Portfolio Design Equity Selection

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1 Index Mutual Fund Selection & Analysis Page 2 Portfolio Tax Efficiency Page 4 Mutual Fund Analysis Example Page 5 ESG Funds Portfolio Design Equity Selection January 2019 Investor Education Investor Education is Critical to reach your Financial Goals Wealth gives you Freedom and Control of your Life Setup an Auto-Investment Plan to Invest on a Regular Basis in Bull and Bear Markets Create a Diversified Portfolio with the Proper Asset Allocation Purchase Quality Investments Manage your Portfolio Properly Building Your Portfolio Page 7 Moderate Risk Mutual Fund Portfolio $50,000 Page 8 Moderate Risk Mutual Fund & Sector Portfolio Page 9 $100,000 Opening a Brokerage Account Page 10 Portfolio Implementation Page 11 Stock Selection Page 12 Stock Selection Example Page 13 Stock Selection Expectations Page 14 Investing in Individual Stocks Page 17 When to Sell a Stock Page 18 Stock Buybacks Page 19 PDM Investment Services, LLC A Registered Investment Advisor 5131 Standish Drive, Troy, Michigan * * info@fginvestor.com For complete disclosure see our website 1

2 Mutual Fund Selection and Analysis 1. Make a list of potential mutual funds in each asset class. 2. Look for funds that outperformed their category over a three, five and ten-year period and have a 4-star or 5-star Morningstar rating. Morningstar 4 and 5 star ratings are based on past 3, 5 and 10-year risk adjusted returns. The star rating is a good place to start but has limited predictive power. The star rating steers you to lower expense ratio funds with less volatility. The star combined with a Gold, silver or bronze advanced rating has more predictive powers. 3. Do your own more advanced research. Investment newsletters and magazines have model portfolios that can help get you started in fund selection. Research each mutual fund using Morningstar or another mutual fund rating services. Most on-line brokers offer some mutual fund research. Below is a list of criteria to consider when grading a mutual fund. Start by looking up the first three items listed below at minimum, then review the additional criteria. Critical Fund Ticker Symbol Search the fund name on Google or Morningstar to find the industry five-digit ticker symbols. Fund Asset Class LCG, LCV, MCG, MCV, SCG, SCV, INT, BOND, MM, etc. Fund Grade - Morningstar 4-star or 5-star and a gold or silver rating. Performance Look for funds that outperformed their category by at least 2% annually over the past three, five and ten year periods and outperforms its benchmark at least 65% of the past 10 years. Manager Over 5 years managing the fund. An MBA degree from a top school and CFA designation. Manager has over $500,000 of personal money invested in fund. Success rate increases from 35% is $0 invested to over 50% if $1 million invested. (Morningstar) Expense Ratio Less than 1.0% expense ratio is good. (See on the next page) Volatility Look for funds that have a beta of less than 1.2. Additional Strategy A sound investment strategy using proven techniques like fundamental and valuation analysis. Turnover Rate Less than 30% turnover is good. Fund Size Less than $8 billion fund size is good. Variation Look for funds that have a standard deviation less than its category. Risk Adjusted Return Look for funds that have a Sharpe Ratio higher than its category. Maximum Downdraft Look for funds that have a lower downdraft than its category. Upside/Downside Capture Ratio Look for funds that have a ratio greater than one. Valuation Look for funds that have the same or lower PE ratio than its category. Age of Fund Younger funds trained in new technologies tend to outperform. Sustainability Environmental, social and governance policy. Large Outflows Funds with large outflows underperform because the outflows make it harder to carry out their strategy and they have increased trading costs and higher capital gains distributions if they do not have high cash reserves. When there is strong money flow into a fund, the success rate is 51% and when strong outflows, the success rate falls to 43%. (Morningstar) More pronounced in small cap. (54% compared to 45%) Active Managed Content > 75% needed to overcome 0.8% management fee. Index hugger will return Index fee. Tax Efficiency for taxable accounts. (tax cost ratio, turnover, dividend yield, potential capital gains) Data from Morningstar. 2

