashing employment along with sales, some are consciously increasing their losses by maintaining employment or payroll for as many of their people as possible. In many cases, this is likely to prove to be wise from the employee, management, and shareholder point of view.
Thus, when analyzing second and possibly third quarter’s earnings, try to grasp how much of the operating earnings decline is due to the fall in sales and covering current expenses. How much of the cost is for carrying employees that are not currently producing? That is exactly what I did when I was running a larger firm during periodic market declines. It proved to be a wise move for our clients, employees, and not bad for me either.
Please let me know if I am making sense to you or if you need help in building your own Personal Allocation View.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.