In today’s world, where politics take up the majority of news cycles and there is an ongoing war of words between the two major political parties, I decided for this letter to replace our often used phrase “conservative investor” with “cautious investor.” I believe this is a good description for the majority of affluent investors, those who have accumulated a larger sum of money through savings and investments over the years. For this majority, the preservation of wealth is a priority. However, these investors are also looking to increase their wealth. The primary method for meeting this dual desire is asset allocation.
It is important to remind everyone that each of our clients’ wealth varies. It is our job to build a portfolio that will produce the required rate of return to satisfy each individual client’s needs and long-term goals. This cannot be accomplished without effort. It is somewhat easy to determine a required rate of return. It is not easy to build a portfolio that can earn this requirement at any given point in time. Once the initial portfolio is built, maintaining it through time takes constant awareness of the changes that occur and the need to address these changes with modifications to the portfolio.
Weighing the benefits expected from any change in a portfolio should be approached with caution, as any change creates the possibility of not one, but two errors. What we sell may produce more profit to someone else, not us. And our replacement may decrease profit for our portfolios. Every portfolio manager knows this, and must have a legitimate basis to make these changes.
Before we recommend an allocation I wanted to share some words from two individuals who helped shape our philosophy towards asset allocation and making decisions under uncertainty. The first is Dr. Benjamin Graham, whose writings I’ve shared in these letters many times over the years. The second is Edward C. Johnson II.
First up is Dr. Graham, and a passage taken from his excellent book The Intelligent Investor:
Weighing the benefits expected from any change in a portfolio should be approached with caution, as any change creates the possibility of not one, but two errors. What we sell may produce more profit to someone else, not us. And our replacement may decrease profit for our portfolios. Every portfolio manager knows this, and must have a legitimate basis to make these changes.
Before we recommend an allocation I wanted to share some words from two individuals who helped shape our philosophy towards asset allocation and making decisions under uncertainty. The first is Dr. Benjamin Graham, whose writings I’ve shared in these letters many times over the years. The second is Edward C. Johnson II.
First up is Dr. Graham, and a passage taken from his excellent book The Intelligent Investor:
We have already outlined in briefest form the portfolio policy of the defensive investor. He should divide his funds between high-grade bonds and high-grade common stocks.
We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds. There is an implication here that the standard division should be an equal one, or 50-50, between the two major investment mediums. According to tradition the sole reason for increasing the percentage in common stocks would be the appearance of the “bargain price” levels created in a protracted bear market. Conversely, sound procedure would call for reducing the common-stock component below 50% when in the judgment of the investor the market level has become dangerously high (Graham 41).
Since the time of Benjamin Graham’s wise advice, the number of alternatives to both stocks and bonds have exploded. Today individual investors have so many choices beyond a simple stock/bond allocation. Yet the basic policy of splitting ones investable funds between risky assets and less risky or even risk free assets is still valid, and it continues to be the basis for our own portfolio policy.
How one determines if a risky asset is a bargain or not is open to debate. But the reality of decision making has not changed. To help you understand how we address this, I want to introduce Edward C. Johnson II and share a few of his words.
Edward C. Johnson II is not as well known today as he once was, but the firm he founded, Fidelity Investments, is known by individuals throughout the world. When I was a youngster, if you mentioned “Mr. Johnson,” everyone in the world of investment management knew who you were talking about. In 1963, he gave a presentation at the First Annual Contrary Opinion Foliage Forum. In this presentation, he said the following about his investment approach:
How one determines if a risky asset is a bargain or not is open to debate. But the reality of decision making has not changed. To help you understand how we address this, I want to introduce Edward C. Johnson II and share a few of his words.
Edward C. Johnson II is not as well known today as he once was, but the firm he founded, Fidelity Investments, is known by individuals throughout the world. When I was a youngster, if you mentioned “Mr. Johnson,” everyone in the world of investment management knew who you were talking about. In 1963, he gave a presentation at the First Annual Contrary Opinion Foliage Forum. In this presentation, he said the following about his investment approach:
We approach the problem of investment first and foremost from a money-making point of view. We are not interested in fancy ideas and theories; we are interested in things that work. You might call us empirical pragmatists. Those are almost too heavy words for anyone to swallow, but I hope they convey a picture. Our almost religion is that we believe strongly in analysis of the present. The past is dead. We can learn from it, trying not to indulge in the “backward” successes we might have made. The future is a dream. That may be as may be. If you come to think of it, the present (I talk like a Zen Buddhist now) the present is really the only thing that anybody can actually use. So many people spend their lives thinking about the future ahead that they are hardly conscious of the present. Now there is not much you can do with the future. You can’t love it, you can’t taste it, you can only dream about it. This is our actual approach; we don’t try to forecast. We can’t buy or sell securities a month from now; we can only do it today. So what do we do today? This is enough for us to know.
The present we try to use, however, is not a static affair. It is dynamic, full of motion. It is the analysis of these dynamics and motion that is completely vital. To analyze correctly in this way the present…is to take advantage of the future without the desperate chances inherent in successful forecasting (Johnson 393).
Like Mr. Johnson, we have no desire to explore fancy ideas, or invest hard earned money on some untested investment theory. Like Dr. Graham, we are unwilling to place 100% of our capital at risk of a large loss. And we do not have 100% faith in our abilities to be right in our analysis of the present, therefore we diversify.