3 Expense Ratio (Morningstar study April 2016) The expense ratio is the most proven predictor of future returns. In the chart below 1 is the lowest expense ratio and 5 is the most expensive expense ratio group. In U.S. equity funds, the cheapest quintile had a total-return success of 62% compared to 20% for the most expensive. This was true in most asset classes. The average success ratio point is 40% because it was reduced by 20% due to funds merged away. Funds with the lowest fees and average to strong past performance perform better in the future than funds with moderate fees and average to strong past performance. International US Dollar-Hedged Funds Long term currency risk has risen from 0% to 10% in the past 15 years. Short Term: If there is strong conviction that the U.S. dollar will continue rising, dollar-hedged stock and bond funds can make sense in the short term. Hedging reduces volatility. Hedged funds outperform 40% of the time over 3 years and 30% over 5 years. (Schwab) Long Term: Un-hedged funds are generally recommended because they offer country and currency diversification and perform better long term. Currency hedging increases fund expenses that can be a drag on performance. Mutual Fund Share Classes Do not use loaded mutual funds. Loaded funds charge front or back end loads to pay for distribution expenses and commissions to brokers. Many funds charge a 12b-1 fees to pay for marketing. All funds charge an operating fee to pay management, operating expenses and prospectus costs. No-load funds only charge operating costs and some charge small 12b-1 fees. Load Retail Shares (A, B, C) Purchase thru commission brokers. A shares upfront fee around 5.75%, B shares when sell fee around 1%, C shares pay annually around 1%. Higher expense ratios. Some 12d-1 fees. No-Load Retail Shares (M, N, S, T) Purchase thru discount brokers or directly from fund company. Moderate to low expense ratios. Some 12b-1 fees. Institutional shares (I, Y, Z) Purchase thru financial advisors and retirement plans. Low expense ratios. High minimums. Retirement Shares (R, K) Purchase thru retirement plans. Low expense ratios. 3

4 Portfolio Tax Efficiency (For Taxable Accounts non-ira accounts) In a taxable account, you should consider the tax efficiency of your investments and how you manage the portfolio. Consider your tax rate when designing a tax efficient portfolio. A tax efficient portfolio may decrease your after-tax return by -1.0% annually. (Pre-tax minus tax adjusted) Net -1% A strategic portfolio may decrease your after-tax return by -2.0% annually, but increase returns by 2.0% from strategy, net 0% You miss out on active managed funds, tactical allocation and strategic allocation. Tax efficient funds and tax efficient portfolio management Low turnover Less than 20% Varies little year to year Low dividend distributions Less than 1.3% yield Varies little year to year Reduce utilities, REITS, dividend stock and bond funds Low capital gains potential exposure Less than 20% Higher in bull market later years and lower in bear markets Dividend and capital gains distributions Q4 Active 10% to 20%, ETF 0% to 10%, stocks 0% Active funds with high outflows have higher distributions Low pre-tax minus tax adjusted return Less than 1.0% Higher in bull markets and lower in bear markets Low tax cost ratio Less than 0.8% (5-year) Higher in bull markets and lower in bear markets Tax Efficient Portfolio Vanguard exchange traded equity funds and exchange traded bond funds No utilities, real estate funds and dividend stock funds Individual stocks Municipal bond funds and bond exchange traded funds A fixed allocation strategy to reduce turnover Tax Efficient Management (Taxable account) Use tax loss harvesting to offset gains in Q4 each year, pull up realized and unrealized gains reports Sell securities that show an unrealized loss and rating has slipped (sell low) Use the loss to reduce your tax liability of capital gains and income ST capital losses reduce ST capital gains, LT capital losses reduce LT capital gains, carryover can apply to the other If losses > gains, you can use the remaining losses to offset up to $3,000 (joint) or your ordinary taxable income, leftover carries forward Reinvest that money into a different security that meets your investment strategy (buy low) Or use the proceeds for income Other guidelines Buy high rated new funds after the capital gains distribution date. Buy the fund with lower capital gains exposure if rating is equal to a fund with higher exposure. Great funds with high capital gains exposure should not be sold except for rebalancing. Vanguard index funds are tax efficient. Buy ETF s for Large Cap, Mid Cap and Small Cap allocation (less chance of active managed fund outperforming) Buy Active Managed Funds for International and Sector allocation (more chance of active managed fund outperforming) 4

5 Mutual Fund Analysis Example PRIMECAP Odyssey Growth Fund (POGRX) Strategy The PRIMECAP Odyssey Growth Fund is in the Large Cap Growth asset class. Joel Fried has been manager since 2004 and has over $1,000,000 of his own money in the fund. He has an MBA degree. The fund is tax efficient and has a high sustainability rating by Morningstar. Management looks for companies that have grown rapidly in the past and have good potential to continue the growth but that have become temporarily cheap for some reason. Stocks are sold when the company or the economic environment has shifted significantly or for valuation reasons. They tend to have more-pronounced sector bets. Technology and healthcare at above benchmark ratings The turnover rate is low at 9%. The fund has a low expense ratio of 0.65%. The fund size is medium at $11 billion in assets under management. Performance The fund outperformed its category by 4% annually in the past 3 years, by 4% in the past 5 years and by 3% in the past 10 years. POGRX Category: LG S&P 500 TR USD 35K 30K 25K 20K 15K 10K History (12/31/2017) POGRX S&P 500 TR USD Category (LG) / S&P 500 TR USD / Category (LG) Annual Report Net Expense Ratio Turnover Ratio Rank in Category Fund Category LG LG LG LG LG LG LG LG LG LG LG Category: LG return as of 12/31/2017 S&P 500 TR USD return as of 12/31/2017 POGRX return as of 12/31/2017 Source: Print page to PDF. Performance Consistency The fund has outperformed its category in over 80% of the years between 2005 and

