With Year End Approaching…

 

 

 

            It is a bit early for year-end commentaries, but as 2005 draws quickly to a close I thought it would be helpful to do some performance thinking in advance. As you know, I consider investing a long-term, goal directed activity, and I use things like Issue Breadth Statistics, infrequent Peak-to-Peak Market Value Analysis, and real world economics as bench marks for performance evaluation. Wall Street, on the other hand, looks at a short list of “magic numbers” that it uses to agitate you on a quarterly basis!  I do not approve of the short-term nature of Wall Street numbers; I do not consider the calendar year, or it’s quarterly subdivisions, relevant time frames (even for conventional Market Value performance analysis); and I never think of an investment portfolio as something that is in competition with indices, averages, or even with alternative investment strategies. Your investment portfolio is unique. It contains only New York Stock Exchange (NYSE), investment grade, dividend-paying Equities balanced with a diverse group of high quality income producing Unit Trusts, CEFs, etc. Thus, comparisons with "the Market", or with various indices just do not compute… even in a 100% equity portfolio. Your portfolio is much more conservative (less speculative) than the S&P 500, the DJIA, or the NASDAQ. Similarly, comparisons with the CPI, or with the average rainfall in Madagascar, are meaningless.

 

 

            The general objectives of your investment program are: (1) to grow the productive "Working Capital" of the portfolio, and (2) to increase the level of base income from year to year. [Note that these objectives will vary from person to person based on Asset Allocation and withdrawal history.] Neither of these objectives is directly related to the market averages or to the rise and fall of interest rates! In other words, realized gains, realized losses, income, deposits, and withdrawals alone affect Working Capital. Transient changes in Market Value, in either direction, are of no consequence. These objectives (Working Capital and Income Growth) are longer-term investment considerations, monitored by a much less frantic means of performance appraisal.

 

        With this approach, it’s simple to form expectations about the rate of productive asset growth and the amount of total income in any portfolio. From the NYSE Issue Breadth Statistics, we determine that 2005 has been the least positive of any year since 2002, just barely in the black. Additionally, the Federal Reserve’s money tightening policy has finally had an impact on fixed income security prices, forcing them down considerably. Thus, the rise in base income and Working Capital should be slower than normal (but still positive) because of fewer capital gains opportunities in both investment classes. But, future growth in both numbers is potentially higher because of higher interest rates and a more fully invested posture than in recent years. It should be apparent, as well, that the change in Market Value should be less positive in portfolios that are more heavily allocated toward Income Securities. But isn’t this according to plan? Of course it is. This is what investing is all about… dealing with the ups and downs constructively, and not emotionally, as our friends on Wall Street would like. Never lose sight of the fact that an unhappy investor is Wall Street’s best friend. By emphasizing short-term results and creating a hyper-superbowlesque environment, they guarantee that the vast majority of investors will be unhappy about something, all of the time.

 

        Thus, as I've said before, I don't think that Wall Street Quarterly and Annual Report calculations are appropriate for diversified, high quality, trading portfolios. Using the Contrarian “Buy Low, Sell High(er)” approach, one should expect holdings to be lower in Market Value than in cost basis, particularly when prices have been falling as they have in recent months. If we don’t buy during the down months, we’ll have nothing to sell when prices rise… that’s the Wall Street way, not ours. For example: some statements compare portfolio Market Value with the CPI because of the common mythology that a higher Market Value keeps you ahead of inflation. Market Value and purchasing power have no common denominator… they are two totally different concepts. It takes increasing income levels to beat inflation, nothing more. (Even the labor unions have figured that one out!) Other statements I’ve seen compare the change in Market Value with the change in the DJIA or the S & P 500. Both averages include stocks only, from various exchanges, and of all quality levels. Dividend payment is a non-issue. Properly diversified portfolios, with or without fixed income securities, are totally different.

 

        It is extremely likely that your Working Capital, which measures the cost of your holdings, has risen in 2005. A reasonable (high end) target for such growth is 10% in the best of years, but anything above the January 1st One Year CD rate is acceptable. Similarly, your portfolio earnings (assuming that they have not been withdrawn) have been reinvested in a manner that will assure an increase in base income next year. [Note that a 100% Equity portfolio is less two-dimensional. There can be no assurance that base income will grow annually.] These are the important issues in growing a portfolio over the long haul. A focus on short-term, Market Value, valuation periods will make you crazy… and significantly poorer over the long run. A focus on Working Capital and income produces confident, happy investors, and over the long haul, a comfortable increase in Market Values as well.
 

 

        I’ve never been able to understand the behavioral dynamics that make investors fixate on Market Value when they know that it has to be lower, simply because of portfolio design. If the market you invest in moves lower, it’s not a problem; it’s an opportunity to purchase things at lower prices. It’s a good thing, a sale! I know it’s normal for people to get agitated when portfolio values fall, but most of you have seen these fluctuations before and understand that such movements are never permanent directional changes. November, for example, has just about erased all of the September and October Equity paper losses. Eventually, interest rate sensitive securities will experience rising prices as well. I developed the Working Capital Model as a way to see beyond the frequent fluctuation in Market Value within both classes of investment securities. My job is to help you reprogram yourself... to abandon the Market Value “dark side” and to embrace “the force” of Working Capital performance analysis.

 

            Sometimes, however, a relapse into Market Value thinking is inevitable. I try to appease the beast by keeping a record of “All Time Highs” in profit levels, defined as the difference between Market Value and the net amount invested. You should expect to achieve ATHs when NYSE Breadth Statistics are positive AND interest rates are trending lower. (As a point of comparison, no major Wall Street measuring device has hit an ATH in nearly six (yes, six) years in spite of the fact that both of these conditions have existed regularly during that time frame. A look at your own long-term record in that regard should produce some smiles. So, when broker statements reflect a lower Market Value, take two aspirin, re-read Chapter Five of  “Brainwashing” and the discussion of “The Working Capital Model” at: http://www.sancoservices.com/workingcapitalmodel.htm, and call me in the morning.

 

 

Steve Selengut
sanserve@...
800-245-0494
http://www.sancoservices.com
Professional Portfolio Management since 1979
Author of: "The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read", and "A Millionaire's Secret Investment Strategy