Category: Personal Finance

Personal Finance, Portfolio Theory August 20, 2018April 24, 2020

Should you invest in bonds? What about gold?

Reading Time: 6 minutes

I thought I would run through a little portfolio theory for today’s post. I want to answer whether it still makes sense to invest in bonds (and perhaps even Gold).

I know, this may be a shocker to some people given (i) the fed was raising rates, (ii) I am a follower of Buffett and Munger who shun no-income earning gold and low interest rate bonds and (iii) I typically run a very concentrated equity portfolio in order to capture the upside of my ideas.

That said, the broader goal of this post is similar to the one on Ray Dalio’s All Weather Portfolio post – that is to say that diversification pays off.

To counter the points above, let me first re-iterate something I said before in my post, Is it time to rotate into consumer staple stocks? (And a digression on interest rates). One quick bragger is that the consumer staples ETF is up 6.7% since that was published compared to 3.96% for the S&P.

But coming back to the topic at hand – no one can predict interest rates, especially long-term rates. The former Fed Chief, Ben Bernanke recently said in late 2015 that he admittedly didn’t expect rates to remain this low for this long and followed that perhaps lower rates are here to stay:

“Certainly there has been a long-term downward trend in longer-term interest rates and every indication is that the equilibrium interest rate —the rate that ultimately will be consistent with stable growth — is lower than it has been in the past. So that’s clear. I expect the Fed will be very cautious and gradual, that’s what they’ve told us many times, and they’ll be looking for evidence that the economy has been able to accommodate the higher rate increases and still continue to grow.”

It is important to remember that demographics change.

People in the US are living longer and population growth is slowing. This puts a downward pressure on interest rates. The former causes pressure since people live longer = people need to save more and this may have a ripple effect (e.g. pensions need to adjust for longer life times than the past).

In addition, as people still retire in the 60-65 age range, but need their capital to be stable for retirement, they buy more bonds. Demand is greater than supply.

Low population growth also means slower GDP growth which pushes interest rates down.

Are we anchoring to high interest rates?

Look back at the interest rate in the 1960s. This followed WWII’s boost to America, creating a powerhouse economy, and encompasses most of the baby boomers being born (this ranges from early-to-mid 1940s and ends in early 1960s). From 1960-1965, the US GDP growth rate was anywhere from 5.5% to 10.7%, much higher than the 2% growth we target today. and yet, where was the rate on the 10 year treasury??

It was between 4.0%-4.5%.

Sure, that’d be nice to have if you want to put cash away in a safe place and earn 100-150bps more than what you get today, but the times were different then.

Ok, now that I can get off my soapbox and hopefully help you think somewhat differently about interest rates, I want to turn to the argument of why someone who chooses to invest in bonds is really adding a ballast to the portfolio.

While it’s tough to swallow a security that is guaranteed to only return ~3% p.a. if you hold it to maturity, I think it’s helpful to realize that you want something in your portfolio that will zig while everything else zags.

That is to say, when you invest in bonds, don’t look at just the coupon on bonds and think that is the only return you can get. If we hit a recession or there is fear in the market, these safer bonds will likely move up, while the equity market goes down. Indeed, since the Fed’s main tool here is to tighten rates in order to stimulate an economy going through a recession that is what we saw in 2008.

However, the counter argument that “interest rates may not help you in the next down turn because they are already low” is equally weak. At the end of 2013, the 10 yr treasury sat at 3.0%. It then went to 1.38% in the beginning of 2016. If one had chosen to invest in bonds at that time, it would have paid off.

For context on that, lets run through a case where you invest in bonds at the end of 2013: you buy the 10 year and sold it 2.5 years later when rates actually tightened. After 2.5 years, you have a 7.5 yr bond now with 3% coupon. The rate for 7 yr bonds at that time after some tightening was then 1.2% in 2016, which means your bond would’ve traded up to ~113 to match current on-the run rates.