6 ` Risk & Reward The fund volatility and variation are the same as its category. The risk-adjusted return is higher than its category risk-adjusted return. The maximum downdraft was 34% in 2008, less than the S&P 500 loss of 37%. The up/down capture ratio is positive at 1.1. Valuation The fund valuation is lower than its category. Summary This fund is strong with an A overall rating, making it one of the best funds in its category. The fund is OPEN to new investors with a $2,000 minimum for taxable accounts and $1,000 for IRAs. The fund is no-load but carries a transaction fee through TD Ameritrade and Schwab. ESG, SRI, Sustainability Funds Morningstar started its sustainability rating system in The S&P 500 Index Funds has an average sustainability rating. The millennials and female are the most focused generation on ESG policies since the Sustainability involves choosing companies with good environmental, social and governance policies (ESG). ESG (Environmental, Social, Governance) Environmental pollution, climate change and recycling Social Company s relationship with employees, suppliers, customers and communities Governance Company leadership, executive pay, internal controls and shareholder rights. SRI Social Responsibility Investing Corporate management that is ethical, efficient and long term focused. They avoid companies in tobacco, alcohol, gaming, weapons, nuclear energy, oil, gas and coal. Strong ESG companies are higher quality and tend to avoid lawsuits, fines, damages and use less water and energy Funds with higher sustainability scores tend to outperform ones that have a lower score. Higher sustainability rated funds we follow. PRIMECAP Odyssey Growth (POGRX) Parnassus Endeavor (PARWX) Mairs & Power Growth (MPGFX) Oakmark Fund (OAKMX), Oakmark International Small Cap (OAKEX) AMG Yacktman (YACKX) Vanguard Equity Income (VEIRX) Dodge & Cox Stock (DODGX) Eventide Gilead (ETGLX) Price Financial (PRISX) FTF s: KRMA, SUSA, ESG, ESGU, DSI 6

7 Building Your Portfolio Select the highest rated funds in each asset class and allocate to the asset allocation that meets your risk tolerance and time horizon. Select funds with higher grades and no transaction fees first. In taxable accounts, consider taxes when rebalancing. Other things to consider when selecting a fund for a portfolio are listed below. Is the fund open to new investors? Fund minimum (taxable and IRA accounts may have different minimums) Fund transaction fee (Between $0 and $75 depending on fund and custodian) When selecting funds consider the asset class, open funds, grade, minimum, transaction fee and performance. The size of your account and taxable nature will determine the number of funds you can purchase. There are about 15 asset classes in our recommended portfolio. In smaller portfolios, start with a short-term and intermediate-term bond fund, then add more bond fund types as the portfolio becomes larger. In taxable accounts, fund minimums range from $1000 to $3000 and in IRAs, minimums average around $1000. With ETFs there are no fund minimums. Below are some guidelines. Portfolio Size Fund Type Sector Funds Fund s per Asset Class $25,000 ETF No Sectors 1 $50,000 MF No Sectors 1 $100,000 MF Sectors 1 $200,000 MF Sectors 2 $300,000 MF Sectors 3 Small Portfolios For smaller portfolios with less than $50,000, select one fund in each asset class. Trying to get to the recommended allocation in each asset class may be difficult for smaller accounts. You may end up using more ETFs because they have no minimum. You can increase the number of funds in an IRA because of the lower minimums. The first place to reduce the number of funds is in bond funds. At minimum, start with a short and intermediate-term bond fund. For smaller portfolios under $10,000 a target or asset allocation fund is a good place to start. Some common target date funds are listed below. T. Rowe Price Retirement 2030 (TRRCX) and Vanguard Small Cap Value ETF (VBR) Vanguard Target Retirement 2030 (VTHRX) Schwab Target 2030 (SWDRX) American Funds 2030 Target Date Retirement Fund (RFETX) JPMorgan Smart Retirement 2030 (JSMIX) Portfolio Builders Most broker websites contain tools to build a portfolio. In Schwab s Mutual Fund Portfolio Builder, you enter your account number, risk level and dollar amount to invest. They will create a portfolio of about ten funds that you can purchase all at once. The fund, asset class, percent allocation and dollar amount of each fund is listed. There were no mid cap funds and all the bond funds were intermediate-term bond funds. Beware of their fund selections, there are no ratings on them, just a copy of the prospectus for you to read. 7

