Published by Nicholas Ward on February 28th, 2018
With volatility finally announcing its presence with a bang in early February after an absence of two years or so, I’ve been doing a lot of thinking about capital preservation as a part of my capital allocation/preservation strategy.
Over the past couple of years, I made it clear to readers that I was growing more and more cautious as the market continued to rise; however, I had a hard time acting on these concerns because it just didn’t make much sense to step out in front of the momentous freight train that was the bull market.
I trimmed overvalued names from time to time but ultimately, I left my cash in the market, deciding to let it run until the tide turned. By waiting for the market to turn, this strategy meant that I wouldn’t call the exact top; but then again, I believe that attempting to time the macro stuff in the short-term is a fool’s errand anyway. Well, the volatility arriving in early February signaled to me that times were-a-changin’.
Since then I’ve been much more willing to cut ties with questionable holdings in an attempt to reduce speculation and sure up the quality of my portfolio. I’m not saying that we’re headed towards a crash, but it’s now clear that the market is willing to hit the sell button. The other day on CNBC, I heard someone refer to the end-cycle bull market as a steamroller and not a train. The gentleman said something along the lines of, “Buying stock in the market today is akin to picking up pennies inform of a steam roller.”
In other words, it’s dangerous out there. There’s always a certain degree of danger in the markets but political changes regarding tax reform an increase debt load are especially concerning for me. If the recent legislation/capital policy in D.C. leads to sustained GPD growth then these growth oriented policies will be great. But, if the debt incurred in the present doesn’t lead towards adequate economic growth, I’m worried that we’re essentially borrowing from the future to put lipstick on a pig in the present. Time will tell whether or not we see economic growth coming in at levels that will balance out the scales regarding the revenue deficit that we’re seeing at the moment; until then, I think it’s prudent to take a cautious stance. Sure, there will be investors nimble enough to grab some small returns, but for the most part, rising inflation, debt, and interest rates could easily represent more pain than pleasure for those brave enough to play the game.
The biggest mental hurdle that investors have when it comes to capital preservation measures (i.e. raising/holding cash) is the fear of missing out (or, FOMO). No one likes the feeling of being left behind or being left out completely. Human beings are social creatures, which oftentimes leads to mistakes in the market. FOMO leads to exuberant momentum that gets out of control. Just about everyone agrees that the basic practice of buying low and selling high is a sure fire way to make money, but FOMO usually inspires us to do the exact opposite. Sometimes losers are losers and winners are winners in the market for good reason, which does complicate this matter further, but in general, I think that focusing on company fundamentals rather than our irrational emotional response to market movement should be the foundation of any conservative portfolio manager’s strategy.
FOMO isn’t just the fear of missing out, but the fear of losing. Typically, humans don’t like to lose either. However, it’s important to acknowledge that the perception of winning and losing in the market is skewed to the individual. “Winning” will look different for every individual. I’m not trying to perpetuate the PC culture message that everyone deserves a participation trophy; instead, I’m saying that everyone’s dreams, goals, needs, wants, and current level of income/savings will be different. Financial independence is the goal and there are so many factors involved in this that it would be impossible to make a blanket statement regarding what “winning” actually means in the stock market/personal finance arena.
Obviously, the more money the better, but it’s not that simple when you factor in the risks that investors have to take to make said money. Maybe your preferred lifestyle in retirement involves swanky mansions on the coast, foreign sports cars, and caviar; if that’s the case you’re going to need to generate quite a bit more passive income than someone like me who would be satisfied with a small cottage (I don’t want to clean/pay someone else to clean a large house), a Prius, and burritos. That mean’s you’re going to require either a much larger nest egg to begin with or a much higher risk tolerance than me with regard to income oriented investments (or, more than likely, a combination of both).
On the flip side, it’s important to remember that you haven’t lost the game if your returns are below the major market averages. Who cares what your neighbor, your co-worker, your cousin, etc, generate in the market? It doesn’t really matter how well some Wall Street wizard of a hedge fund manager does, unless you’ve invested in that fund, of course. Talking heads, market analysts, bloggers like me; we all like to talk about our returns as if they’re measuring sticks of quality.
Within the financial industry I suppose this is true, but when you’re talking about the average, everyday, retail investor who isn’t interested in climbing the Wall Street ranks, but instead retiring comfortably and leaving a legacy to his or her offspring, the only measuring sticks that matter are the ones associated with your own retirement timeline.
The market appears to be a competition because everything in compared in a relative sense, but it’s hard to pace a race against others when everyone’s finish line is different. I’ve been guilty of this myself because the competitor in me enjoys the pursuit of alpha; however, I’ve also recognized how getting caught up in this sort of triviality could potentially harm me in my individualized pursuit of financial freedom.
When I focus on beating the market (or the myriad of well known hedge fund managers that I’ve pitted myself against for no other reason than pride), I find myself focusing much more on the opportunity cost of conservative low beta investments or cash as a larger part of my asset allocation. I think it’s important to factor in the harm that inflation can do to a cash pile over time, but I don’t think it’s necessarily fair view it in that light. Sure, inflation will eat away at cash over time, but it will never (in a healthy economy) experience the downward volatility that is possible in the equity space. Investors can own short dated TIPS or less liquid fixed income assets, but generally, I think cash is a great hedge against a bear market for a dividend growth portfolio. Cash creates the flexibility to augment your income stream when the market presents attractive opportunities to pick up high quality dividend growth names at discounted prices. Sitting on the sidelines with a large cash position may not result in outsized gains, it may not “win” you the game when it comes to investing, but it certainly won’t lose it.
