A Survey of The Investing Horizon

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So where do we stand with the stock market? The S&P 500 trades at just under 22 times trailing operating earnings according to Bloomberg …

… and 17.5 times forward earnings estimates according to J.P. Morgan.

So by these measures, the market is overvalued compared to 25 year averages. However, when the earnings yield is compared to current interest rates, the market is — if anything — rather cheap.

Ed Yardeni calls the current conventional wisdom the “2-by-2-by-2” scenario: 2% real GDP growth, 2% inflation, and a peak Fed Funds rate of 2%.

What If We Have Much Higher Interest Rates?

But much higher interest rates could upset the apple cart. While there are many reasons for lower potential growth and inflation — such as the aging of society — what if the conventional wisdom is wrong and higher growth and inflation cause a substantial increase in interest rates?

As the above chart shows, interest rates don’t generally have a negative effect on stocks until the ten year Treasury is above 5%. While it’s not impossible for rates to go higher than 5%, I see no reason for it to happen any time soon without much higher growth and/or inflation rates. And demographics and global trade would seem to keep a lid on both.

Runaway Inflation Seems Rather Unlikely

There are a lot of smart people who seem to think a normalized 4%-5% ten year Treasury yield is a reasonable planning assumption. For instance, Morningstar has a 4-5% ten year Treasury baked into its discounted cash flow (DCF) models to come up with their fair value estimates on stocks.

There is a lot of room between the current 2.24% on the ten year Treasury and a potential 5 handle. But with gradual Fed balance sheet reduction and possible higher growth from a tax cut or infrastructure package, the 10 year Treasury could easily reach 3%-3.5% over the next year or so — maybe even 4%. But that would require the Keystone Cops in Washington to get their acts together. And don’t forget the Fed is pushing in the other direction with higher short term interest rates because their outdated Philips Curve Model suggests inflation should be on its way any day now.

While commodities prices are mixed (weak ag prices/strong industrial metals), global trade should ease pressures on inflation. The official unemployment rate looks low, but there still seems to be some slack in the labor market with the low participation rate and wage growth below par. And to the extent wage pressures exist, companies will likely invest more in automation.

Maybe A Lot More Long Term Upside?

The good folks at Bespoke show that trailing 10 and 20 year stock market returns are still pretty lousy, which hardly seems an indication of a bubble ready to be popped.

And as this chart shows, we may well have entered a new secular bull market in 2013, which could bring huge gains over the next decade plus.

Can The Fed Control Its Urge to Cause a Recession?

So even though we’ve had a great 8 year run since the bottom in March of 2009, it seems we have room to the upside if the economy continues to do well. Unless we have a big geopolitical shock or the Fed hikes us into a recession. If we get a recession, we get a bear market. This is as close to a certainty as you will find in the markets.

While it seems everyone is looking for signs of the bottom falling out of the stock market, the data shows no bubble that I can see. Well, Tesla and Nvidia look rather bubbly but M&A and the IPO market are certainly not red hot. Big Cap Tech has had a great run, but they have real earnings and cash flows, and valuations are much more reasonable than during the bubble era. This is not about metrics like eyeballs and page views like 1999-2000. There is no sock puppet bullshit this time; by and large, they are real, substantial businesses.

It seems to me there is no need for a recession unless the Fed decides it wants to cause one by raising rates too much — so they can get the dry powder to lower rates in case of a recession, which they will likely cause by raising rates…

How To Plan For An Uncertain Future

If you are worried about a bear market, you should reduce your risk while times are good. Make sure you have enough liquidity so you won’t stop buying during a bear market if you are young and in the accumulation phase. And don’t sell into a decline!

Planning for your liquidity needs is even more important if you are in or near retirement. If you are worried about a coming bear market, you should sell down to the sleeping point now, when times are good. Don’t put yourself in a position to be a forced seller into a big decline. That only makes you fail to meet your long term goals while lining the pockets of guys like Warren Buffett and Seth Klarman.

I try to stay hunkered down all the time, and I plan for my liquidity needs as if a bear market will begin tomorrow. This is more sensible than to assume you will have some magical insight nobody else has that will enable you to sidestep the worst of a bear market.

See also:

J.P. Morgan Guide To the Markets as of June 30, 2017

“Run of the Mill” Market Returns – Bespoke

S&P 500 Remains Reasonably Valued – Brian Gilmartin

Jeff Saut Still a Huge Secular Bull

“Success in investing doesn’t correlate with I.Q. once you’re above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
— Warren Buffett

High Returns From Low Risk

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Pim Van Vliet’s book High Returns from Low Risk examines the investment paradox that the lowest risk stocks (measured by volatility) outperform the highest risk stocks over the long term. This phenomenon has been established across markets and eras. The book builds on the work of Eric Falkenstein in The Missing Risk Premium and his paper on risk and return at SSRN.