8 Moderate Risk Mutual Fund Portfolio $50, Model FUND NAME SYMBOL ASSET CLASS ALLOCATION DOLLARS PRIMECAP Odyssey Growth POGRX LARGE CAP GROWTH 15% $7,500 Oakmark Fund OAKMX LARGE CAP VALUE 12% $6,000 Akre Focus AKREX MID CAP GROWTH 8% $4,000 Parnassus Mid Cap PARMX MID CAP VALUE 7% $3,500 Price QM U.S. Small Cap Stock PRDSX SMALL CAP GROWTH 7% $3,500 Vanguard Strategic Small Cap Equity VSTCX SMALL CAP VALUE 6% $3,000 Oakmark International OAKIX INTERNATIONAL 8% $4,000 Price International Discovery PRIDX INTERNATIONAL 7% $3,500 Matthews Pacific Tiger MAPTX ASIA 5% $2,500 Fidelity New Markets Income FNMIX EMERGING MARKET BOND 0% $0 PIMCO High Yield Bond PHYDX HIGH YIELD BOND 5% $2,500 Fidelity Floating Rate High Income FFRHX BANK LOAN 5% $2,500 Vanguard IT Investment Grade Bond VFICX INTERMEDIATE TERM BOND 5% $2,500 Vanguard Short-Term Corp Bond ETF VCSH STORT TERM CORPORATE BOND 5% $2,500 Money Market Fund MM MONEY MARKET 5% $2,500 Asset Class Key LCG-Large Cap Growth, LCV-Large Cap Value, MCG-Mid Cap Growth, MCV-Mid Cap Value, SCG-Small Cap Growth, SCV-Small Cap Value, INT-International, INT EM MKT-International Emerging Market, INT BOND-International Bond, HY BOND-High Yield Bond, IT BOND- Intermediate Term Bond, ST BOND-Short Term Bond, MM-Money Market. 8

9 Moderate Risk Mutual Fund & Sector Portfolio $100, Model FUND NAME SYMBOL ASSET CLASS ALLOCATION DOLLARS PRIMECAP Odyssey Growth POGRX LARGE CAP GROWTH 10% $10,000 Oakmark Fund OAKMX LARGE CAP VALUE 8% $8,000 Akre Focus AKREX MID CAP GROWTH 6% $6,000 Parnassus Mid Cap PARMX MID CAP VALUE 5% $5,000 Price QM U.S. Small Cap Stock PRDSX SMALL CAP GROWTH 5% $5,000 Vanguard Strategic Small Cap Equity VSTCX SMALL CAP VALUE 6% $6,000 Oakmark International OAKIX INTERNATIONAL 8% $8,000 Price International Discovery PRIDX INTERNATIONAL 7% $7,000 Matthews Pacific Tiger MAPTX ASIA 5% $5,000 Price Global Technology PRGTX TECHNOLOGY 5% $5,000 First Trust Financial AlphaDEX ETF FXO FINANCIAL 5% $5,000 Price Health Sciences PRHSX HEALTHCARE 5% $5,000 Fidelity New Markets Income FNMIX EMERGING MARKET BOND 4% $4,000 PIMCO High Yield Bond PHYDX HIGH YIELD BOND 4% $4,000 Fidelity Floating Rate High Income FFRHX BANK LOAN 4% $4,000 Vanguard IT Investment Grade Bond VFICX INTERMEDIATE TERM BOND 4% $4,000 Vanguard Short-Term Corp Bond ETF VCSH STORT TERM CORPORATE BOND 4% $4,000 Money Market Fund MM MONEY MARKET 5% $5,000 9

10 Opening a Brokerage Account A discount broker is a financial institution where you can setup an account to hold and trade your stocks and mutual funds. Discount brokers offer the lowest prices for trades and offer on-line trading. For most long-term investors, a discount broker is the best place to hold and manage your investments. The most critical things to consider when choosing a broker are trading costs, the number of mutual funds offered, reliability, execution speed, local offices and research. If you are working with an advisor, you may have to use their custodian platform. The largest differentiators between brokers are mutual fund trading costs, research and the availability of local offices. Most brokers offer cash management accounts that consist of basic banking services within a brokerage account and offers services like direct deposit, check writing, wire transfers, debit cards, and automatic sweep accounts. An automatic sweep automatically invests cash between interest-bearing bank accounts and brokerage accounts. Also consider security: On your end change your password often, use strong passwords, use secure internet access connections, avoid public computers, Wi-Fi and check account statements and check your credit reports annually. On the brokers end: Some have a random number generator at login for extra security, track activity and login location, insurance against fraud and s strong employee security policy and training program. See the table below for a quick comparison of the top discount brokers for occasional traders. All of them have no account maintenance fees for taxable accounts, automatic sweep accounts, no extra limit order fees, options trading, no-load mutual funds, less than $2500 to open a new account, and are web browser based. For frequent traders and options, TD Ameritrade, Interactive Brokers and TradeStation are best. TD Ameritrade Schwab Fidelity E-Trade Vanguard Trading Experience A A A A C Range of offerings A A A B C Research A A A A C Local Branches A A B C Stock trading costs A A A A Mutual Fund transaction costs B C C B Customer Service A A A A Portfolio Analysis & Reports A A A A Mutual Fund Transaction Fees TD Ameritrade $24 x 2 Schwab $75 x 1 Fidelity $75 x 1 E*Trade 10