Even though you bought a 3% 10 yr bond, it went up as people flocked to securities that are safe havens and that investment would’ve provided a ~8% IRR if you then sold it. Not too bad!

Comparison of Different Portfolios
I’d like to show you a few scenarios. First, the results of a portfolio invested 100% in US stocks late in a cycle where a bubble bursts (tech bubble) compared to one that is 80 / 20 stocks to bonds as well as one with some allocation to gold to show the impact of non-correlated assets. I will also show this for 2008. This comes to an interesting tool I’ve been utilizing at www.portfoliovisualizer.com. I know I’ll get this comment, but obviously past results are not a predictor of the future, but do think it helps at what may happen in the future.

The first results show what the value would be if you invested $10,000 in 1998 and rebalanced semi-annually.

Portfolio 1 = 80% US stocks, 20% 10-year treasury
Portfolio 2 = 60% US stocks, 20% 10-year treasury, and 20% Gold
Portfolio 3 = 100% US stocks

As you can see, portfolio 1 & 2 performed better over this time frame. Interestingly, portfolio 2 performed the best with its allocation to gold. It worst year was only a 5.7% drop as well, compared to 21% drop for Portfolio 3. Portfolio 1 & 2 underperform in bull markets, which might be obvious, but helped outperform during the bear.

Let’s again look at the 3 portfolios with a starting point of 2004 and ending in 2012. Again, portfolio 2 outperforms the all US stock portfolio as does portfolio 1. Portfolio 2 this time outperforms by a much wider margin since gold is seen as a hedge against extreme scenarios, like the one we saw in 2008. Remember from 2004-2006, the Fed was also raising rates.

I am a total Buffett follower and understand the difficulty buying gold since it is an asset that produces no cash flows. But from a portfolio perspective, I understand the rationale for buying. If your gold assets go up in a time like 2008, that gives you flexibility to sell it and buy stocks at very attractive valuations, which is flexibility I find valuable (though admittedly, I currently have no allocation to gold in my personal accounts). Also, you should watch this video I find humorous on Bernanke’s view on gold vs. Ron Paul.

At the same time, I also realize that a 30 year bond today that will fall 17% if rates go up by 1% may not be attractive despite the upside if rates tighten. The point of this analysis is to say that having a moratorium on bonds may not be the best idea either.

Bottom line: Do I think one should invest in bonds and even gold? Yes. Do I think they will return less than stocks over the next 10-20 years? Also yes. But the flexibility these asset classes may provide this late in the cycle may be attractive (much like insurance). You also have the option to buy corporate bonds which offer slightly higher yield than treasuries, but are still safe havens in times of distress.

Personal Finance July 18, 2018April 24, 2020

Why do sin stocks outperform?

Reading Time: 3 minutes

Do you know what the best stock of all time is? You may be surprised to hear its a business in a secularly declining industry.

It’s Altria – the tobacco company that owns Philip Morris. Take a look at the returns on that one! Sin stocks outperform!

Altria

Altria isn’t the only sin stock that’s performed well. Sin stocks are stocks of companies that benefit from human vices, such as alcohol, fire arms, gambling, and tobacco. As shown below, I picked a few of these sin stocks and plotted them against the S&P500 over the past 10 years. Those stocks are:

Altria – Tobacco
RCI – Strip Clubs
Anheauser-Busch – Alcohol
Diageo – Alcohol
Wynn Resorts – Casinos
Las Vegas Sands – Casino

Note, the chart above is total return so it includes dividends, which I think is important given sin stocks typically have high payouts.

So what gives? I know plenty of people who have invested in the next social benefit (such as solar or water infrastructure) and lost money. One theory of why socially-beneficially stocks under perform is that they try to do good, but do not do it well.