According to the deans of finance, this should not be the case. For instance, the Capital Asset Pricing Model (CAPM) assumes a linear relationship between risk and reward. But of course this does not represent the real world.

    “Bearing higher risk generally produces higher returns. The market has to set things up to look like that’ll be the case; if it didn’t, people wouldn’t make risky investments. But it can’t always work that way, or else risky investments wouldn’t be risky. And when risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk’s all about.”
    — Howard Marks

So You’re Telling Me There Is a Free Lunch?

The following diagram shows a frown whereby risk increases return up to a point, but the highest risk stocks underperform the lower risk stocks. You should take some risk, but not too much.

Valuation Still Matters

Since the low risk anomaly has been identified, several ETFs such as USMV & SPLV have been created to exploit it. In recent years, a lot of hot money has chased the strategy and driven up the prices of low volatility stocks. The observation of the phenomenon has changed it.

So returns from low risk may be somewhat muted going forward until the excitement fades and the hot money moves on to chase something else. As in any other investment strategy, valuation matters, and you should seek a margin of safety.

Why The Anomaly Should Persist Longer Term

So we see that the low risk anomaly exists. But why should it exist, let alone persist? For ordinary investors, the main reason is the pull of the possible lottery ticket payoff from exciting, high risk stocks. It is a lot easier to brag about owning Tesla or Nvidia than it is about owning Johnson & Johnson or a regulated utility. And as the popularity of lotteries shows, people are blind to probabilities when they can fixate on a potential huge payoff. Low risk stocks just don’t have the same visceral appeal, so they tend to be avoided as if they are only appropriate for widows and orphans.

    “Our desire to impress others causes us to take too much risk.”
    Eric Falkenstein

For institutional money managers, the reasons the low risk anomaly should persist are incentives and short term comparison periods. Professional money managers don’t pursue absolute returns with low risk because it can cause wildly different short term returns than their benchmarks. They are measured and compensated based on their performance versus these benchmarks over short time periods, not over complete market cycles. If they neglect the horserace, they will likely be fired. Thus, they avoid low risk stocks, leaving a juicy opportunity for investors with a long term orientation and a lack of fear of being different than the crowd.

    “Suppose a stock always generates gains of 10% a year, while the market varies between -40% and +60%. How risky is this stock from a relative perspective? Sometimes it lags the market by 50% and sometimes it performs 50% better than the market. From a relative risk perspective, the steady stock is very risky. From an absolute perspective, there’s no risk at all because every year you earn 10% with no volatility. … Professional investors have to focus on relative risk to prove to their bosses, clients, and others that their performance is above average.”
    — Pim Van Vliet

Additionally, professional money managers tend to gravitate toward complexity because of self preservation in terms of marketing. It is hard to sell a strategy where they are just buying boring low risk stocks and hanging on. Average people might figure they could do that. Why would they need to pay someone else 1% a year to do it for them? So I think this is another reason the pros will continue to avoid low risk stocks and go for the complicated and high risk stocks that tend to baffle the average guy.

Low Risk Outperforms in Bear Markets, but Lags In Bull Markets

While low risk stocks tend to outperform in a bear market, it can be difficult to hang on during a bull market when you are likely to lag. The sense that everyone else is getting rich can be hard to take without capitulating. Persistence over an entire market cycle is needed to get the outperformance the low risk strategy can deliver.

    “The low volatility portfolio wins by losing less during times of stress.”
    — Pim Van Vliet

Low Risk Is Better For Long Term Compounding

Van Vliet also shows that there is an additional cost to the investor in high risk stocks due to compounding effects. Compounding causes big losses to have an outsized negative impact on long term performance. The smoother ride of a low risk stock portfolio leads to a much bigger pile of money in the long run, because it doesn’t interrupt the magic of compounding with big losses.

    “The longer your investment horizon, the greater extent to which risk will hurt your long-term returns through compounding effects. For a high-risk portfolio this difference is more than 6% per year.”
    — Pim Van Vliet

Low Risk Helps Retirees and Near Retirees

A potential bear market is a huge risk for people in or near retirement. A big loss at that time of life can put a huge permanent dent in their lifestyle. A cash cushion and a bond allocation should be considered, but a substantial allocation to stocks is still needed because of lengthening lifespans. Low risk stocks fit the bill in this regard as well.