On Monday morning, Becky Quick interviewed Warren Buffett on CNBC. Regarding Berkshire Hathaway’s annual results/letter to shareholders, Warren Buffett said, “It’s insane to risk what you have and need for something that you don’t really need.”
Buffett was talking specifically about buying on margin, which is a dangerous practice that he claimed not to use at Berkshire and doesn’t advise that another else use either.
He went on to say, “My partner Charlie [Munger] says there is only three ways a smart person can go broke: liquor, ladies and leverage.”
Buffett drove the fact home by acknowledging that Munger simply added liquor and ladies to the statement because they both end in the letter “L” and highlighted the fact that really leverage is by and away the biggest danger that “smart” investors face.
I think the statement that Buffett made regarding taking unnecessary risks can easily be flattened out to cover many more issues than trading on just margin. Putting something at unnecessary risk can easily be applied to a myriad of capital allocation applications. This is especially the case with the “and need” portion of his statement; this is why general wisdom regarding retirement planning is that those who are nearing the end of their work lives should move a higher percentage of their assets into low risk investments like fixed income. When your ability to generate income is diminished, the “need” factor increases with regard to the assets that you’ve already accumulated. Once again, this will be different for everyone, which is investors shouldn’t focus on “winning”, but rather meeting their personal goals.
This circles back to my FOMO/capital allocation argument and the importance of understanding your risk tolerance and maintaining a proper asset allocation in relation to your risk tolerance. I mentioned my change of sentiment regarding the strength of the bull market now that volatility has returned. Now that I’m no longer riding the bull market wave, I’m less much less likely to take risks. In the last 30 days or so I’ve made several moves to help sure up my portfolio.
I sold two companies who announced that they were freezing their dividends; this was a rules based decision. If a company cuts or freezes its dividend, I will sell if 99% of the time (I say 99% because there is always an exception to the rule).
Note: At Sure Dividend, we sell if a business cuts its dividend, not when it freezes it.
I sold out of several low growth, interest rate sensitive names because I felt strongly that they would underperform the market moving forward; not because of the XIV related sell-off, but because I feel very strongly that the FED will raise rates at least 3 times in 2018 and I don’t like investing into headwinds (this too, seems like an unnecessary risk to me in a market with so many high quality, viable dividend growth names). And lastly, I trimmed back my exposure of Bristol-Myers Squib from overweight to full, locking in profits on a trade that I originally put on in 2016/2017.
I went overweight in Bristol-Myers shares in 2016/2017 as the company sold off on concerns that Opdivo was losing market share because I thought the double digit sell-off was over done. Over time I had slowly unwound this trade, locking in profits all along the way once Bristol-Myers recovered and I closed out the “overweight” portion of my trade in early February as a way to raise cash. Bristol-Myers was showing strength into the overall market weakness which help me to trim my position (it was down ~5% as the broader markets were down more than 10%) and this strength has continued into the recent recovery with the shares hitting 52-week highs. Bristol-Myers is a well known healthcare name but it’s actually now much of a dividend growth company. Bristol’s management has made a habit of giving investors annual raises in the 2-3% range and this just isn’t getting it done for a company yielding ~2.5% (I typically like for my holdings’ Chowder Numbers, which is current yield plus 5-year dividend growth rate, to be in the double digits and Bristol’s isn’t anywhere close).
I mention this trade specifically because of the post-sale run-up that Bristol Myers experienced. Sure, if I owned a working crystal ball I would have held onto my shares for another week or so before selling them. However, I didn’t expect for the market to recover so quickly from the initial weakness and I also didn’t expect Bristol-Myers to continue to move so strongly to the upside. In hindsight, I left some cash on the table, but let me explain why that doesn’t bother me in the least.
Bristol was cheap when I bought it and when I sold it in early February its multiple had risen to the point that it was trading at fair value (if not, at a slightly expensive valuation). As you can see in this F.A.S.T. Graph below, Bristol-Myers shares sunk well below their long-term historical average valuation in late 2016/early 2017 and have since recovered, recently crossing back above that normal valuation line.
Because of Bristol’s unattractive dividend growth statistics, I knew when I went overweight that this likely wouldn’t be a long-term position for me. I hoped to have the opportunity to take advantage of weakness, selling shares purchased near lows once they had reverted back towards their long-term historical norm.
There is no use crying over spilled milk when a company that you sell due to fundamental/rules based investing continues to rise higher. Thankfully, in Bristol-Myer’s case I still have a fair amount of shares so I get to continue to benefit from this company’s good fortune. However, even if I didn’t, I wouldn’t feel pressure to buy back shares and chase their growth because I know that the trade I made was well thought out and I was acting within my prescribed portfolio disciplinary measures.
Instead, I focused on the gains that I made and continued to monitor the market, looking for attractive opportunities. I found several during the downturn, adding to my Apple (AAPL) position as well as initiating exposure to Reality Income (O) and Gramercy Property Trust (GPT) near 52-week lows. I’m happy to have cash in my pocket because it allows me to capitalize on further weakness if there is any. I don’t feel pressure to chase the bounce because I know that I still have ~90% of my portfolio invested in equities. I’ve taken these steps to assure that I’m not suffering from FOMO, putting myself at risk of being hurt by the steamroller mentioned above.
