Friday, July 19, 2013

July 2013 Portfolio Summary

As the summer rolls on and the market continues up, the May-Investments portfolios sit pretty fully invested and well positioned, we believe, for the current market environment.

Generally speaking, the mutual fund portfolio has nine fully invested positions and a tenth position in gold, which is only a partial position but the remaining cash in the portfolio is tentatively scheduled to increase our investment in the precious metals asset class.  We’re just waiting for it to stop falling before we double up.  It has been a long wait.

Eight out of ten positions are in U.S. stocks.  The U.S. market is much stronger than most international markets and alternative investments, so we are less diversified than we would be were that not the case.  We are over-weighted in financials (banks and brokerages), healthcare (biotech as well as a more broadly diversified fund), and consumer cyclicals (automotive and a more diversified consumer discretionary fund).  We are under-weight technology (but do have a position in software).  Our position in Japan is back up to a full weighting.

In the Custom Wealth Management portfolios, the core equity portfolio is fully invested again after a management buyout at Zhongpin, a Chinese pork producer, forced the sale of one stock and opened up room for a couple new positions.  The “flexible middle” part of the portfolio is fully invested, home to exchange traded funds in the financials, healthcare, and consumer cyclicals sectors, as well as an automotive industry sector mutual fund.  In the diversification part of the portfolio, we have Japan and a partial position in gold.  We also own the S&P MidCap 400 Value Index position, which isn’t much of a diversifier, but reflects the fact that few markets are keeping up with the U.S. market.  Why diversify when the best performing market seems to be our own?  Generally speaking, the remaining cash is set aside for us to allocate back into precious metals at some point in the future.

It looks like the economy may continue with its slow growth on into the latter part of 2013.  For the past three months, the May-Investments Leading Economic Indicators have posted modest increases, reversing a three-month decline during the first quarter of the year.  The fear of sequestration during the first quarter turned out to be worse than the reality of sequestration thereafter.

There is modest strength in retail sales, global shipping, corporate profits and manufacturing new ordersWeakness is apparent in the outlook by small business owners, drilling activity, and capacity utilization, and the rate of growth in commercial & industrial loans and the money supply (M2) is declining. 

Overall, the LEI isn’t projecting robust growth, but at least there is a slight upward trend. The indicators are supposed to help us look forward about six months, so hopefully our January forecast for continued economic growth throughout the year will remain on target through the rest of 2013.

If so, I would expect markets to cooperate as well.  As money begins to dribble in off of the sidelines, valuations (Price/Earnings ratios) are adjusting up.  Corporate profits have increased slightly, but as P/E ratios increase the value of stocks goes higher and the strong performance of stocks is attracting the attention of investors who are getting paid almost zero, nada, zilch to have their life savings invested in banks.  Today’s low interest rates continue to enable huge deficits by the government at the expense of consumer spending, particularly by seniors.  It probably isn’t a good thing that “savings” are being moved into “investment” accounts, but it’s happening every day and it’s one reason why the market keeps rising even as the pace of economic growth simmers down.

The biggest market risk remains…the political mess in Washington D.C.  While we got past the debt cliff and have even moved past the onset of sequestration with minimal fanfare, the budget wars are far from over and it’s never too late for the folks in Washington to step in and make matters worse.  It seems to be what they do best. 

Douglas B. May is President of May-Investments, LLC and author of Investment Heresies.

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Throwing Her Hat In The Ring

Throwing your “hat in the ring” is an early 19th century boxing term. An 1810 article reported that “a young fellow threw his hat into the ring and followed, when the lame umpire called out ‘a challenge.’ …He then walked round the ring till a second hat was thrown in, and the umpire called out, “the challenge is answered.”

Given the rough and tumble world of political service, it may be appropriate to use a boxing term to describe Barbara Traylor Smith’s July 19th announcement that today she filed papers noting her interest in serving out the distinguished Harry Butler’s remaining term on the Grand Junction City Council.

Having served the community through the Grand Junction Rotary club, and more recently as Chairman of the Strive Foundation board, Barbara’s commitment to the local community is already well established. This latest challenge allows her to focus more time studying the issues confronting Grand Junction and learning more about how the community wants the City to serve its citizens in the future.