11 Portfolio Implementation As you purchase funds in each asset class, efficient implementation of a portfolio is important. Equities can be purchased all at once or with multiple purchases on down market days over a few months, depending on market conditions. If the market is in a strong uptrend and not overvalued, invest all at once. If the market is fair valued or overvalued, purchase the bond funds and weaker performing asset classes first. On the next correction, purchase the stronger performing asset classes. In a taxable account, implementation can be a tax event if funds are purchased in Q4 just before their annual distribution. Consider buying after the distribution. Before selling funds in taxable accounts, consider the tax consequences. 11

12 Stock Selection Process - PDM Investment Services Growth Investing Great companies have strong growth stories, great management, little meaningful competition and are riding a long-term secular trend. Apple with smartphones and itunes, Amazon with on-line shopping, cloud storage and media, Google with internet search, smartphones, YouTube and on-line marketing, Facebook with its social network, on-line marketing and Instagram, Cognizant with application software and IT services, Visa with paperless money, credit and debit card processing and Cerner with healthcare IT and paperless healthcare records. Value Investing The greatest value investors of all-time were Warren Buffett, Benjamin Graham (Father of Securities Analysis and Value Investing) and Michael Price (Mutual Shares Fund) They all used fundamental analysis with deep research to select investments, not technical analysis and momentum. Warren Buffet used cheap leverage form insurance operations and bought stocks that are safe, cheap, high quality and large. Warren Buffet and Michael Price took a financial and leadership position in companies that helped turn them around. Value investing is difficult for the average investor due to the amount of deep research and influence on the company. PDM Investing We look for high quality growth companies at a reasonable price. Predictable and consistent revenue and earnings growth, rising earnings estimates, an expanding or steady pretax profit margin, strong return-on-equity and return on invested capital, low debt to equity ratio, high free cash flow, reasonable priced and a strong stock chart with low stock price volatility. Stock Ideas Sources Focused Growth Investor, Investor Advisory Service, AAII Superstars Report, Investors Business Daily and Dow Theory Forecasts Stock Research Sources Technical, Charts, Momentum StockCharts.com, Y-Charts Fundamental & Valuation Schwab.com, Valueline.com, ManifestInvesting.com, BetterInvesting.org and Morningstar.com. Stock Portfolio Performance Per an AAII study, the chance of a great stock idea making money was about 50%. To be successful you must have a plan and execute to it. The art of trade execution is more important than the actual stock idea. When you purchase a stock, you must monitor it and be ready to sell when the reasons you bought it no longer exist. A stock portfolio must be diversified. Based on stock portfolios we have seen, if you purchase 4 stocks, you would expect the following annual results, on average. The portfolio above produced 1.3% return that year and the S&P 500 produced a 5.0% return. 1 outperform expectations +20% 1 perform at expectations (S&P %) +5% 1 slightly underperform expectations 0% 1 significantly underperform expectations -20% The key to success is screening out the big losers. The big winners carry the market. Our stock picking strategy does not always produce winners like Cognizant. If the metrics change, the stock may be sold at a loss. Investing in individual stocks is difficult and most individual stock portfolios will lag the S&P 500 over time. My personal all-stock portfolio is producing slightly better returns than my diversified mutual fund and sector portfolio but with more volatility. 12

