Mid-Year 2017 Investment Update

I thought I would write a bit about investing today, including an update on some personal stock investments.  As I’ve shared before, I’m a big fan of passively owning businesses (i.e. investing in stocks).  Over the long-term, businesses are one of the best places to put your money to work building wealth.

I’m not going to share actual numbers at this point but instead I’ll go through some investment decisions I’ve made and why I’ve made them.  If you’d like a bit more detail on numbers (although I show this on a % basis, not the actual $ values), you can check out more information in a previous post.

Most of my savings are tied up in low-cost index funds in a few different, mostly stock, investments.  I focus on index funds since it’s clear that actively managed funds adds significant costs but doesn’t help performance.  Remember, if you’re following the commonly recommended 3% withdrawal rate in early retirement, a 1% fee, which sounds small, actually takes up ⅓ of your annual spending money!

At the same time, while I’m a big believer and user of index funds, I am not a completely passive investor.  The active part of my investing approach is in tilting my asset allocation depending on relative valuations.  Usually this tilt is relatively small but last year I shifted a lot of money from US stocks to emerging markets (again, using broad market index funds).  This is essentially the same strategy as rebalancing except with much bigger swings in the % of each asset class.

In addition, I have some “play money” at no more than 10% of my net worth, where I make more concentrated investments, usually in particular sectors, countries, or even companies if I think there is a good opportunity.  What has worked for me is to look for bargains, particularly where recent performance has been very poor and there are sensational negative headlines in the news, while long-term fundamental trends are still mainly positive.

What has not worked for me in the past is finding strong growth trends and identifying specific companies or funds that will win big with those trends.  Maybe some can do it but I’m apparently unable to identify the next Amazon, Google or Facebook in the forest of options and the research is pretty clear that it’s a nearly impossible job.

In my experience trying to invest with a growth focus, the price to buy is usually very high and my investment results have been poor in aggregate.  So now I focus on finding relative value.  The research also shows a value-based approach can provide higher returns, although it’s still not easy.

I don’t profess to be an investing genius by any stretch but I do believe it’s possible to get a bit of extra return by tilting over long periods of time when relative valuations of investments become very different.  This is because many financial factors like profit margins, earnings growth, and P/E multiples, that strongly affect investment prices, are cyclical and strongly mean-reverting over multi-year periods.

I continue to learn and experience better investing results but so far I’ve been able to achieve a small boost in investment results over a completely passive approach with a similar asset allocation.

With “value” investing, you still have to do your research because it’s not as simple as buying low-priced investments.  After all, there are always good reasons the price has declined and they can and do sometimes perform very poorly for very long stretches of time or even go to zero.  Investments like this are referred to as value-traps.

At the same time, stock prices often decline beyond fair value based on short-term factors and investor psychology.  These offer great bargains and can provide good returns over time.

It’s important to note that avoiding investing while waiting for bargains is not a good strategy.  Stocks go up over time so if you’re on the sidelines, you’ll miss out.  Many, many investors wait on the sidelines for things like a 10% drop to “get in”.  But before that 10% drop occurs, the market often goes up 20% or more!

Instead, I think a better approach is to stay fully invested according to your long-term asset allocation plan spread across your investments that could include US large cap stocks, US small cap stocks, developed international, emerging markets, real estate, bonds, commodities etc.

But while you are fully invested, when one of your asset classes becomes cheap (especially if it becomes very cheap!) because of poor performance, then you should shift more of your investment money into it by selling something that has performed better.  You might want to even consider overweighting that asset if it’s relative value looks very attractive.

So how do you hedge risk and put the odds in your favor?  In this post, I’ll explain a little of how I think about and analyze investments in order to do this.  It’s not science and nothing is certain but if you make a diversified set of bets that have downside protection and good upside, I believe it’s a viable approach to get some extra gains.

As I mentioned before, I strongly shifted to emerging markets from US stocks.  I already covered the details of my reasoning in Extreme Rebalancing so I won’t cover the details here but the short story is that US stocks are expensive relative to emerging market stocks.  Based on a variety of specific factors, over the next ten years I believe that it’s much more probable that emerging market stocks outperform US stocks.

It’s important to note that I don’t think emerging market companies or countries are better than those in the US.  In fact, I think the US has many unique advantages that are hard to replicate and will do very well over time.  But….