    “For older investors, conservative stocks are more attractive than all stocks, as they have less time to recoup any portfolio losses they have experienced.”
    — Pim Van Vliet

An Antidote to Financial Noise and Unnecessary Complexity

Pim Van Vliet’s book is a breath of fresh air. That one can ignore all of the noise and succeed with low risk stocks is a blessing for the individual investor, if he is willing to put in the work and can stand to be different from the crowd. I am perfectly happy ignoring the horserace and earning high returns with low risk.

I love to find boring, cash cow companies that it is hard to brag about owning. Sacrificing your ego for financial gain can be emotionally counterintuitive, but lucrative. I would much rather have the cash register ring reliably than have bragging rights.

This book functions as an antidote to all of the noise in the blogosphere from financial pros hating on simple strategies such as investing in dividend paying stocks. For one example, see Dividend Stocks Are The Worst by Meb Faber.

I’m sure Meb is a good guy and he is smart as heck. His shareholder yield strategy (dividends plus buybacks) has a lot of strengths, but it also has weaknesses.

While he has pointed out the drag from taxes owed on dividends, I would point out that qualified dividends are only taxed at 15% in the 25% federal bracket. In the 10% & 15% brackets, the tax rate for qualified dividends is 0%. In an IRA or 401(k), taxes are deferred. And in a Roth, dividends are tax free.

In a bull market shareholder yield will likely beat the pants off of a dividend strategy. But the problem with buybacks is that they occur most during a boom when stock prices are high, and they get shut off during a recession when stocks are cheap. An awful lot of companies destroyed value by buying back a bunch of stock in the 2002-2007 bull market, only to reissue it at much lower prices in the aftermath of the financial crisis.

We could go back and forth all day long, but to me it is a matter of personal preference and goals. My goal is not to beat the market, but to comfortably afford the life I want to live. Pim Van Vliet shows that a low risk strategy can even outperform. I may beat the market without even really striving to do so. And I certainly won’t fire myself if I am 50 basis points shy of the S&P 500’s total return.

A Dividend Oriented Strategy Beats Dollar Cost Averaging In Reverse in Retirement

Another substantial benefit of the dividend growth strategy over the “living off of the pile” strategy promoted by most of the financial industry is that it is perfect for turning a portfolio into a stream of income during retirement.

This solves a major weakness in the mainstream advice to gradually sell off part of your portfolio every year in retirement. Dollar cost averaging in reverse destroys value just as dollar cost averaging in the accumulation phase creates value. A low risk, dividend growth strategy is simply much more practical in the real world for real people than trying to live off of the pile.

And the smoother ride of investing in largely defensive, low risk stocks with secure and growing dividends means that I won’t panic and sell during a downturn. The key is that I believe in it, and I know it will get me to my goals if I stick with it. That is much more than good enough for me.

    “The great strategy you can’t stick with is obviously vastly inferior to the very good strategy you can stick with.”
    — Cliff Asness

See also:

DR 167: Interview of Josh Peters of Morningstar March 18, 2015: Soundcloud and Transcript

The Joys of Hunkering Down

Worrying is a serious offense

The Seduction of Pessimism

Why Simple Beats Complex

4 Signs of a Bubble

Mohnish Pabrai Lecture at UCI, 6-7-17 — Few Bets, Big Bets, Infrequent Bets

Is the staggeringly profitable business of scientific publishing bad for science?

“Humility means loving the truth more than oneself.”
— Andre Comte-Sponville

Important Insights From The Investing Greats

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Find A Strategy You Can Stick With

“The great strategy you can’t stick with is obviously vastly inferior to the very good strategy you can stick with.”
— Cliff Asness

This is why protecting your downside is more important than maximizing your upside. Forget the horserace and look to a strategy you can live with in good times and bad. For me, that strategy is investing largely in defensive, high quality companies that grow their dividends. It may lag in a bull market, but I can sleep like a baby in tough times. The key is that I know it works and I believe in it. That inoculates me against selling and locking in a big loss during a bear market.

You Don’t Get Extra Points For Degree of Difficulty

“If you’re in a wonderful business for a long time, even if you pay a little too much going in, you’re going to get a wonderful result if you stay in it a long time.”
— Warren Buffett

High quality companies can be great long term compounders.

Figure Out What Not To Do And Don’t Do That

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”
— Charlie Munger

Inversion is the key to Munger’s success. Learning from the folly of others and avoiding their mistakes gives you a huge advantage in life and investing. Figuring out what not to do is more important than trying to be brilliant.