13 PDM Stock Analysis Example Cognizant (CTSH) Growth story: Application software and IT services, outsourcing to India. Over the past 16 years Cognizant stock rose 5,000% and the S&P 500 (SPY) rose 120%. We have followed and owned this stock for more than 15 years. All stocks using this strategy will not perform this well since the metrics can disappoint and stocks will be sold Consistent Revenue and Earnings Growth over 8% (Schwab) Revenue Growth (A) 2013 to %, 17%, 20%, 9%, 9%e, 10%e (slowing, over 8%) Earnings Growth (A) 2013 to %, 24%, 17%, 10%, 10%e, 17%e (slowing, over 8%) Positive Earnings Surprises and Rising Earnings Estimates (Schwab) Earnings Surprises (Q) (strong) Earnings Expectations (Q) (strong) Expanding or Steady Pretax Profit Margin, Return-on-Equity, Return on Invested Capital (Y-Charts) Pretax Profit Margin (Q) 2013 to %, 13.2%, 13.1%, 12.0%, 13.1% (steady, moderate) Return-on-Equity (A) 2013 to %, 22%, 21%, 19%, 16% (falling, moderate) Return on Invested Capital (A) 2013 to %, 17%, 16%, 15%, 14% (falling, moderate) Low Debt to Equity and High Free Cash Flow (Y-Charts) Debt to Equity (A) 2013 to %, 3%, 3%, 1%, 1% (low) Free Cash Flow (TTM) 2013 to 2017 ($ billion) 1.0, 1.4, 1.5, 1.3, 1.8 (rising, high) Reasonable Valuations (Schwab, Manifest Investing, Y-Charts) Schwab Target to Price Target= $83/share, Price= $75/share = 11% upside to target Manifest Projected Annual Return 11% Price to Free Cash Flow (TTM) 24 (Top is 30) Strong Technical Trend (Stock Charts) Relative Strength Indicator (10-year) 65 (Range 30 to 70) An ideal time to purchase a stock is in a correction when the stock is trading along its technical support line or making new highs. 13

14 Stock Selection Expectations (Case against using individual stocks in your portfolio) PDM Stock Picks (50/50 chance of outperformance) From our experience, it is our opinion that when you purchase 4 stocks based on good research, you should expect the results listed below, on average. You have a 50:50 chance of not meeting expectations on a stock investment. A mix of 50% winners and 50% losers can still produce positive portfolio returns if the winners outweigh the losers. Compare the annual returns of the stock portfolios you manage to a good asset allocation fund like T. Rowe Price Retirement 2030 Fund (TRRCX). Is there any value-add for the time you spent in research and trading individual stocks? How many fallen stars have you owned? From our experience, when you purchase 4 stocks based on good research, you should expect a 50:50 chance of meeting expectations on the stock investment. 1 outperforms expectations outperforms market 20% 1 performs at expectations performs at market 5% 1 slightly underperforms expectations underperforms market 0% 1 significantly underperforms expectations severely underperforms market -20% Returns of the 4 stocks was 1.3%compared to a 5% market return. The key to success is screening out the big losers. Per an AAII study, the chance of a great stock idea making money was about 50%. To be successful you must have a plan and execute to it. The art of trade execution is more important than the actual stock idea. When you purchase a stock, you must monitor it and be ready to sell when the reasons you bought it no longer exist. A stock portfolio must be diversified. Also see the Arizona State finance professor Hendrick Bessembinder s research on buy and hold. Focus on avoiding the loser with your screens. It is hard to predict who the winner will be. What matters the most is how your whole portfolio performed each year relative to its benchmark. You could have 3 losers and one big winner and still beat the market. Select 4 stocks randomly from the Dow and look at their past year performance and future year s performance. Random had a 50:50 shot of a positive stock selection. The S&P 500 over the past year returned -1.3% (5/20/2016). The average of the stocks selected below returned 3.0%, outperforming the S&P 500 by 4.3% and most mutual funds. McDonalds +25.9% Verizon +4.5% Disney -8.2% Boeing -10.3% Even with the track record listed above, you will likely perform close to market averages over a long period of time. If your strategy is not a solid strategy, your performance will be worse Fallen Soldier list. Companies that no longer meet our strict requirements based on fundamentals and valuation. TROW, CSTE, AMG, QCOM, NOV, TRMB, DDD, SSYS, KORS, CTRX, SLB, SWI. PDM Stock Portfolio s (Moderate Risk) (20% individual stocks hurt performance by 1% annually) (Jan-Apr) Pure Stock Portfolio (My 401k) 33% 10% -1% -4% Diversified Mutual Fund & Stock Portfolios (4) 21% 5% -2% -1% Alpha -1% to Diversified MF Portfolio Diversified MF Portfolio 23% 5% 0% -1% 14