The price you pay when you purchase an investment matters.  A lot.

Right now, investors are paying  a lot more for a dollar of earnings from US companies than you have to pay for a dollar of earnings in emerging market companies.

I made this shift after 5 years of poor performance in emerging markets and a particularly bad 2015 that resulted in a cumulative valuation difference that was so large that I decided to make a much bigger allocation shift than I normally do.  The valuation difference had simply become so large that it was compelling.  I made this shift with the next 10 years in mind.

I would not have been surprised if emerging markets underperformed the US for another few years.  I had no idea what would happen short-term (over a few years).  This is not short-term market timing, which I agree no one can do consistently.  I’m simply looking for relative value based on long-cycle trends in different asset classes.

Again, there is strong historical evidence in economics of “reversion to the mean”.  This basically means that investments that perform well for a while tend to then underperform for the next period.  These periods are usually on the order of at least a few years.

Reversion to the mean is the fundamental reason that rebalancing actually does work.

I’m just making more extreme shifts than rebalancing would call for when I think there is an opportunity due to significant differences in returns, and subsequent valuations, usually over a multi-year timeframe.

As a disclaimer, I am not an investment professional and my choices could certainly end up costing money instead of earning money so please don’t take my actions as something to replicate.  You should do your own research and make investment choices that align with your own skills and mindset.  This is also something relatively new for me as I’ve gotten more involved in investing.  The bulk of my investments and historical gains have been the standard recommendation of broad-market, low-cost index funds with a relatively standard asset allocation among the main investment classes.  And I think this is the best core investment strategy to follow.

Having said that, this “tilting” has worked very well for me in 2016 and 2017 so far, with emerging markets outperforming US stocks nicely.  While this happened faster than I expected, there is still a lot of room to go before emerging market businesses close the valuation gap with US businesses so I am not making any changes to my allocation at this time.

In terms of “play money”, I have made some changes.  I sold an investment in a Brazil index fund, EWZ.  I invested in Brazil after a horrible 2015 stock market meltdown, in the middle of a deep recession, corruption, and weak commodities including oil that have a big effect on Brazil’s economy.  Such a rapid drop caught my eye and after some research, I felt like there was value here.

The demographics in Brazil are attractive, with a young population, and the country is diversifying away from commodities in a slow but steady way.  And all the headlines on corruption I actually saw as positive.  The visibility and anger from the citizens should lead to at least some positive change as the country inevitably comes out of recession.  The numbers also reflected an attractive valuation with a >4% dividend yield, low price/book ratio, low CAPE (a P/E ratio using 10 year earnings to smooth out year to year fluctuations), among other valuation factors.  This is a simplified view but it gives you a sense of how I try to look for true valuation factors and positive long-term trends in order to avoid “value-traps”.

I didn’t expect such a rapid comeback in the market and I was prepared to hold this investment for at least 5 more years. But I got lucky and the Brazil stock market rocketed up in 2016 and early 2017.  In addition, the Brazilian currency strengthened against the dollar, boosting dollar gains.  With such a strong year, and valuations not such a screaming deal anymore, I sold a little after the one year mark (so I would be taxed at long-term rates).  This let me take an 88% gain.  Note this is significantly more than the return you see on EWZ if you look it up due to the lucky timing of good portion of my purchases right after Brexit, plus the currency effect.   EWZ could, and probably will, continue to rise nicely over the next ten years but I wanted to take this money out and look for better bargains elsewhere.

I also purchased shares of EPOL, an index fund for Poland, recently.  This is also unexpectedly up this year.   I have a bit over a 30% gain at this point.  Again, the timing is just luck but based on various valuation metrics, fundamental factors, and negative recent events, I felt there was a good probability this would be a good investment.  As with Brazil, 2015 was a bad year and the previous many years were also not great.  But the economic fundamentals were strong and the country was likely to continue doing well in a number of business areas.

In addition, part of the negative story in 2015 was some political decisions that hurt investors.  This caused a backlash by investors and they sold holdings due to higher perceived risk.  I made the assumption that this was a rare event and as a new investor, this negative recent past would be to my benefit.  Similar to the negative scandal headlines in Brazil, these news-worthy events tend to create a negative investor psychology that is relatively short-lived since economic fundamentals are rarely changed much.  This creates bargains.  I plan to hold EPOL at least until the 1 year mark and probably much longer at this point.

