Sunday, December 4

Week 22 - Core Holdings

Situation: Seasoned investors will try to strike an investment balance between equities (ownership rights that yield dividends or rent) and credits (loans that pay interest). They also attempt to balance their core holdings with “hedges” that are designed to mitigate potential losses. We introduced an ITR Goldilocks Allocation (Week 3 blog) that is designed to protect against bear markets by investing 67% of the entire portfolio in Lifeboat Stocks (see Week 8 blog) and high grade bonds. The remaining 33% is risk capital--core “cyclical” stocks that rise or fall with world markets.

Goal: Orient the ITR reader to potentially useful core holdings by providing specific examples.

On the equity side, a Goldilocks-type of allocation will assign 33% of holdings to Lifeboat Stocks. An additional 17% is distributed to multinational stocks whose strength is the ability to capture revenue from emerging markets. These two types of holdings mitigate against portfolio losses caused by recession and dollar devaluation, respectively. In fact, recent global market events have demonstrated that emerging markets reflect the US market and are not de-linked, as was once thought. This stands to reason because emerging markets such as Brazil, India and China market goods and services predominantly to the US rather than their own consumers. This then means that companies on the ITR Master List which are dependent on revenue from emerging markets will also fit the classification of “core holdings” (e.g. MCD & MMM). The result is that our equity allocation in the “at risk” category is weighted at 67%, while the remaining 33% is composed of Lifeboat Stocks used to hedge that risk.

For the individual investor, core holdings represent one of the few available opportunities to “beat the market”. As defined, core holdings exaggerate market swings because we’ve excluded the moderating effect of “defensive” (lifeboat-type) stocks. This makes it important to have a strategy in place to reduce and “even out” that risk over time. One means of accomplishing that is to purchase stock in large companies that have the resources to recover from recessions. Reinvesting dividends, and making regular periodic purchases through a DRIP to buy shares that are “on sale”, also helps to attenuate that risk. Examination of the 20 largest companies on the ITR Master List shows that 10 are Lifeboat-type defensive stocks (ABT, JNJ, MDT, WAG, KO, CL, PEP, PG, TGTWMT). Core holdings can be selected from the remaining 10 companies. Investing in those companies that have a return on equity (ROE) above the S&P 500 Index average (16%), and a Price:Book ratio less than 3.3, leaves:

   3 energy stocks (XOM, CVX, OXY)
   3 manufacturers (GD, EMR, UTX)
   1 conglomerate (MMM)
   1 railroad (NSC)

We’ve made an example pick of 4 stocks that represent core holdings and included an emerging markets play (MMM), an energy producer (XOM), a manufacturer (UTX), and a railroad (NSC). We’ll back-test our example by making a virtual investment of $150/mo in each of the 4 DRIPs from 2/3/97 to the present. We’ll use SPY as a proxy for the S&P 500 Index, and the Consumer Price Index as a proxy for inflation. Having to pay commissions reduces a monthly DRIP investment by $4/purchase for SPY, MMM and NSC, and $2.50 for UTX. The XOM DRIP, however, doesn’t have a commission.

The result of our analysis shows that (as of 11/30/11) SPY had a total return of 2.58%/yr vs. inflation at 2.32%/yr. The stocks used in our example, however, did much better with a return of 5.18%/yr for MMM, 8.70%/yr for UTX, 7.86%/yr for XOM, and 11.3%/yr for NSC. In the aggregate, an investment of $106,800 ($600/mo x 178 mo) grew to $234,352 (8.58%/yr). We are using the above example to prepare a spreadsheet for our readers that will be presented two weeks from now. We are incorporating calculations for two Lifeboat Stocks into this week’s example based on information we will discuss in next week’s blog (Lifeboat Stocks Revisited).

Bottom Line: DRIPs of 4 cyclical stocks (selected from ITR’s Master List) outperformed SPY by 6%/yr over the past 15 years.

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