Here at May-Investments, we understand that it is a big commitment and we are enthusiastic in our encouragement about her decision. At work, as in retirement, “it’s not about the money. It’s about your life!” We want Barbara to feel free to contribute what she can to the city where we all live. Although it would be nice to coast and let others do all the work, that’s not the way it works in real life. After considering her family, faith, and business commitments, Barbara believes that she can make a positive contribution while still meeting her primary responsibilities. At May-Investments, we want everyone to reach their God given potential and are excited for Barbara as she steps up to this challenge.

We wish her the best. And, by all means, feel free to give her a call about potholes needing attention in the event that she is selected by the City Council to step into the ring.

Douglas B. May is President of May-Investments, LLC and author of Investment Heresies.

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The Style Box Paradox

Zeno’s dichotomy paradox refers to a philosophical conundrum where someone wishing to get from point A to point B must first move halfway before completing the journey. However, since they always have to complete half the journey first, and the half-journeys can go on ad infinitum, the Greek philosopher was forced to conclude that they would never arrive at the destination but would forever be stuck at various halfway points. It’s a great theory, but it just doesn’t make sense in the real world. People get to their intended destination all the time.

In investing, the theoreticians often study portfolios in the context of investment style boxes. Some portfolios are characterized as small cap value while others are classified as large cap growth. Classifying portfolios in this way is helpful in understanding fund performance looking backward over a discreet time period. However, classifying portfolios by style box classification is not particularly helpful while building portfolios. In the real world, bottom up investors shouldn’t care that much what style box the stock falls in. A more helpful way to classify stocks when constructing the portfolio is by industry and sector. At May-Investments, our portfolio building process has always emphasized sector rather than style box classification. We might look for a consumer stock with good earnings growth prospects that sells for a reasonable valuation, but we really don’t care how the stock is classified by the style box methodology.

A recent Fidelity Investments study explains that, “beyond company-specific factors, sector exposure has been the most influential driver of equity market returns.” While passive indexers mimic their marketing masters who repeat ad nauseam the myth that stock selection doesn’t matter and that a static asset allocation makes up 85% of investor return, in reality the studies showed that asset allocation is so important that it shouldn’t be held static, and that stock picking and sector selection actually matter a lot. While these facts inconvenience the passive indexing crowd, that doesn’t change them.

Style box investing, while great for performance attribution, helps little during the portfolio construction process. It’s a great theory, but it just doesn’t make sense in the real world. The Fidelity study notes that managing sector exposure is key because, “of the distinct risk and performance characteristics of the 10 major sectors.” While a specific stock’s style box attributes fluctuate constantly as ever-changing financial characteristics evolve, companies’ sector and industry attributes remain fairly constant. Moreover, these consistent performance drivers have a wider dispersion between the best and worst performing categories. “Equity sectors tend to have significant performance dispersion relative to each other, which is a key attribute for any alpha-seeking equity allocation strategy,” Fidelity observes. In other words, for investors trying to focus their portfolio on the best performing investments, more can be gained by focusing on sectors where the difference between the best and the worst is significantly wider than is the case with styles.

Another key difference is that different sectors have lower correlations to one another. This makes it easier to diversify risk than can be done using a style box orientation. “During the 2000s, the average correlation of sectors versus one another was 0.52, while the same average correlation among style box benchmarks over the same period was 0.76.” The higher the correlation, the higher the risk that all types of styles will rise and (more importantly) fall at the same time. Fidelity goes on to note that portfolios created with equity sectors “are more efficient – providing higher return and lower risk – than those created using style box components.”

Vanguard Fund founder, John Bogle, has made quite a stir lately criticizing the exchange traded fund industry for creating industry specific ETFs and branding the investors who use them as some form of wild speculator. Bogle, of course, made his fame and living off of passive investing. To his credit, he developed a firm based on low-cost investing strategies. To maintain that his approach is the only legitimate strategy is a bit arrogant, however. The lowest price car in the U.S. is the Nissan Versa S Sedan, priced at $12,780. The car comes with a manual transmission, a less fuel efficient engine, 2 wheel drive, bad ground clearance, a hardtop and very few bells and whistles. Are we all fools for not buying the lowest priced car, as Bogleheads suggest? Or are there other reasons to prefer a different way of viewing the world?

Anyone interested in getting a copy of the Fidelity Investment Insights white paper (Equity Sectors: Essential Building Blocks for Portfolio Construction) can e-mail us and we will be glad to forward a copy of the study.

Douglas B. May is President of May-Investments, LLC and author of Investment Heresies.

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