Our asset allocation process begins with looking at the current rate of interest available to investors today. We know, lacking default, and holding to maturity, that the current yield to maturity is the maximum return we will receive. If we give up this certainty, then we should demand a higher expected rate of return for the risk we take. The difference between the certainty and the expected return for risk taking is our margin of safety.
With that in mind, let’s look at the current rates on US Treasury Obligations for various maturities as of October 4, 2018:
Our asset allocation process begins with looking at the current rate of interest available to investors today. We know, lacking default, and holding to maturity, that the current yield to maturity is the maximum return we will receive. If we give up this certainty, then we should demand a higher expected rate of return for the risk we take. The difference between the certainty and the expected return for risk taking is our margin of safety.
With that in mind, let’s look at the current rates on US Treasury Obligations for various maturities as of October 4, 2018:
Attempting to place a present value on the entire market is close to impossible. We can, however, with the help of public information provided by companies and index providers, estimate a present value of a subset of the market. The following represents our best estimate of returns available if we could buy the S&P 1500 as constructed today and were not subject to the whims of the general public over the next five years. In other words, buying the index without the ability to sell at any time over the next five years.
In October 2015, our monthly letter was titled “A Bond-Free Portfolio: Why Cash Should Replace Bonds to Reduce Risk and Improve Returns.” You can read this letter in its entirety on our website. At that time this was the US Treasury Yield Curve:
In that letter we made the following statement concerning bonds:
Given the current rates paid, bonds are very vulnerable to negative returns. If interest rates are higher in the near future, then the market value of the bond principal could easily fall well beyond the amount of interest income received. Cash on the other hand, will not suffer at all. In fact if rates increase, cash will add positive returns to your portfolio.
Even though interest rates are much higher today than they were three years ago, the increase is not enough to change our recommendation and purchase bonds. However, we do recommend the three month US Treasury Bill or an available 3 month FDIC insured Certificate of Deposit paying above 2% as a cash equivalent.
Historically I have felt comfortable when our estimated returns for common stocks provided a margin of safety in excess of 50%. Although the calculated margin of safety is well above our comfort zone as a percentage, it is well below the historical averages we have calculated for years, and thus causes me a great deal of concern. Given that interest rates, at least on a nominal basis, are well below our historical averages it may be that my concern is unjustified.
Conclusion
Justified or unjustified, the continued low current rates for all bond maturities relative to our expected returns from common stock warrant, in our opinion, a continued but less aggressive overweight to common stocks.
For cautious investors, we are now recommending a reduction in common stock weighting to 60% to 65%, and an increase in short-term cash equivalents to 35% to 40%.
For individuals who are a little more adventurous, we believe that cash or equivalents should be increased to a minimum of 20%.
A Final Note
While in college I took on the job of service manager for a small Toyota dealership. Finding mechanics who were competent was a chore. Luckily, I was able to hire an exceptional mechanic. I could give him any job that came through the door, and I knew it would be done correctly and on time. When highly skilled and competent people are available, it’s a duty to find a way to add them to your team.
And so it was when Mr. Craig Ferguson called us out of the blue and inquired about working as a member of our team. Craig has years of experience in our industry. He was worked in sales, operations, compliance, research, and management for various investment companies large and small. He is also a really nice person. If you have never met Craig, make sure you introduce yourself next time you call or stop in.
Until next time,
Kendall J. Anderson, CFA
Graham, Benjamin. The Intelligent Investor. 4th ed., Harper & Row, 1986.
Johnson, II, Edward. "Contrary Opinion in Stock Market Techniques." Classics: An Investor’s Anthology, edited by Charles D. Ellis, The Institute of Chartered Financial Analysts, 1989, 392-398.
Historically I have felt comfortable when our estimated returns for common stocks provided a margin of safety in excess of 50%. Although the calculated margin of safety is well above our comfort zone as a percentage, it is well below the historical averages we have calculated for years, and thus causes me a great deal of concern. Given that interest rates, at least on a nominal basis, are well below our historical averages it may be that my concern is unjustified.
Conclusion
Justified or unjustified, the continued low current rates for all bond maturities relative to our expected returns from common stock warrant, in our opinion, a continued but less aggressive overweight to common stocks.
For cautious investors, we are now recommending a reduction in common stock weighting to 60% to 65%, and an increase in short-term cash equivalents to 35% to 40%.
For individuals who are a little more adventurous, we believe that cash or equivalents should be increased to a minimum of 20%.
A Final Note
While in college I took on the job of service manager for a small Toyota dealership. Finding mechanics who were competent was a chore. Luckily, I was able to hire an exceptional mechanic. I could give him any job that came through the door, and I knew it would be done correctly and on time. When highly skilled and competent people are available, it’s a duty to find a way to add them to your team.
And so it was when Mr. Craig Ferguson called us out of the blue and inquired about working as a member of our team. Craig has years of experience in our industry. He was worked in sales, operations, compliance, research, and management for various investment companies large and small. He is also a really nice person. If you have never met Craig, make sure you introduce yourself next time you call or stop in.
Until next time,
Kendall J. Anderson, CFA
Graham, Benjamin. The Intelligent Investor. 4th ed., Harper & Row, 1986.
Johnson, II, Edward. "Contrary Opinion in Stock Market Techniques." Classics: An Investor’s Anthology, edited by Charles D. Ellis, The Institute of Chartered Financial Analysts, 1989, 392-398.
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