The last change is that I picked up some shares of Target.  I don’t like picking individual companies, because there is a lot more risk but I don’t see many bargains out there right now and this one looked worth picking up.

Obviously the headlines are full of the death of retail due to online shopping.  And this has a real basis.  The number of retailers filing for bankruptcy lately has been shocking.  But I don’t believe all brick and mortar retailers will disappear.  Some will adapt by making creative changes.  Target and Walmart are a few that I think will survive.  Both these retailers are sophisticated and have a lot of resources.  While they don’t have the online/data strength of Amazon, they already do a lot online and have good capabilities using big data analytics.  They also have retail strengths including attractive real estate locations, brands, and distribution networks.

Target was the more attractive investment with a lower price (based on P/E ratio, a dividend yield of 4.1% and some other valuations factors), compared to Walmart but both are decent bargains (btw, Buffett has large holdings of Walmart) now that everyone thinks every retailer is going bankrupt soon.  As always, I’m ready to hold this for several years (happily collecting a 4% dividend return along the way since this is about double the return on a ten-year bond).  It’s been up about 5% and then down again and is currently down about 3% since I bought it.

One of the nice things of a high dividend yield, especially a recently high one due to a significant stock price decline, is that it adds significant downside protection.  Yields of about 4% in today’s environment (outside of utilities and energy companies) are about as good as you will get.  Many investors are hungry for yield since bonds return so little, and this creates a decent floor in the stock price.  If the stock declines further, and boost yields more, many investors will swoop in for the yield and drive the price back up.

As long as the chance of a big, sustained earnings decline is low, the company should be able to recover within a few years and not need to cut the dividend or do other drastic measures.  It’s certainly possible that a long-term earnings decline happens.  Online competition will force Target to lower prices and will lower traffic.  This is the biggest factor of concern and why retailers are currently on sale.

Politics could also play a role. For example, the currently debated border tax will hurt retailers, although everyeone would be equally affected so prices would simply rise across the board and not create a competitive disadvantage for Target in particular.

At the same time, well-capitalized, profitable companies have a good track record of responding to market challenges while weaker competitors go out of business.  I believe this is the situation for Walmart and Target.  I could certainly be wrong, which is why only a small portion of my net worth is invested in Target, but there is a good probability of strong returns over the next few years as well.

Update 6/22/17:  My position in Target didn’t last long.  After Amazon announced the purchase of Whole Foods, Target and many others in the food retail space dropped a lot.  I actually bought more when it was down 10% and then spent the week determining if this was enough of a change to revisit my investment hypothesis or if it was the typical headline noise that provides more of a buying opportunity.  I decided that this changed my investment hypothesis enough that I no longer wanted to hold the position so I sold at about a 3% loss.

Unexpected changes like this are part of why I rarely invest in individual companies.  The risk is simply too high.  I still like the dividend yield (even more so now!) and certainly believe Target could end up being a really good investment over the next few years but the margin pressure and time for any turnaround is now likely much longer so it’s not attractive enough to me right now.  I will keep looking for a better opportunity.

It’s important to remember (and I tell myself this all the time) that everyone looks like a genius in a bull market.  A rising tide lifts all boats and higher risk bets do particularly well in rising markets.  This does not last so it’s important to stay grounded.  This is why I limit my riskier individual investments to <10% of my portfolio and even within that 10%, each individual investment is only a few % of my portfolio.  I also focus on value to provide downside protection.

Of course many investors (mostly in the US of course) would consider my strong tilt to emerging markets as very risky but I would beg to differ.  Based on the relative valuations, I consider US stocks as much riskier at this point in time for the next several years.

If you do invest in a more targeted way like this, don’t try to do everything.  There will be many investments that you miss.  That’s perfectly fine.  It’s more important to feel good about the few investments that you do make.  Don’t worry about the ones you miss. There will always be more opportunities in the future.