The Cost of Taxes Should Be Included In Your Opportunity Cost Calculations

“Intelligent people make decisions based on opportunity costs. It’s your alternatives that matter.”
— Charlie Munger

“Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum. In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15% or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.
— Charlie Munger

Something I struggle with is the temptation to always be doing something. If I have a position with a big gain that is trading above fair value, I start to play with alternatives. The problem is that action for the sake of action should be avoided. It helps me to remember Munger’s comment about the huge advantage you can get from letting a company compound tax deferred over the long term. Unless there is something fundamentally wrong with the business or I have a much cheaper and more desirable alternative, sticking with a high quality winner generally makes sense. This helps me by increasing my hurdle rate to action in such a situation. 3.5% is Munger’s high end estimate for a company with a 15% annual total return, so depending on the company, I adjust downward. Since my holding period is less than 30 years, I generally figure between 0.5% and 1.5% for the benefit for long term tax deferral. If it’s a close call, taking no action can make sense.

A Half Dozen Or So Things I Have Learned from Josh Peters About Investing

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Congratulations to Josh Peters, who is moving on from being founding editor of the Morningstar DividendInvestor newsletter to managing a mutual fund. I’ve made some real money by looking over his shoulder and getting turned on to some great companies by him over the years.

But more than that, I am deeply grateful to Josh for his unvarnished sharing of his investment process, warts and all. Crystal clear thinking coupled with honesty and integrity oozed out of everything he wrote for the newsletter. Josh, thanks for being a great mentor and good luck in your new job!

Here are some things I’ve learned from Josh over the years:

1). A secure and growing dividend can give you a margin of safety beyond just price.

2). Don’t rely on forecasts or make big macro bets, but have a range of reasonable planning assumptions, like a normalized 10 year treasury yield of 4 – 5% in your valuation models.

3). Investing for income and total return are not only not mutually exclusive, they are better together. A secure and growing dividend bought at a reasonable price is a good foundation for meeting your long-term financial goals.

4). Valuation matters when investing in dividend paying stocks. It should never devolve into just a hot trade where you are buying them at any price because it has worked in the recent past.

5). The most important question to ask about a potential investment in a dividend paying stock is this: Is the dividend safe? You want to understand the cash flow dynamics of a business to avoid dividend cuts, as this is the key to successful equity income investing. Josh did this well with his decision to bail on the Kinder Morgan family in 2014, more than a year before Kinder Morgan (KMI) cut its dividend by 75%.

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6). Josh’s Dividend Drill is a great format for evaluating a dividend-paying stock. It has 3 main steps:

Step 1 — Is it safe?

Step 2 — Can it grow?

Step 3 — What is a reasonable long-term total return target?

To me, Josh has represented the best of Morningstar, of which I am a big fan. His successor, Mike Hodel, has some big shoes to fill, but here is hoping he is up to the task. It certainly helps that he has the entire Morningstar team behind him.

See also:

DR 167: Interview of Josh Peters of Morningstar March 18, 2015: Soundcloud and Transcript

A Dozen Things I Learned from Todd Wenning About Investing

A Dozen Sentences Explaining what I’ve Learned from Warren Buffett about Investing

A Dozen Things I’ve Learned from Charlie Munger (Distilled to less than 500 Words)

Becoming Warren Buffett (HBO Documentary Films)

How To Sell Finance Books Like Harry Dent

humility and curiosity
“It’s what you learn after you know it all that counts.”
— Earl Weaver

5 things I’ve learned from Charlie Munger

Hempton on Valuation Analysis and here

Normal Accidents

Moats and Knights

“The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low….Our evidence thus contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. Rather, it is consistent with anecdotal tales about managers signaling their earnings expectations through dividends or engaging, at times, in inefficient empire building.”
— Rob Arnott and Cliff Asness

Recent Portfolio Moves

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Mid-Year Portfolio Moves

I’ve maintained radio silence for a while, but I haven’t been idle. Being largely invested in a mix of defensive dividend yielders and growers, I’ve had a great first 6 months of the year, up 18.6% on a total return basis. With utilities, REITs and consumer staples up big year-to-date, I’ve trimmed some of my winners. I raised about 9% cash and put about half of that to work in a new stock. I may be early, but risk management is my discipline.

Contenders for New Money

There are a lot of great stocks I have on my watchlist. Here are some of them, and my thoughts on them:

TJX (TJX) — The parent of T. J. Maxx, Marshall’s and HomeGoods is a formidable discount retailer. Many consider it Amazon-proof because of their ability to source high-quality discount goods. There is also the treasure hunt factor luring shoppers into the stores and away from their computers. Yields 1.3%. Ross Stores (ROST) is their competitor and a similar good performer. Stock is just not cheap enough and the yield is not high enough to get me to pull the trigger. Probably my loss.

