Investment
Performance Analysis Using the Working Capital Asset Allocation
Model
It matters not what lines, numbers, indices, or gurus you worship, you
just can't know where the stock market is going or when it will change
direction. Too much investor time and analytical effort is wasted trying to
predict course corrections… even more is squandered comparing portfolio Market
Values with a handful of unrelated indices and averages. If we reconcile in our
minds that we can't predict the future (or change the past), we can move through
the uncertainty more productively. Let's simplify portfolio performance
evaluation by using information that we don't have to speculate about, and which
is related to our own personal investment programs.
Every December, with visions of sugarplums dancing in their heads,
investors begin to scrutinize their performance, formulate couldas and shouldas,
and determine what to try next year. It's an annual, masochistic, right of
passage. My year-end vision is different. I see a bunch of Wall Street fat cats,
ROTF and LOL, while investors and their alphabetically correct advisors
determine what to change, sell, buy, re-allocate, or adjust to make the next
twelve months behave better financially than the last. What happened to that old
fashioned emphasis on long-term progress toward specific goals?
The
use of Issue Breadth and 52-week High/Low statistics for navigating the sea of
uncertainty, and Peak-to-Peak interest rate and market cycle analysis are much
more useful as performance expectation barometers than the DJIA was ever meant
to be. When did it become vogue to think of Investment Portfolios as sprinters
in a twelve-month race with a nebulous array of indices and averages? Why are
the Masters of the Universe rolling on the floor in laughter? They can visualize
your annual performance agitation ritual producing fee generating transactions
in all conceivable directions. An unhappy investor is Wall Street's best friend,
and by emphasizing short-term results in a superbowlesque environment, they
guarantee that the vast majority of investors will be unhappy about something,
all of the time.
Your
portfolio should be as unique as you are, and I contend that a portfolio of
individual securities rather than a shopping cart full of one-size-fits-all
consumer products is much easier to understand and to manage. You just need to
focus on two longer-range objectives: (1) Growing productive Working Capital,
and (2) Increasing Base Income. Neither objective is directly related to the
market averages, interest rate movements, or the calendar year. Thus, they
protect investors from short-term thinking associated with anxiety causing
events or trends while facilitating objective based performance analysis that is
less frantic, less competitive, and more constructive than conventional methods.
Briefly, Working Capital is the total cost basis of the securities and cash in
the portfolio, and Base Income is the dividends and interest the portfolio
produces. Deposits and withdrawals, capital gains and losses, each directly
impact the Working Capital number, and indirectly affect Base Income growth.
Securities become non-productive when they fall below Investment Grade Quality
(fundamentals only, please) and/or no longer produce income. Good sense
management can minimize these unpleasant experiences.
Let's develop an "all you need to know" chart that will help you manage
your way to investment success (goal achievement) in a low failure rate,
unemotional, environment. The chart
will have four data lines, and your portfolio management objective will be to
keep three of them moving upward through time. Note that a separate record of
deposits and withdrawals should be maintained. If you are paying fees or
commissions separately from your transactions, consider them withdrawals of
Working Capital. If you don't have specific selection criteria and profit taking
guidelines, develop them.
Line One is labeled Working Capital, and an average annual growth rate
between 5% and 12% would be a reasonable target, depending on Asset Allocation.
(An average cannot be determined until after the second full year, and a longer
period is recommended to allow for compounding.) This upward only line (Did you
raise an eyebrow?) is increased by dividends, interest, deposits, and realized
capital gains and decreased by withdrawals and realized losses. A new look at
some widely accepted year-end behaviors might be helpful at this point.
Offsetting capital gains with losses on good quality companies becomes suspect
because it always results in a larger deduction from Working Capital than the
tax payment itself. Similarly, avoiding securities that pay dividends is at
about the same level of absurdity as marching into your boss's office and
demanding a pay cut. There are two basic truths at the bottom of this: (1) You
just can't make too much money, and (2) there's no such thing as a bad profit.
Don't pay anyone who recommends loss taking on high quality securities. Tell
them that you are helping to reduce their tax burden.
Line Two reflects Base Income, and it too will always move upward if you
are managing your Asset Allocation properly. The only exception would be a 100%
Equity Allocation, where the emphasis is on a more variable source of Base
Income… the dividends on a constantly changing stock portfolio.
