Concepts in Portfolio Management Ty Hughes Director, D.C. Regional Chapter December 5, 2016
Basic Principles When to sell a company Adequate diversification Using benchmarks to assess portfolio performance Reasonable exceptions for total return Tracking your portfolio with Google Sheets
Applying BI Principles
Growth and Profitability. "Own the best companies in an industry. Look for quality management. The growth rate should be acceptable for the size of the company. Value. Check the Relative Value, the relationship between the current price-to-earnings ratio (P/E) and the historical P/E for the company. Expected Total Return. Use the stock selection guide. Keep upgrading the expected return of your portfolio. Safety. This is best achieved by diversification.
Managing a Portfolio
Review your portfolio quarterly, normally after earnings season Update your stock selection guides quarterly Look for changes in company fundamentals (moat, sales, and earnings) Identify companies with a change in fundamentals If there is a significant price drop, determine why Compare portfolio performance with a benchmark
When to Sell a Company
When something is truly wrong with the company business and it won t likely be fixed within a year. When the stock price has risen so much that future gains are unlikely. You can hedge and sell part of your position. When you find a better stock. This is a way of exiting a weak holding and increasing the projected average return of the portfolio. When you need the money.
Adequate Diversification
50 Stocks in a Diversified Portfolio 40 16 stocks ± 4 Standard Deviation (%) 30 20 10 0 0 10 20 30 40 50 Number of Stocks
0% Impact of a 50% Drop in One Stock on Overall Portfolio Return -10% Portfolio Return -20% -30% -40% Stocks Return 1-50% 2-25% 5-10% 10-5% 12-4.2% 15-3.3% 20-2.5% 25-2.0% -50% 1 2 5 10 12 15 20 25 Stocks in Portfolio
0% Impact of a Single Bankruptcy on Overall Portfolio Return -20% Stocks Return 1-100% Portfolio Return -40% -60% 2-50% 5-20% 10-10% 12-8.3% 15-6.7% 20-5.0% 25-4.0% -80% -100% 1 2 5 10 12 15 20 25 Stocks in Portfolio
30% Position Size Guidelines 25% 20% Ranges from 1/2 to 2x of the target holding percent % of Total Assets 15% 10% 5% 0% 8 9 10 11 12 13 14 15 16 17 18 19 20 Number of Holdings (Stocks)
More on Diversification Should hold at least 16 ± 4 companies. Hold companies from four different sectors. Mix of fast and slower growing companies. Mix of small, medium and large companies measured by revenues 25% large cap, 50% mid-cap, and 25% small cap. Don t sacrifice quality for diversification.
Using Benchmarks
If you don't know where you are going you'll end up someplace else. - Yogi Berra Compare your portfolio performance against a benchmark that is representative of your asset allocation. Don t compare apples and oranges. Bonds and equities behave differently. Large cap, small cap and international stocks have different returns. It is easy to create a custom benchmark that reflects the asset allocation in your portfolio.
ETFs S&P 500 INDEX Russell 2000 ishares Dow Jones U.S. Index Fund (ETF) NASDAQ 100 Ticker SPX RUT IYY NDX Index Funds Vanguard Total Stock Market Index Fund Admiral Shares Vanguard 500 Index Fund Admiral Class Vanguard Value Index Fund Admiral Shares Vanguard Mid-Cap Growth Index Fund Admiral Shares Vanguard Mid-Cap Value Index Fund Admiral Shares Vanguard Small-Cap Index Fund Admiral Shares Vanguard Small Cap Value Index Fund Admiral Shares Vanguard FTSE All-World ex-us Index Fund Admiral Shares Vanguard Developed Markets Index Fund AdmiralShares Fund Vanguard Emerging Markets Stock Index Fund Admiral Shares Vanguard Total Bond Index Fund Admiral Shares Ticker VTSAX VFIAX VVIAX VMGMX VMVAX VSMAX VSIAX VFWAX VTMGX VEMAX VBTLX
Sample Benchmark Assumes all U.S. equities 25% large cap, 50% mid cap, and 25% small call.