But in my opinion, and what has been discussed elsewhere, the reason why sins stocks outperform comes down to 4 factors:

operate in monopolistic or oligopilistic markets
- Consider cigarette companies which were told they could no longer advertise via new regulation. That essentially eliminated their marketing teams, increasing earnings and cash flow, but also eliminated any new entrants into their space (i.e. if you can’t advertise, you can’t enter)
managers may overlook them or underweight them
- One theory that is that fund managers underweight sin stocks or simply avoid them in order to please their shareholders or their own ethics. In essence, by all the socially responsible funds avoiding these stocks, they make them cheaper at the same time.
they also happen to be “bond proxy” stocks
- As interest rates fell from all time highs in the 70s & 80s to essentially zero following the Great Recession, stocks that are “bond proxies” performed demonstrably well. These sectors include utilities and consumer staples. Sin stocks (outside of casinos) are also very stable businesses and have nearly inelastic demand. As such, as investors were pushed out of bonds and into stocks, these stable businesses with high dividends were solid opportunities.
there may be an embedded risk premium
- Similar to the “avoiding” bullet above, financial theory would tell us that the because there are lots of funds out there that actively avoid these stocks, that should drive the cost of capital up for sin stocks (and drive it down for non-sin stocks). As a result, investors expect a higher return given the elevated risk premium.

To be clear, I am not advocating that you need to invest in these companies, but I find it fascinating and not something that one would necessarily expect. I also am always trying to understand any biases I may have that prevents me from generating the best returns I can.

Investment Philosophy, Personal Finance, Portfolio Theory June 30, 2018April 24, 2020

Ray Dalio’s All Weather Portfolio and the place for fixed income in the portfolio

Reading Time: 4 minutesAfter reading Principles, by Ray Dalio, this past winter (which I highly recommend as it gave me many, many things to think about) I have been reconsidering my position on being highly underweight fixed income. Perhaps you are similar to me and kept waiting for rates to move up for an attractive entry point. Ray Dalio’s All Weather portfolio is something to consider.

Now the ten year treasury is hovering around 3% and as I noted previously, is not that far off from long-term averages. Does it make sense to allocate more of our portfolios to fixed income now?

Perhaps you have heard of Ray Dalio’s “All Weather Portfolio” in which he allocates a surprising amount to fixed income, as shown below. His rationale centers on a few factors. One is that by having weighting your portfolio at 80% stocks / 20% bonds is actually heavily weighting “risk”, given the volatility of stocks vs. bonds and for someone like Ray Dalio who is trying to build wealth over the long, long term, performing well in down markets matters.

Bonds should go up when stocks go down due to “flight to quality” impact in a down market. The allocation to gold and commodities provides extra diversification, plus these assets perform well during periods of high inflation, whereas bonds will not perform well.

40% long-term bonds
15% intermediate-term bonds
30% stocks
7.5% gold
7.5% commodities

“The principles behind All Weather Portfolio relate to answering a deceptively straight-forward question explored by Ray with co-Chief Investment Officer Bob Prince and other early colleagues at Bridgewater – what kind of investment portfolio would you hold
that would perform well across all environments, be it a devaluation or something completely different?”

The results are pretty surprising. Dalio says he’s back-tested the portfolio from the great depression, to the Weimar Republic when hyperinflation set into Germany. If you choose not to read Principles, then I implore you to read the white paper on Bridgewater’s website on the background of the strategy.

Using portfoliovisualizer.com, I decided to see the results for myself and ran different 3 portfolio cases from 1978-2017.

The first is based on Dalio’s All Weather Portfolio, though admittedly, I had to do a 15% allocation to gold as a general commodities fund was not available that far back. I then ran a 60% stocks / 40% intermediate treasuries portfolio and then an 80% stocks / 20% intermediate treasuries portfolio.

Let me first say that it shouldn’t be too surprising that the higher stock portfolio wins out. Stocks have been a terrific asset class over this time period. Its higher risk, so higher return makes sense.