Line Three reflects historical trading results and is labeled: Cumulative
Net Realized Capital Gains. This
total is most important during the early years of portfolio building and it will
directly reflect both the security selection criteria you use, and the profit
taking rules you employ. If you build a portfolio of Investment Grade Value
Stocks (IGVS), and apply a 5% of Cost Basis diversification rule, you will
rarely have a downturn in this monitor of both your selection criteria and your
profit taking discipline. Any profit is always better than any loss and, unless
your selection criteria is really too conservative, there will always be
something out there worth buying with the proceeds. Three 8% singles will
produce a larger number than one 25% home run, and which is easier to obtain?
Obviously, the growth in Line Three should accelerate in rising markets
(measured by the IGVSI). The Base Income just keeps growing because Asset
Allocation is also based on the cost basis of each security class… get it? Note
that an unrealized gain or loss is as meaningless as the quarter-to-quarter
movement of a market index. This is a decision model, and good decisions should
produce net realized income.
One other important detail: No matter how conservative your selection
criteria, a security or two is bound to become a loser. Don't judge this by Wall
Street popularity indicators, tealeaves, or analyst opinions. Let the
fundamentals (profits, S & P rating, dividend action, etc) send up the red
flags. Market Value just can't be trusted for a bite-the-bullet decision… but it
can help.
This brings us to Line Four, a reflection of the change in Total
Portfolio Market Value over the course of time. This line will follow an erratic
path, constantly staying below Working Capital (Line One). If you observe the
chart after a market cycle or two, you will see that lines One through Three
move steadily upward regardless of what line Four is doing. BUT, you will also
notice that the lows of Line Four begin to occur above earlier highs. It's a
nice feeling since Market Value movements are not, themselves,
controllable.
Line Four will rarely be above Line One, but when it begins to close the
cap, a greater movement upward in Line Three (Net Realized Capital Gains) should
be expected. In 100% income portfolios, it is possible for Market Value to
exceed Working Capital by a slight margin, but it is more likely that you have
allowed some greed into the portfolio and that profit taking opportunities are
being ignored. Don't ever let this happen. Studies show rather clearly that the
vast majority of unrealized gains are brought to the Schedule D as realized
losses... and this includes potential profits on income securities. When your
portfolio hits a new high Market Value watermark, look around for a security
that is no longer an IGVS and bite that bullet.
What's different about this approach, and why isn't it more high tech?
There is no mention of the popular market indices, or comparison with anything
other than investors' personal, reasonable, goals. This method of looking at
things will get you where you want to be without the hype that Wall Street uses
to create unproductive transactions, foolish speculations, and incurable
dissatisfaction. It provides a valid use for portfolio Market Value, but far
from the judgmental nature Wall Street would like. It's use in this model, as
both an expectation clarifier and an action indicator for the portfolio manager
on a personal level, should illuminate your light bulb. Most investors will
focus on Line Four out of habit, or because they have been brainwashed by Wall
Street into thinking that a lower Market Value is always bad and a higher one
always good. You need to get outside of the Market Value vs. Anything box if you
hope to achieve your goals. Cycles rarely fit the January to December mold, and
are only visible in rear view mirrors anyway… but their impact on your new
performance Line Dance is totally your tune to name.
The Market Value Line is a valuable tool. If it rises above working
capital, you are missing profit opportunities. If it falls, start looking for
buying opportunities. If Base Income falls, so has: (1) the quality of your
holdings, or (2) you have changed your asset allocation for some reason, etc.
So, Virginia, it really is OK if your Market Value falls in a weak IGVS Market
or in the face of higher interest rates. The important thing is to understand
why it happened. If it's a surprise, then you don't really understand what is in
your portfolio. You will also have to find a better way to gauge what is going
on in your markets. Neither the CNBC talking heads nor the popular averages are
the answer. The best method of all is to track IGVS statistics… if you need
drugs; these are better than the ones you've grown up with. Have a nice
change!
Steve
Selengut
http://www.valuestockindex.com/
Professional
Portfolio Management since 1979
Author
of: "The Brainwashing of the American Investor: The Book that Wall Street Does
Not Want YOU to Read", and "A Millionaire's Secret Investment
Strategy"
Investment
performance,asset allocation,stock market,investing,investors,working capital
model,DJIA,IGVSI,performance chart,market data,statistics,investment
strategy,stocks,income investing,fixed income