Expected Return
0.3% 26.6% -8.8% 22.6% 16.4% 12.4% -10.0% 23.8% 10.8% -8.2% 3.6% 14.2% 18.8% -14.3% -25.9% 37.0% 23.8% -7.0% 6.5% 18.5% 31.7% -4.7% 20.4% 22.3% 6.1% 31.2% 18.5% 5.8% 16.5% 31.5% -3.1% 30.2% 7.5% 10.0% 1.3% 37.2% 22.7% 33.1% 28.3% 20.9% -9.0% -11.8% -22.0% 28.4% 10.7% 4.8% 15.6% 5.5% -36.6% 25.9% 14.8% 2.1% 15.9% 32.1% 13.5% 1.4% -50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 S&P 500 Annual Return
Historic Returns Geometric Average S&P 500 3 mo. T-bill 10 yr. T-bond 1928-2015 9.50% 3.45% 4.96% 1966-2015 9.61% 4.92% 6.71% 2006-2015 7.25% 1.14% 4.71%
Declines in the S&P 500 from Jan 1950 - Nov 2016 Decline % Number Avg. Length of Decline in Months Avg. Recovery Time in Months 5-10% 41 1 1 10-20% 11 4 3 20-30% 4 11 8 30-40% 2 9 15 40+% 3 23 60 The 3 pullbacks of greater than 40% all occurred during recessions: 1973-74, 20000-02, and 2007-08 Source: Delta Investment Management
S&P 500 Observations The market is volatile year-to-year but has always gone up in the long term. The market has always recovered from its lows and then reached new highs. Selling when the market has dropped or buying because the market has gone up guarantees poor return. Trying to time the market is a sure way to lose money. If you don t have at least a 4-5 year time horizon, don t invest in equities.
Beware the Prognosticators Trump will not be president. Corollary: The Republican Party is in disarray. Sell everything! 2016 will be a cataclysmic year for the stock market Royal Bank of Scotland (RBS), January 12, 2016 A recession worse than 2008 is coming CNBC, January 15, 2016 Oil will slide to $20 per barrel - Morgan Stanley, Goldman Sachs, Citigroup and Bank of America Merrill Lynch, January 11, 2016 China is Headed for a 1929-style Depression - The Economist, May 2016 Source: Delta Investment Management
Equity Return Return = EPS Growth + Dividend Yield + P/E In applying this formula consider: GDP is generally correlated with EPS growth for the total market. Average dividend yield from 1960-2015 was 3%. P/E for a stock is generally correlated with growth and quality but market P/E tends to refer to the mean over the long term.
Example - Market Return Assumes market EPS growth equal to GDP. Note impact of P/E reversion to the mean Current P/E P/E RTM (5 yrs) P/E RTM (3 yrs) Gr EPS Div P/E Total Return 2.5% 2% 0 4.5% 2.5% 2.5% -9.0% -4.0% 2.5% 3% -14.5% -9.0% P/E reversion to the mean is from 25 to 15.6.
Example - Growth Stock Assumes a growth stocks with 10% EPS growth. As P/E returns to the mean, dividend yield will increase. Current P/E P/E RTM (5 yrs) P/E RTM (3 yrs) Gr EPS Div P/E Total Return 10% 1% 0 11% 10% 1.3% -9.0% 2.3% 10% 1.5% -14.5% -3.0% P/E reversion to the mean is from 25 to 15.6.
What is the likely total annual return for equities over the next 5 years?
Tracking a Portfolio with Google Finance
Google Sheets has a robust set of financial functions for building custom spreadsheets There are separate functions for stocks and mutual funds. They are easy to learn. Google Sheets are private unless you share them. But don t include identifying information. Learn more at the Google Sheets help page Here is the Google Finance documentation
Click on chart to go to the Google Sheet
Click on chart to go to the Google Sheet
Google Finance Tips
Use the Google finance functions. Sometimes Google historic data throws an error. Use iferror([formula], - ). Add colors with conditional formatting. Take the time to format your spreadsheet. Learn the difference between A1, $A1, A$1 and $A$1 and use it to replicate formulas. Create a dashboard linked to multiple sheets. Experiment - you can t break the spreadsheet, use the undo function Control+Z to go back.
Questions?
Backup Slides
Equity Risk Premium The equity risk premium is the expected return on stocks in excess of the risk-free rate Stocks - T-bills Stocks - T-bonds 1928-2015 6.05% 4.54% 1966-2015 4.69% 2.90% 2006-2015 6.11% 2.53% Theoretically, return on equities should equal the risk free rate + the equity risk premium
Examples - Risk Premium T-Bill Risk Premium Total Return Currently 0.8% 4.5% 5.3% RTM 4.7% 6.1% 10.8% Above returns include inflation. Nominal returns would be somewhat lower. Current rate of inflation is 1.6%. The102 year average is 3.18%.
Average Annual Inflation by Decade Source: InflationData.com