15 Active Managed Mutual Funds (Stock picking underperforms) Each year less than 40% of active managed mutual funds outperform their passive ETF benchmarks. Less than 5% of active managed mutual funds outperform their passive ETF benchmark with over 80% consistency each year. Stock Analyst Accuracy (Poor) Based on a Bespoke Investment Group study. Lowest rated stocks by analysts tend to outperform highest rated stocks. This is because there are no more sellers for lowest rated stocks and no more buyers for highest rated stocks to 2014 Average annual return: Lowest rated=13.2%, Highest rated=9.5%, S&P 500=6.5%. Highest rated do add some value. This is even more pronounced in the first year of a bull market and less pronounced in a bear market. Portfolio Return Contributors (Stock picking contributes the least) Global Stock Market Performance (largest contributor) Nearly impossible to do Asset Class Performance (next largest contributor) Best use of time Equity Selection (smallest contributor) A lot of wasted energy Stock Selection Expectations (50/50 chance) AAII Study 2006 to 2013, 45 successful professional investors, each invest in their 10 best ideas The chance of a great stock idea making money was 49%. To be successful you must have a plan and execute to it. The art of trade execution is more important than the actual stock idea. Listed below are the five types of traders. When losing money, neither buy more nor sell shares Take the quick 20% profit for fear of losing it Sell stocks that have fallen by a predetermined amount and show no sign of recovery after a certain period of time Start with a small investment with the intent of acquiring more if the stock price falls and conviction still exists, sell if conviction is gone Make long-term high conviction investments in companies with very predictable earnings. Take small profits as the stock appreciates Dow Theory Forecast Study (Based on 12-month total returns on Dow stocks from 1992 to 2015) The study looked at six different stock execution methods. Average 12 Standard Best 12 mo. Highest Gainer Month Return Deviation Worst 12 mo. Lowest Gainer 1. Hold All But Exclude Bottom 5% Performers 21.3% % -36% 222% -34% 2. Hold All But Exclude Top and Bottom 5% Performers 16.5% % -38% 96% -34% 3. Hold All Stocks for 12 Months 16.7% % -39% 223% -71% 4. Sell Any Stock if Up or Down 20% 11.4% % 25% 111% -55% 5. Hold All But Exclude Top 5% Performers 12.0% % -40% 96% -71% 6. Sell Any Stock If Up or Down 10% 5.7% % -21% 64% -42% As you can see from the table above, the best strategy was Hold All But Exclude Bottom 5% Performers. 15

16 Top Stock Newsletter Portfolio s (Very few outperform the S&P 500) (Aggressive risk. 100% stocks) Performance from Hulbert Financial Digest years S&P 500 TR 32% 13% 1% 7% Investment Advisory Service IAS 36% 11% -2% 10% DTF 40% 19% -1% 9% AAII Superstars 44% 4% -3% 6% Valueline 23% 11% -1% 5% Benjamin Graham (1960 s) I think the most important reason why the investor should not be led to emphasize his selection of individual stocks, and to neglect the general level of the stock market is the fact there is no indication that the investor can do better than the market averages by making his own selections or by taking expert advice This advice includes active managed mutual funds. He was implying index funds would be better but they did not exist to invest yet. Growth stocks can be overpriced and value stocks can be difficult to evaluate. On average people buying mutual funds have done better than picking stocks. Most are not educated and skilled to select individual stocks. Industries are easier to forecast than a stock. It is extremely difficult to beat the averages selecting your own stocks and for most mutual funds. 16

17 Investing in Individual Stocks We continue to reduce the number of stocks we cover to only the highest quality names. Investing in individual stocks has not offered much value for the time it takes to do the research. Our edge comes from tactical asset allocation, asset class allocation, active managed mutual fund selection and the addition of sector funds in our portfolios, not individual stock selection. Compare the annual returns of the stock portfolios you manage to a good asset allocation fund like T. Rowe Price Retirement 2030 Fund (TRRCX). Is there any value-add for the time you spent in research and trading individual stocks? How many fallen stars have you owned? From our experience, when you purchase 4 stocks based on good research, you should expect a 50:50 chance of meeting expectations on the stock investment. 1 outperforms expectations, 1 performs at expectations, 1 slightly underperforms expectations and 1 significantly underperforms expectations. Focus on avoiding the loser with your screens. It is hard to predict who the winner will be. Below is a list of reasons against using individual stocks in a portfolio for the individual investor. Our stock portfolios containing 30% individual stocks and 70% active managed mutual funds are performing close to the ones with only active managed mutual funds and ETFs. Even a sound stock selection process that uses fundamental, valuation and technical analysis will yield some poor performing stocks. One would think a company with consistent revenue and earnings growth, good profit margins and steady return-on-equity would yield a rising stock price. Cerner is growing revenue and earnings 15% per year consistently and the stock fell 30% from its 52-week high made in Our stock coverage drop rate over the years has been high, as stocks fail to meet our criteria over time. The global stock market and the allocation of asset classes are the main contributors to a portfolio s performance. The individual stocks or mutual funds play a much smaller role. There is no analysis that can pick up all the forces driving a company s stock price. Most analysis is based on past data to predict future performance and earnings estimate s that are often wrong. There are endless variables that can cause a stock price to drop. Investor sentiment, earnings estimates, analyst rating, activist activity, political, regulation, new competition, customer risk, bear markets, currency changes, credit risk, interest rate risk, changes in management, fraud and rumors of trouble that are not true. Individual stocks are more volatile than most mutual funds offering lower reward-risk ratios. If highly paid professionals with teams of researchers can t beat the market, what chance does an individual investor have? Only a small number of stock picking active managed mutual funds outperform their index ETF s consistently over time, even if you exclude their management fee. Based on the Hulbert Financial Digest rating of investment newsletters, less than 5% of stock-picking newsletters outperform the S&P 500 consistently over time. (Based on our calculations) According to an AAII Study from 2006 thru 2013, 45 successful professional investors, each invest in their 10 best ideas. The chance of a great stock idea making money was 49%. The best stock-picking newsletters we follow are the Investment Advisory Service, Investor s Business Daily, Motley Fool Stock Advisor and Dow Theory Forecasts. Picking stocks and trading stocks can be fun and keep you interested in investing until you take some big losses. It is ok to own small positions in a few individual stocks you know well in your portfolio. Individual stock selection works best when stocks are purchased at the bottom of a bear market when great companies are selling at compelling values. Using individual stocks in a portfolio late in the market cycle adds less value. It is still ok to use a few high quality stocks in the technology, financial and healthcare allocations at times. Select 4 stocks randomly from the Dow and look at their past year performance. Random had a 50:50 shot of a positive stock selection. The S&P 500 over the past year returned -1.3% (5/20/2016). The average of the stocks selected below returned 3.0%, outperforming the S&P 500 by 4.3% and most mutual funds. 17

