Portfolio strategy
A few more drops from the orange
Investors are always trying to squeeze a few more drops from the orange. One technique I have read about many times is to follow a strategy of matching the market in bull markets and seeking to have one’s portfolio go down less than the market in a bear market. It is touted by some high-profile professional money managers. We can call the strategy ‘Match up, Down less’.
In this post I will take a look at this strategy and see if it has merit or whether it is simply a clever marketing/sales pitch by money managers to attract more assets under management (AUM).
Stocks and portfolio management
There’s no doubt that successful portfolio management is much more than just stock picking. The structure and management of a portfolio makes a big difference. Successful stock investing includes holding the optimal number of stocks, diversification amongst sectors, cyclicals vs non-cyclicals, geography, company way of making money, company size, company interest rate sensitivity, portfolio balance, approach to buying, approach to selling and tax considerations, to name some of the most important.
But, within all this portfolio management stuff, there are some basic ideas. If we think about Warren Buffett, we think about buying only superb companies with moats that can reinvest excess capital at very high rates of return. We want highly competent management with skins in game. And those companies will only be bought if they can be had at a bargain price.
To develop some thoughts about the merits of the ‘Match up, Down less’ strategy, let’s look at some other strategies that share kinship with it.
Smoothing out volatility
This is the so-called strategy of smoothing out volatility. Diversification and balance will naturally tend to smooth out volatility. But that is not their primary purpose. Their main function in a portfolio is risk management and that has nothing to do with volatility. Volatility comes with the turf. In my view, investors should not think of volatility as a negative that has to be controlled. It is something that happens and the thoughtful investor will take advantage of plunging prices to hunt for bargains to buy. Warren Buffett was always happy to point out that when prices go down, risk also goes down. When the stock market soars on irrational exuberance, this often presents opportunities to sell stocks whose price well exceeds fair value.
This leads me to the thought that strategies designed for no other purpose than to smooth out or reduce volatility cannot enhance long term performance, only hurt it. Often investors will develop a portfolio of blue-chip stalwarts. Warren Buffett calls this conventional rather than conservative. Conventional blue chips will tend to be overpriced and will underperform.
Dividend investing
The basic idea as explained in one blog is that “companies with a long history of dividend growth will generally show a strong business model and robust financials. They have gone through many recessions and never stopped increasing dividend payments.” These are said to be the ‘dividend aristocrats’.
The blog states: “In fact, many studies (such as Vanguard) have proven that dividend growers are likely to outperform the market and do it with less volatility.” This assertion cherry picks one observation from the Vanguard report and is misleading out of context.
The Vanguard report does not say there is evidence dividend growers will outperform the market. On the contrary, it says the performance of dividend growth strategies has been dependent on the time period of measurement and is ‘largely explained’ by other factors.
As usual we can turn to Warren Buffett for a clear opinion. Buffett explains that there are companies whose “earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America. 1998) p124.
And what makes sense for shareholders? “…you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.” (Buffett, 1998) p125.
Dividend investing frequently puts investors into companies in oligopolies that generate great cash flow but have little scope to invest back in the business. Such a strategy will have a hard time matching the market over the long haul.
This helps our thinking when we reflect on the ‘Match up, Down less’ strategy.
Sector rotation strategy
The next strategy I propose to look at is called sector rotation. It is focused on hoping to take advantage of the business cycle in stock selection. It has the idea of sector rotation through the business cycle. It is a market timing strategy. Timing strategies are one of the most sure-fire ways to lose money in the stock market.
Below is a chart produced by RBC Direct Investing, a unit of the Royal Bank of Canada, Canada’s largest bank. It offers a simple visual representation of sector rotation. For example, it suggests holding 1) Consumer Staples and 3) Healthcare stocks when the economy is about to enter a recession. The theory is that these stocks are more recession resilient. A further example. At the stage of an Early Recovery, it suggests buying 5) Information Technology stocks to take advantage of a resurgent economy.
This sound pretty clever. But it is deceptively attractive in its simplicity. Investors should, by all means, educate ourselves about the business cycle and its relationship to the different sectors. This education will inform us as we invest using the sound principles of operation we have committed to follow. But, a strategy of sector rotation through the business cycle is a recipe for failure.
Warren Buffett has said many times that he never has an opinion as to where the economy is heading in the short to medium term. The simple fact is that few have the expertise to identify not only where we are in the business cycle but also know how the cycle will unfold. The former involves a sophisticated knowledge of economics and the latter the ability to forecast where the economy is going. Not only is such forecasting virtually impossible, but there is often no correlation between the economy and the stock market. Investing based essentially on the business cycle outlook is a fools’ game.
Match upside and less downside
If one were able, over the long haul, to match the stock market total returns in bull markets and have less of a pullback in bear markets one would be beating the market. It sounds enticing.
Logically there are only three ways to pursue this strategy. First, would be to structure the diversity and balance of the portfolio so that it would ‘Match up, Down less’ by itself. Second, the strategy would be to buy and sell counter to stock market cycles. Third, the strategy is simply to be a better stock picker.
As for structuring the diversity and balance of a portfolio I can’t think of tweaks that would ‘Match up, Down less’ by themselves. Clearly diversity and balance are really important for a portfolio. Adding more defence takes away from offence. Adding more offence takes away from defence. It’s hard to have your cake and eat it too.
The second strategy, buy and sell counter to stock market cycles, is market timing pure and simple. Market timing is the effort to buy a stock or stocks when the outlook is good and sell them when the outlook darkens. It is one of the most sure-fire ways of losing money in the stock market. It comes freighted with all the perils of behavioral biases.
Benjamin Graham makes a distinction between ‘the way of timing’ and ‘the way of pricing’. He writes: “Since common stock, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which he may try to do this: the way of timing and the way of pricing. By timing we mean the endeavor to anticipate the action of the stock market – to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value.” (Graham, The Intelligent Investor, fourth revised edition. 1973) p95
As for the third strategy, simply to be a better stock picker, it’s not a strategy at all. It takes years to develop the skills to be a better stock picker. A better stock picker wouldn’t be a ‘Match up, Down less’ investor. They would perform well in all markets.
Conclusion
The conclusion I’ve come to is that all these so-called strategies are no more than enticing ideas with little or no substance or record of performance. The only approaches to investing that are worth paying attention to are those used by investors with documented track records that span many decades. I think of Warren Buffett, John Templeton, Philip Fisher and their ilk.
+++++++++++++++
Readers wishing to dig deeper into some of the ideas in this post might check out these posts:
Dynamic asset allocation and the Equity Risk Premium
Asset allocation out of step with modern investment management
+++++++++++++++
You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
+++++++++++++++
Want to dig deeper into the principles behind successful investing? Click on the ABOUT tab to read an introduction. It will help readers get the most out of the Nuggets of Investing Wisdom blog.
+++++++++++++++
Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
+++++++++++++++
You can also use the word search feature on the right-hand side of this page to find references in both Nuggets blog posts and also in the Motherlode.
+++++++++++++++
To explore the Motherlode, click on the Motherlode tab
If you like this blog, tell your friends about it
And don’t hesitate to provide comments or share on Twitter and Facebook