The Dow Jones Industrial Average (The DOW) first crossed and closed above 10,000 back on March 29, 1999 more than ten years ago. The DOW’s all time high (closing value) was set on October 18, 2007 at 14,146. Since then the markets have been very volatile posting enormous single day gains and losses. On October 13th, 2008 the DOW closed up more than 11% with a record point gain of more than 936. In the past few weeks we have had a number of near record single day gains and losses. Just what is the source of such record volatility and how do you maintain a rational investment portfolio in such an irrational setting?
The source is fear:
- Banks fear Federal Reserve action/inaction and central government regulations that force banks to act outside their normal functions.
- Small Business owners fear the HC law and its unintended consequences and are NOT hiring new employees and cannot borrow to expand/improve operations.
- Debt: both private and public debt is rising and dramatically so.
- Europe, specifically Greece, Portugal and Spain. Greece is likely to default on billions in loans made by EU banks and American Banks. What does that mean to the average American?
There are a number of investment styles such as: Value, Growth, Income, Wealth Preservation, etc. Large Cap companies, Mid-Cap and Small Cap, Cap referring to the market capitalization of a particular corporation (number of shares authorized times the price per share) as opposed to debt financing.
We have for the first time in decades the opportunity to invest, carefully, in large, multi-national companies (that do business in USA and overseas) that are traditionally viewed as a Growth style investment that are now paying very high dividend yields (% of dividend relative to the current price per share). The combined opportunity to received 1.5% dividend yield up to 6% on DOW and other companies plus the opportunity to grow the price by more than 10% is highly unusual. Most investments either offer stable or valued income with very modest growth, such as a phone company stock or public utility.
The danger of investing in or ‘chasing yield’ is that a corporation’s board of directors and management can reduce or eliminate their common stock dividend in times of cash shortages. That is why we must analyze the balance sheet and income statements of each company that we may consider investing our hard earned money with.
What are the major investment styles?
- Growth: Where investors seek companies and industries with a strong growth trend in sales and earnings. Growth is defined as beating the growth of the economy or GDP. These types of investments have typically much higher P/E ratios and pay little if any dividend. These stocks generally have a much higher volatility relative to the market and have little tolerance for earnings ‘disappointments.’
- Value Investing: Is essentially bargain hunting. Buy great performing stocks that have had significant sell-off of late and as a result major decreases in current prices. The price of the stock is trading at a closer relation to its book value than normal. Here one must buy into these positions early on in order to reap the benefits of price appreciation as the price returns to ‘normal’ price ranges.
- Income: Investing in stocks and bonds that pay higher dividends/interest than other investment alternatives. The objective here is typically current income with no emphasis on growth or price appreciation.
- Wealth Preservation: The objective here is to maintain the accumulated wealth of one’s estate through a more conservative approach. These types of portfolios tend to be weighted more towards fixes income with a percentage of equity stocks that have a low beta and even lower volatility. Of course these equities have very low price appreciation. Stocks in this category are typically public utilities, such as in the electric generation and phone company stocks. These stocks tend to distribute the majority of their earnings in excess of capital requirements in the form of higher dividend yields/interest rates. These portfolios also have a higher weight of treasury bonds, etc.
- Momentum Investing: Investment managers in this style look for trends in companies that have a higher rate of earnings appreciation for a short period of time. Timing is critical here and very hard to buy at the absolute low and sell at the absolute high. This style has a much higher risk to significant loss than other styles.
- Contrarian: Investment managers in this style usually are investing when the average investor is selling or staying away. Here the time horizon is much longer, typically more than 10 years. Essentially when the average investor is buying/selling these managers are selling/buying.
- Blended or Balanced Approach: Is just that, a portfolio that has a mix of equity and fixed income and growth/income stocks.
Market Capitalization: Also known as Market Cap is a measure of the size of equity capitalization employed in the financing of the entity. Market Cap is determined by the number of shares outstanding (common shares) times the current price. Currently the largest market cap of any corporation publicly traded is Exxon-Mobile with a market cap exceeding $515 billion. There are three categories of capitalization: Large, Mid and Small. Large cap stocks typically have long histories of solid performance in both earnings and price appreciation. Whereas Mid. and Small cap companies have a shorter track record of both earnings and price performance. These two categories also are typically higher beta (risk) and more volatile than their large cap cousins.
Types of Investors:
- Conservative: These investors typically cannot tolerate volatility in their portfolio. They will be weighted more towards fixed income with very low risk equity positions: Utilities, etc.
- Moderate: They like higher returns than pure fixed income but are not very adventurous. Most investors fall into this category. Normal weighting here would be 40% fixed 50% equity and the remainder in cash/money markets. These portfolios will be well balanced with more than 30 individual positions.
- Aggressive: These investors seek to beat the market averages, have a shorter time frame and definitely have the ability (psychologically and financially) to absorb deep losses in their portfolios. These portfolios typically have a high concentration of in one or two sectors with very few individual security positions. Much higher rate of gains and losses.Example of a growth/value investment: Cisco Systems (NYSE:CSCO) is a DJIA component and normally pays a very low dividend as a percent of its common share price. CSCO also has a P/E ratio (Prices/Earnings per Share) much higher than a value or income oriented investment. As of 09/02/2011 CSCO’s PE was 10 based upon 2012 EPS estimates. The current yield is 1.6% which is unheard of for a growth company. The ten year US Treasury is yielding barely 2% with zero growth potential and a substantial risk to rising interest rates which would erode the current bond price. Additionally, there is virtually no risk of CSCO abandoning or reducing its dividend as they are currently holding more than $44 BILLION in cash.
The only way to determine which style of investing that is appropriate for you is to know these few basics:
- What is your risk tolerance? Many small business owners when asked to assess their risk tolerance related to investing in the stock market they often describe themselves as being conservative. However, in reality the small business owner has a high percentage of their total wealth is concentrated in only one sector and one company – their own. That makes them very aggressive investors. A wise adviser will point this fact out rather bluntly. The overwhelming majority of advisers and investors NEVER discuss this very important aspect of investing. An adviser/investor MUST measure their return relative ro the exposed risk of loss. Risk adjusted returns are normally substantially lower than the pure math of gain/loss typically measured.
- What is your Time Horizon?: Time horizon refers to the actual time you have to invest before you retire or make regular (monthly) demands on these funds. Short time horizon you should be heavily invested in fixed income and near cash assets as you do NOT have the necessary time to rebuild these funds should a market correction wreck your plans for retirement.
- Maturity Risk?: Is similar to time horizon but relates directly to fixed income. A bond that has a longer maturity date(time where the bond is fully paid off by borrower) has a higher risk of non-payment of interest or of default.
- Objectives/Goals?: Why are you investing these funds? Retirement, vacation planning, education, etc. This question is almost never asked and is very important.
Before we can recommend any investment no matter how attractive WE believe it to be we must have a serious and lengthy conversation. We can be reached at www.thomascapitalmgt.com, firstname.lastname@example.org or by calling 928-282-5731.
Thomas J. Zaleski EA RIA
Thomas Capital Management.