But look at the results of portfolio 1, the All Weather Portfolio. Results over this time period are not too shabby, logging a 9.4% CAGR and growing $10K to $380K. But the really interesting thing to me is the worst year and worst drawdown. The worst year was only down ~4%! Compare that to the stock heavy portfolio of -25% and having a near 40% loss in portfolio value during the year. Makes me think of “Slow and steady wins the race”

This analysis isn’t perfect for a host of reasons. Bonds have been in a bull market for 30 years and were at much higher rates during this time period and subsequently went way down. I do like a quote from the white paper though, in which it states,

“In the US after peaking above 15% in the 1980s, cash rates are now zero. Stocks and bonds price relative to and in excess of cash rates. A 10-year bond yield of 2% is low relative to history but high relative to 0% cash rates. What is unusual about the recent environment is the price of cash, not the pricing of assets relative to cash.”

For further analysis on portfolio outcomes that aren’t tied to back testing, I decided to build a monte carlo spreadsheet analyzing a 50/50 portfolio of stocks and bonds. I then ran 10 random simulations over 40 years to see where the portfolios would shake out. This was pretty simple analysis and I probably should’ve added a component that says, “if stocks are down, then bonds are flat or up”, but decided to keep it random.

Given how high the standard deviation is for bonds, it is no surprise that the highest returning situations are driven by bonds outperforming, but we should also not ignore the simulations where in year 38 out of 40, stocks fall 45%, as shown in scenario 3. Bond provide decent offset to a devastating scenario.

I think the takeaway I have is that bonds / fixed income can make sense in the portfolio, depending on what you buy. So far, all I’ve shown is buying treasuries, but think there are solid opportunities in high yield and municipal bonds which are much more stable than stocks, but provide good returns.

I’ll follow up in another article on a bond fund that I think makes a lot of sense to buy for a pretty attractive return.

-DD

Personal Finance June 27, 2018April 24, 2020

Is it time to buy consumer staple stocks? (And a digression on interest rates)

Reading Time: 6 minutesConsumer staple stocks had a great run following the Great Recession. It makes some intuitive sense. Bond yields were forced to at or near zero, which meant investors had to push out into the risk spectrum in order to hit their prior return thresholds. If you can’t get a 5%-7% return via bond yields, then maybe buying very stable high dividend stocks makes more sense. As a result, utilities, REITs, and consumer staple stocks all enjoyed high returns.

We should review how consumer staples stocks perform under a variety of scenarios though.

Bond yields rose following the passing of the Tax Plan in 2017, which was a strong form of fiscal stimulus. Yields on the 10yr moved from their stubborn below-2.5% band and finally topped 3%.

This 3% threshold number doesn’t necessarily mean anything, but the market tends to focus on round number (e.g. DOW 30,000! – new market top!).

The quick rise (or fall in bond prices since they move inversely) was really more of a sign to investors that the era of ultra low interest rates may be coming to an end.

As a result, investors extrapolated the recent news into the future and sought to get out of the way of rising interest rates. They also sold off the bond proxy sectors.

They also may have moved back into some fixed-income investments that became more attractive. As shown in the next chart, it is interesting how similar the charts are for these sectors when compared to the 7-10 year treasury stock chart shown in the bottom.

Was this warranted? Is it time to step into one of these sectors?

I argued it was at the time, mainly consumer staples. As an update in 2020, I’d probably say they’ve run their course as people hoard food in response to COVID 19. Utilities seemed just too expensive to me and they remain that way. These are highly regulated industries that obviously provide stable cash flow and high dividends, but little opportunity for upside. I also just find the yields offered by REITs just isn’t that great for what you get for a cyclical industry (although admittedly the spread between REIT yields and treasuries is wider than average).

There is one thing I’d like to address before we get to consumer staples stocks: 1) No one can predict interest rates and 2) investors should separate what the Fed is doing with what long-term interest rates are doing.

I’ve been hearing interest rates are “definitely going up” for about 10 years now. Even pre-crisis, people were saying interest rates were too low (relative to long term history). But in recent memory, remember at the end of 2013 when the yield on the 10 year ended at 3% (following the “taper tantrum”) and subsequently went as low 1.6% in 2016? Rates really haven’t gone up that much despite the fiscal deficit and inflation fears.

