Monday, January 21, 2013

Diversification in investment strategies

We all have our own investment tastes which depend largely on our personality. Some of us are risk takers, others are traders. Many amongst us consider ourselves value investors without realizing that buying value is in the eye of the beholder. Is it value investing if you buy a growth stock with annual earnings growing at 20% for a price earnings ratio of 12?  Or do you buy value when an investment has a dividend yield of 8%? Is it value if you buy a company’s assets at 50cents on the dollar?
I could ask similar questions for momentum investors or growth investors. In the end, you will invest with what you feel comfortable with. Personally, approaches such as the Low PE and Moderate Dividend portfolio are ‘too much shot-gun’ for me. But research shows it has merits. Yet, I am sure that my method is not quite what Jim O’Shaughnessy had in mind – I still weed too much.
ETF investing does make sense to me. It should be difficult to be above average and if you have to deduct management expenses such as commissions and broker fees, I do see why using a market index as performance benchmark is reasonable. It is like driving cars – in polls most people that are asked think they’re better than the average driver. This is an mathematically impossibility. The same with investing, and is the extra 1 or 2% per year in 'extra' return worth the effort and worry to perform above average?  So, just in case the Low PE an Moderate Dividend portfolio doesn’t work out, I also have a portfolio of Market ETFs. My bias is Canadian stocks with whom I am more familiar. But, our market is small and focused on resources, banks and real estate. What about High Tech companies such as Apple or Consumer product companies such as Procter & Gamble or Coca-Cola? What about Europe and Asia? In my ETF Portfolio, I would like to have 40% Canadian, 40% U.S. Stocks, 20% European Stocks. Asia is being taken care of by Canada’s dominance in commodity prices (which are responding to BIC country demand) and by many of the U.S. giants who often have significant overseas profits and businesses. So, we will in future blog posts we will create and track this portfolio – which I have put my TSFA (Tax Free Savings Account).  I want dividends and appreciation and I want it tax free. International dividends are not tax deductible!
Investing in blue-chip high quality companies such as Brookfield Asset Management; the Canadian Banks; Kraft; Microsoft; Proctor & Gamble; BCE and reinvesting the dividends for ‘ever and ever’ is another market outperforming strategy. Typical long term returns are 15% annually. So if the other 2 portfolios don’t perform as well as hoped for, this one may make up. More details in later blogs this year.
Dividend stocks such as the ones above replace currently my fixed income portfolio as well. The Bond markets over the last decade or so have outperformed the stock markets. No wonder, with falling interest rates as far back as 1982! Stocks are assets that increase in value in a modest inflationary setting when nominal price increases combined with leverage enhance corporate profits beyond mere GDP growth. We examined this in great detail last year in our stock evaluation spreadsheets. Bond values, especially long term bonds, will lose value in a more inflationary setting with interest rates rising. Today, with central banks suppressing interest rates while printing money (possibly 1 trillion dollar coins) the risk of inflation has increased dramatically. Some recommend gold as protection and that has merit. But gold does not earn cash flow which is the number one objective for us who pursue ‘financial adulthood’, while most other hard assets provide inflation protection as well as income – especially real estate. So, at this point in time, I would consider using the dividend strategy inside your RRSP if you already have one.

Here is a big exclamation mark !!!!! Remember, an RRSP is only worthwhile if you expect in future years to have a lower marginal tax rate than today. With governments taxing the ‘rich’ this is not likely. Since most of us plan to be richer rather than poorer over the years, I suggest using your TSFA first and do not put additional money in your RRSP.
Capital preservation is quite important for RRSPs as you cannot claim ‘capitol losses’ and it is difficult to make up for them within RRSPs. So, yes we want our most conservative portfolios in the RRSP. In addition to the above dividend strategy, use your existing RRSP to invest in short term bonds and money market funds or short term GICs. Holding cash in your RRSP is losing money since inflation will decrease its value!
Investing in ‘themes’ is the most dangerous game that I know. Investing in ‘Energy’; Wind Power; the Hydrogen Economy; Green Ethical Businesses has been one of my biggest losers (remember Ballard?). I suggest you stay mostly away from it. But we’re living today in a North American energy revolution- this is not 'theme' investing in the strictest sense. It is investing in a severely depressed market where many have given up, i.e. 'with blood in the street'. I think, as far as producer companies is concerned there is more 'blood' to come - high on my list is a possible take-over of Encana. 

However, there are also investments in the gas industry that pay dividends and have a lot of upside in the natural gas markets. Pipeline companies; LNG transporters, service companies. I think that in gas infrastructure money is to be made in the near to medium future. Then there are the oil and gas producers themselves – North American companies are caught-up in the land-locked battles and their production is sold at severe discounts. We want to see who’s left standing 3 to 5 years from now and when everyone has given up on this sector it may be time to come back. Personally, I think that the gas producers have reached the bottom or are near. Since we can’t precisely time the bottom we can apply the aforementioned ‘Nibble’ strategy.
Deflationary – inflationary cycles are long 15 to 25 year trends and we’re just starting to re-enter the inflationary part of the cycle. For now, I suggest not to invest in debt that extends beyond 2 years. Just treat it as cash. Remember cash does not earn real returns and as such you should not have more than 15% cash.
Currently my ideal total portfolio looks as shown below:
A - Investment Real Estate (not paper securities): 50%.
B - Paper Securities (Stocks and Bonds): 35 – 50%
C - Cash: 0 – 15%

We’ll refine this during the year.

No comments:

Post a Comment