18 When to Sell a Stock When you purchase a stock or mutual fund, you should plan on holding it long-term, or at least through most of a bull market. If it is a cyclical stock, it must be sold before the next bear market. If it is a good growth stock, you may be able to hold it for years through economic cycles. Reasons to sell not related to the company fundamentals: Portfolio Cash Withdrawals, Portfolio Rebalancing (Position 2x others) or Tax Purposes. Buying a stock is much easier than selling it. We tend to fall in love with our stock picks and have a hard time admitting we were wrong. Your approach to selling should be disciplined without emotion. One of the hardest decisions involving portfolio management is deciding when to sell a specific stock. Selling too early can result in loss of future profits. Selling too late can result in loss of invested capital. If possible, sell your stock on days the stock bounces. Do not look back at the price you bought the stock when considering selling it. Sell your lower rated stocks with small valuation discounts and buy higher rated stocks with higher discounts. Consider the transaction costs and tax consequences if you do a lot of trading. Sell a stock or mutual fund when the reasons for buying no longer exist. Would you buy the investment today? If the answer is no, you may consider selling it. If it is still a great company at fair value, hold the stock or mutual fund. Is the problem a short-term or long-term issue? Short-term issues like product delays or product recalls are good buying opportunities. Use corrections to buy great companies. Reasons to sell a stock are listed below. Fundamentals & Growth Revenue growth has slowed, mature industry Earning growth has slowed Profit margins are falling, new competition Return on equity is falling Valuations Extreme overvaluation At fair value and you found a better opportunity Momentum / Technical Poor relative price performance Inconsistent performance and low predictability High risk and high volatility Poor risk reward ratio Other The company is acquired CEO resigns for no apparent reason Major changes in business strategy New regulation A large scandal, legal or accounting issue A string of earnings restatements 18

19 Stock Buybacks Stock buybacks hit record highs in 2007, 2013, 2014 and Companies sell shares of equity to raise capital and the buy back shares to retire capital. The effect of a buyback is to increase EPS, since the company s future profits will be divided among fewer shares. Stock buybacks allow investors to defer taxes where dividends are taxed each year. The primary reasons companies buy back stock since are: They believe their stock is undervalued and a cheaper place to deploy capital than other alternatives, like spending and acquisitions. They have accumulated more capital than their company can invest or spend profitably. There is no benefit to sitting on cash. Stock buybacks don t necessarily indicate weak investment, especially when capital is abundant, like in Many companies have more money than they can invest productively. They should not invest excess cash in new equipment or structures until they are ready to fully utilize their existing stock. Bad signs of stock buybacks are: If a company is significantly leveraged up its balance sheet to buy back its stock. This can occur when its excess cash is tied up offshore. To offset the dilutive effect of stock-based compensation for its employees, vs. using it to retire outstanding shares. Some believe a strong buyback environment reduces productivity. Investment in equipment and software can increase productivity. In periods of rapid technological and structural change when a growing proportion of consumption and employment growth is generated by services that did not exist in earlier periods or were run on different business models. The recent growth of online services is an example. 19