If you had to guess, no, if you had to invest your portfolio on it – where do you think long-term interest rates will settle at? 4%? 5%? Higher? What do you think the long-term rate has actually been? I’d actually like for you to guess that in your mind before reading further….

The long-term average from 1900 is…. 4.69%. But that also includes some significant outliers, so when we look at the median, its actually 4.02%. BUT… that also includes the 1980’s. Really when you look at the long-term, it actually just seems like the 1980’s and ’90s were the outliers… but either way, do you think 4% vs. 3% changes the calculus much for equity valuations? Probably some, but not as dramatically as I’ve heard pundits call for (I actually did a simple DCF of a 0% growth company. The equity valuation moved lower by about 8% when the discount rate went up 1%, to 11% from 10%. However that could already be priced into a stock / stocks).

This all brings me to my second topic on interest rates, that I hear quite often as well: “The Fed is raising interest rates so rates are definitely going up.”

Well, hold on now. Didn’t I just mention the 10 year was at 3% in 2013? At that point, the Fed was still buying $85 Billion in bonds each month and its balance sheet swelled to $4.5 trillion (from $0.8 trillion pre-crisis) and kept the fed funds rate at zero in order to stimulate growth. And yet, here we are with that bond buying spree over and the Fed raising the Fed Funds rate and as of today the 10 year sits at 2.88%.

So what gives? One, NO ONE can predict interest rates. And the Fed generally signals very clearly what is planning on doing, so don’t think additional rate rises aren’t priced into the market.

So many factors come into play with interest rates. The main reason pointed to these stubbornly low interest rates has been stubbornly low inflation. That why the Fed has been doing what its doing. However, demographics and even technology play a role in inflation. As noted in an ECB report,

“When the working-age population shrinks and life expectancy increases, the number of wage earners relative to the total number of consumers is expected to decrease. The longer retirement period incites households to save more to smooth out consumption in the future. This puts downward pressure on the equilibrium real interest rate.”

This could be one reason why our inflation and interest rates remain low in the US as the baby boomers age. Another topic I want to make clear is that the Fed impacts the Fed funds rate. This is different than the long-term treasury rate.

The Fed Funds rate is the rate at which banks will lend to each other overnight, so it is very short term. Therefore, it effects other short-term rates as well, like T-bills, since they are substitutes for lenders. That can have an impact on similar tenors of bonds. The Federal Reserve of St. Louis describes it as such:

“Given that movements in the fed funds rate are closely linked to movements in short-term interest rates, but less so to movements in long-term interest rates, changes in the policy rate are likely to impact the yield curve.”

If the past is any evidence, the projected increase in the fed funds rate will successfully raise short-term interest rates but have a limited impact on long-term interest rates. This will imply a reduction in the term premium for bonds and loans.

These observations rely on the Fed not letting inflation stray significantly away from its annual target, which has been set at 2 percent. It is thus likely that, despite the continuing rate hikes, the government, firms and households will all continue to enjoy historically low interest rates on their long-term liabilities.”

That leads us to the current situation, where the yield curve is very flat. That is, the difference in yield between the short-term rates and long-term rates is pretty low. This has historically preceded recessions in the US, though is not perfect. And to be clear, I don’t think we are going into a recession this year.

Unemployment is low which imply less slack in the system, so why do long-term rates refuse to move? No one knows for sure, but one reason could be that long-term investors are not convinced inflation will be a strong as people suspect. In fact, if inflation moves to 3%, holding a 3% 30-year treasury bond would be a real-yield of 0%

So quickly back to consumer staples stocks. Is it time to move back in? I will try to address that in future, company-specific write-ups, but if you are thinking of avoiding the sector now because of interest rates, I hope this write-up challenges your assumptions.