And it’s perfectly fine to not invest if you don’t find a good-enough bargain.  For example, I’m sitting on a much larger cash allocation than I am comfortable with.  I would love to invest it all and most of my investing career I have been 90-100% invested, with good results.  But I don’t see really good bargains right now and am comfortable holding more cash.  More importantly, I want to protect some of this cash for other purposes over the next few years so having this much allocated to cash is a bit of a short-term anomaly for me.

But if the markets tank, I won’t be able to resist putting it back to work.  Based on my past history, I will probably be too anxious and invest it too early during a decline.  This is referred to as catching a falling knife.  But I’d rather do this than wait too long and see the market recover before I can invest.

As an example of missed opportunities, I also researched Chipotle last year, suspecting it might be a good investment after the big food scandal and subsequent decline in the business.  The company seemed to have a lot of strengths and was still growing and opening stores.  The challenge for me was that I couldn’t get a good read on the value of the business.  Earnings had declined as business declined and profit margins also declined as Chipotle spent money trying to fix its problems.  So despite a significant stock price decline, it still didn’t look like a bargain to me.  So far in 2017 I’ve been wrong, with Chipotle stock up over 30%.  Oh well.  No regrets.

Similarly, Russia looked (and still looks) very cheap right now from a current P/E ratio and CAPE perspective.  Similar to Brazil, the economy is heavily tied to oil (even more so than Brazil) but unlike Brazil there are fewer positive political and demographic trends in Russia.  I didn’t feel as comfortable investing in Russia despite the great bargain prices.  But I should have.  Russia’s stock market was one of the top performers in 2016, rising about 50%.  Even though it still looks cheap, I won’t invest in 2017 after such a strong year in 2016, because the downside risk has gone up too much.

I also mentioned I’ve built up a large cash cushion.  I have a few specific reasons for this.  One of these is that I wanted 3-5 years living expenses to manage sequence of returns risk in case we end up retiring early in the next few years.  My wife and I don’t have a solid plan on this yet but if we actually do, then I’m worried about sequence of returns (the risk of poor investment returns early in retirement that force you to sell investments at a large loss), especially after many years of strong investment gains.

As they say on Wall Street, bears make money and bulls make money but pigs get slaughtered.  Our investments have done really well and I want to protect some of those gains, especially since we have already hit financial independence and have some potentially short-term needs for the money.

As I mentioned before, I’m actually much happier being 90-100% invested in stocks and have done this my entire working career, but I have shifted to 75% stocks and 25% cash and short-term bonds.

If stocks drop 10% (from whatever peak they hit), then I would put 33% of this cash back into stocks even though this is probably too aggressive.

A 20% decline triggers another 33% of cash invested.  These level of declines are quite common.  In many years a 10% drop happens during the year and a 20% drop happens every few years on average.

If stocks dropped 30%, which is more rare, I would put everything to work in the stock market, regardless of sequence of returns.  And if it kept dropping to a 40% or 50% loss, so be it.  I would simply hold on and ride it out, curtailing spending and adding more shares from any income I could generate.

So that’s my update and some insight into how I invest.  Mainly I’m a standard index fund investor like many, but I also have a stubborn independent streak and don’t mind doing things differently.  My big shift from US stocks to emerging markets in early 2016 was an aggressive move that I made that most people would advise against.  Time will tell if this was smart move but so far, so good.

Whatever investment approaches you use, I wish you the best in your journey to financial independence.

If you’d like to share your thoughts on what I’ve done, or want to share your own approach, please comment!  Have a great day!


2 thoughts on “Mid-Year 2017 Investment Update”

  1. I like some of your views here. The price you pay for a stock definitely matters a lot. Interesting, I’ve been eyeing target for a little while, although holding off because it’s a retailer. The low price to earnings and high dividend do provide a safety cushion.


    1. Retailing is definitely a scary area right now. Of course that’s why they are on sale for investors. If there was no actual risk, the prices wouldn’t be low. I expect Targets earnings to drop, maybe a lot, as they refurbish stores, try the new small store footprint they are piloting in Chicago, and lower their prices to compete but there is a good probability they will figure out a way to be successful. So the P/E ratio may not be the best judge of value for a while (e.g. P/E ratios are very high in a recession because earnings are low but that is still when you want to invest). The dividend yield provides me more comfort in terms of downside protection. Companies usually cut dividends as a last resort and Target has a lot of financial strength. Only time will tell though!


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