Sunday, January 28, 2018

Preparing for the Melt Down

Gary Shilling, a well-known investor, notes that academic studies indicate that average stock performance is based on 3 main components: 50% from market performance; 30% from industry sector selection and only 20% from individual stock selections. “If you’re right on the economy and industry sector, you’ve got the lion’s share there”. 

 Sallie Krawcheck, another well-known investor answers the interviewer’s question: So you don’t buy individual stocks at all anymore?   “Nope”.  …..  “No. I just view myself as a recovering research analyst. I am no longer enamoured with the undertaking.”

Most investors lose money by aggressively aiming at market out-performance, but this is for most not achievable. From personal experience I can tell you that my outperformance at various times was plain luck. Now, it is true that the best way to grab opportunity is when it falls in your lap. So you have to position yourself to be lucky and the odds take care of the rest. But this may be true for the best investors of this planet but not for the average investor, who may hit the home run only a few times during their life. For us, average market performance is plenty.
I work in the oil industry and it has been good for me as a career. But I was never good at investing in junior oil companies. In fact, the reason that my net worth growth only slowed down somewhat during the current oil price downturn was the fact that I had very little invested in the oil industry.  I was definitely below the sector allocation of the TSX.  Yes, I had nearly half of my net worth portfolio in real estate and a significant part of that in a personal residence in a highly desirable area of Calgary; I had invested in hospitality outside Calgary; in senior housing and a little in rental apartment units which were hardest hit in rental income. Overall, my portfolio barely declined; to the contrary it went up because I have invested a significant proportion of my portfolio invested in the U.S. – often ETFs and only the bluest of blue chips.

It is a boring portfolio with most of my experiments in a smaller discount brokerage account. I missed most of the TSX bear market in 2016 and have increased investments in Europe and a miniscule amount in China. Yes, I have outperformed the TSX but underperformed the U.S. indexes by a mile. Who cares; we all grow our net worth based on personal circumstances. My best advice is to let your winners run and hope to never sell and cut your mistakes short. Dare to admit you were wrong. Yes, it may deflate your ego a bit. In fact, a bit less ego is beneficial for most of us.
Yes, I have bought a bit more commodities and commodity related stocks lately. These cyclical industrial sectors have been in a nasty bear market for years now and there is significant upside (in my ego driven opinion). If you as a Canadian bought ETFs of Canada’s stock market you are not very diversified. So as a Canadian investor you may be forced to buy individual stocks to achieve diversification. You should set up your own sector allocation – in fact one of the most diversified markets in terms of industrial sectors is the U.S. so may be start with the sector allocations of the Dow or the S&P500.  All those indexes have pros and cons. But it is a starting point for stock portfolio allocation.  Not for your total net worth portfolio which includes cash, real estate, your career, and maybe some esoteric stuff such as art or collector cars.
So, let’s use the S&P500 sector allocation as a guideline and buy Canadian stocks based on that. So much in banks and insurance; so much in telecom; so much in pharma.  You may soon find out that Canada’s banking sector is very good but that it is tough to find good pharma stock. Thus, you may have to adjust your Canadian stock portfolio asset allocation. Real Estate should not be a problem with companies like Brookfield that trade in Toronto. Focus on companies that pay good quality dividends – nearly half of your stock profits come from dividends and dividends provide cash flow during tough markets.

Next, we move international, Warren Buffett likes to invest only in companies he understands. That is not quite possible unless you are Warren Buffett. But I would like to apply this rule to asset allocation. You are probably most familiar with Canada and as such you don’t have to be an extreme allocator by only investing Canada’s portion of the world economy (2% or so) in Canadian stocks. I don’t and that is not strictly home-bias. But I do aim to place more and more assets internationally.  It is true, I don’t blame Canada’s poor stock market performance on Justin Trudeau; it is also our market make up and neither do I credit our good economic performance to Justin. Maybe some is also due to Steven Harper’s economic decisions. Most of it I attribute to Canadians and Canada in general. Neither do I think that the current U.S. stock market outperformance is just because of Trump and has nothing to do with Obama or the insuppressibly U.S. entrepreneurial spirit. Besides, what is more economically stimulating than putting your investment money back into your home economy. I am one for sure that would be scared to put big money in China’s dictatorial system. There is not such a thing as that business is not personal. You bet it is. There is nothing wrong with having 30% or a bit more of your stock portfolio invested in Canada.
But with me already putting 50% of my net worth assets in Canadian or better yet in Alberta real estate would it be wise to put a large portion of my money also in Canadian government bonds and in Canadian stocks?  I don’t think so. That, and also thanks to Justin and Rachel, I am more and more tempted to put my stock portfolio elsewhere or in Canadian dividend paying companies with a more global portfolio. Brookfield, Sunlife (I had my fill with ever-disappointing Manulife), Brookfield; Algonquin; Alterra now Innergex Renewable Energy; Power Corp; Vermilion and many others. Right now I am, more or less, comfortable holding 30% of my paper securities (including bonds which are only a minor proportion of my portfolio) in Canada. I suggest an equal amount in the U.S. – for now and 20 -30% in Europe. Not more than 10% in China and other emerging markets.  Cash is cash even if held as a money market fund in one of my brokerage accounts. We discussed cash before and I am comfortable to aim for having 1 to 2 years cost of living in cash as a minimum and 15% cash as a maximum. Don’t forget if you have a net worth of say $ 5million that would be more than $750,000 in cash and short-term interest paper. You don’t need that much just to live off for 2 years – I certainly don’t. Always think in terms of a total net worth portfolio that is real estate; stock and bond portfolio; gold and cash. Speaking of Gold – holding gold bullion is like holding cash. Holding a gold ETF convertible into gold bullion such as Central Fund of Canada, I compare with a money market fund.
So as part of preparing for the just started Melt-up and the coming Melt-down, I suggest you go through your net worth portfolio and see where most of your risk lies and get rid of it over the coming months.  Next check your diversification of assets and your regional diversification in your stock portfolio.  By the way, I consider your career also part of this diversified portfolio in particular part of your industrial sector diversification. If you work in oil and gas; don’t also have 60% of your portfolio invested in oil and gas companies – no matter how well you know the industry. The road is littered with terminated oil and gas executives and self-deluded CEOs.  When checking your portfolio risk and diversification, please leave your ego at the room entrance. Nothing is so healthy as a deflated ego after a big investment loss; only then it is too late!

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