These are generally high-margin sectors that grow very consistently and generate good FCF. There is some disruption going on, but its nothing in the context of the tech sector. At ~15x forward earnings, the sector now appears cheap and I’m thinking of adding to the sector, but will be avoiding more challenged names. For example, before Campbell Soup’s sell off, it was clear that they’re organic trends were challenged and consumers are avoiding high sodium foods. There’s chatter that they may be bought out by Kraft-Heinz, a name I will be doing work on, but for now I’ll pass on Campbell.

Anyway, I digress. Let me know what you guys think

-DD

Investment Philosophy, Personal Finance June 18, 2017April 26, 2020

Are you speculating or investing?

Reading Time: 3 minutes

I think when most people begin to invest in stocks, they buy companies that make a product that they really like or that they think will be beneficiaries of major trends. This seems completely reasonable, but is simple speculation until cash flow enters the equation. Before I get into how I approach investing in companies, I’ll first break down the significant differences between the two, as I think it’s an important distinction and provides a valuable backdrop before we put money to work.

Back in the 1990’s, the commercial internet had just dawned. What was clear was that it would change the way we live forever; what was not clear was how. One new service was going to offer grocery delivery ordered online. It would deliver groceries to customers during a 30-minute period of their choosing. This presumably would change the way we shop for groceries forever (sound familiar?). Their plan was simple; they would raise cash from an IPO to fund investments in warehouses and expand to new cities. Clearly, THIS was the future. The company raised $375MM in an IPO to fund expansion and the company at peak was valued at $1.2BN. Moreover, they had an uber experienced and already successful founder, Louis Borders (of Borders bookstore fame), in addition to top-of-the-line VC money and guidance.

The company was growing too. It achieved 750,000 users, had 3,500 employees, and for the 3 months ended Dec-31-2000, the company did $84MM of revenue compared to $9MM in the 3 month period in the prior year (+833%!). However, the company’s losses expanded to $173MM from $49MM (and cash flow was a similar story) as it tried to expand quickly and needed to invest back in the business. In the end, the company was running out of cash, capital dried up (the tech bubble burst, closing the public equity markets), and it declared bankruptcy in 2001. The name of this company was Webvan if you want to study it further.

Ok, so how is that different than investing? Both investing and speculation involve taking risk. As Ben Graham said, investing inevitably has “substantial possibilities of both profit and loss.” However, in speculation the risk vs. reward is often miscalculated. You believe, since the price of something has gone up in the past, you can anticipate these movements and gain profitably from them. And maybe this strategy works for a little while, but see how similar that sounds to a roulette wheel? “It hit black 3 times in a row… it must be red next time.”

Think about today’s market. Infrastructure spending, tax reform, the next tech event… nothing has actually even been laid out yet, which has allowed investors to write their own narrative. This has led to speculation and driving stocks higher.

When investing, we must take a calculated, fundamental approach to what we are buying, while also being realistic. We are buying an asset that we want to produce cash flows in the future to grow our capital or pay us back. However, we can’t pay any price for it if we want our capital to appreciate at a fast rate – which should be our goal! That philosophy alone also eliminates some “investments” out there, such as art, popular crypto currencies, etc. – to wit, anything that is not a producer of cash.

We must understand the industry, the company’s position, management, and cash flow. Unfortunately, this is harder than speculating, but also can create more significant wealth with much less risk. There is no free lunch, so it does require challenging work, but it can be well worth it and will be the subject of future posts here.

Think about it; is something in your portfolio right now that you’d equate to Webvan? Good concept, excellent product, or immense potential, all they need to do is… make a great leap? Or you’ve seen this stock rise so much in the past, you don’t want to miss the opportunity. This is all speculation and yes, sometimes there is a place for it in our broader portfolios and yes, it can be hard to draw the line between investing and speculating.

In future posts, I will delve further into my investing approach. But for now, I want to leave you with the following; if you have a large speculative position in a company, consider taking some risk off the table in favor of a real investment.

– Diligent Dollar