Wells Fargo (WFC) — The best of the big banks. More involved in “boring old banking” than their megabank peers. Warren Buffett owns just shy of 10% of their shares. The upside is that it’s relatively cheap. I also like this one for its portfolio diversifying properties — it benefits from higher rates and a stronger economy. The downside is that the current low interest rates and the flat yield curve are crushing their NIM (Net Interest Margin). Political bashing in this election year makes for short-term downside, but now highly-regulated banks are in their best shape from a safety and soundness and capital standpoint in decades. Despite a generous 3.2% yield, I don’t see the urgency to buy it here, especially since their dividend growth rate downshifted to 1/2 a cent per share per quarter in 2016.

Ford Motor (F) — The only car company not to be bailed out in the financial crisis. Great turnaround under Alan Mullally. Fat 4+% yield (plus special dividends) is attractive. Just too cyclical for me. With some auto loans stretching to 72 months, what happens to demand when the economy slows, and/or the Fed raises rates? Reported earnings today and was slammed down by 8% on guidance for a contraction in sales in 2017.

Compass Minerals (CMP) — Sells mainly highway deicing salt for winter driving and has a small (10% of revenue) sulfate of potash business. Their long-lived, low-cost salt mines like the one at Goderich in Ontario benefit from salt’s low value-to-weight ratio and their access to cheap shipping throughout the Upper Midwest by barges on the Great Lakes and Mississippi River. Great 4% yield. Short-term concerns include the very warm winter last year leading to high salt inventories and weak pricing. 20% of their salt business by volume occurs in the UK and will take a currency hit from Brexit. A normal-ish winter in terms of snowfall would increase cash flows and help the dividend growth outlook. The long-term concern of global warming means that I want a big margin of safety on this one. Recent selloff has my trigger finger getting a bit itchy.

Fastenal (FAST) — A great operator in a fragmented industry, sells fasteners and other industrial supplies to industrial and retail customers. Nice 2.9% dividend yield. They have been struggling to manage their transition from their hyper-growth store opening phase, to their current effort to invest in their sales force to sell their vending solutions to industrial firms. This and recent weakness in manufacturing prompt me to take a pass for now.

Microsoft (MSFT) — Thank God for the arrival of Satya Nadella to replace Steve Ballmer. Nadella has refocused the company on investing in and growing their cloud business, Azure. Azure offers IaaS (Infrastructure as a Service) and PaaS (Platform as a Service) on a subscription model — you only pay for what you use. They are number 2 in the cloud to Amazon Web Services and growth was over 100% in the recent quarter. Given the explosion in data and computing power needed in the future, this looks like a secular grower with a lot of runway. They also have a SaaS (Software as a Service) business that is transitioning their legacy businesses to Office 365, and their Dynamics business includes ERP & CRM solutions. I don’t really know much about the wisdom of the LinkedIn deal, but given his performance so far, I’m willing to give Nadella the benefit of the doubt. With much improved capital allocation including a 2.6% dividend yield and good historic and expected dividend growth (this article anticipates an 11% dividend increase announcement in September), this is my kind of stock — a cash cow with good growth prospects.

If you can’t guess, Microsoft was the winner of my investment derby, and is the newest member of my portfolio, with a 4%+ weighting.

Don’t Let Anyone Tell You Dividends and Dividend Growth Don’t Matter for Stock Returns

EE S&P 2% Yld

This great chart from Eddy Elfenbein shows the S&P 500 scaled against a 2% dividend yield. The rally since 2009 has been more than just the Fed. But, so-called bond-like stocks are expensive now. You want to discriminate between them (no ETFs for me) and prepare your portfolio for higher rates.

In a time of low projected future returns on the indexes from the likes of Jeremy Grantham at GMO and Rob Arnott at Research Affiliates, people have rationally decided that all else equal, a higher yield with mid single digit growth will get you closer to a high single digit total return than an S&P 500 index fund is likely to do. As long as you sell the ridiculously overvalued in favor of the less overvalued and manage your risk.

But I believe it is definitely time to lean a bit more toward value and the unloved. On this basis, Wells Fargo and Compass Minerals are high on my list for future buys.

See also:

Calculated Risk: The Future is still Bright!

Jeff Saut Still A Secular Bull

Why Home Solar Panels No Longer Pay in Some States

Best-Paid CEOs Run Some of Worst-Performing Companies

Non-Traded REIT Sales Plunge 75% in Three Years — Hurray!

Charlie Munger, Buffett’s partner on 50% declines — on Vimeo

Mohnish Pabrai Lecture at Univ. of California, Irvine (UCI), May 24, 2016 – YouTube