Chatter from Moscow, Turkey, European capitals, and the confused and confusing White House seems to indicate attempts to avoid raising the price of confrontation, with the hope that internal political problems in almost all countries will lead to lower military commitments. Possible but unlikely based on US actions before WWI and WWII, which appears to be the script that the former Obama White House staff is following through their statements. Focusing on socially restructuring the US economy instead of spending on qualitative and quantitative defensive needs has opened the window for aggressors. This has happened twice before and appears to be happening again. The political focus on US domestic policies and the growing gap in preparedness has encouraged the aggressors to attack.
Bear Market Signs
Current and prior administrations saw imbalances in the economy through a top-down approach. They found it acceptable to increase money supply growth, which eventually led to an increase in the size of the federal deficit that unleashed inflation from its constraints. Today, many look back on 2019 as the base case for a healthy economy, although problems existed on some corporate and personal earnings statements.
Many see the large jump in 2021 earnings and extrapolate those gains further into 2022. However, if one looks at the growth rate from 2018 through 2022, it is far lower than prior growth rates and precedes the anti-profit and anti-trust executive actions proposed by the current administration. We are currently seeing materially lower earnings projections and planned tax increases that will hurt earnings in 2023, which will potentially impact corporate spending in 2022.
The one main securities sector enjoying the current market is the energy sector, which the White House is blaming for inflation and suggesting it should be punished, rather than taking responsibility for its own actions. These actions are not going to lead to increased capital expenditures in the “oil patch”.
Preparing for the Next Bull Market
As I have previously mentioned, I am trying to focus where possible on looking across the valley of the bear market and likely recession to climbing out of the swamp and beginning the next bull market phase. I have written in the past that if one slashes the wrist of a securities analyst, a historian will bleed. One advantage I have over most other market-oriented analysts is access to the portfolio holdings of many open- and closed-end type vehicles around the world. Rounding out this area, I also review the financials of a more limited number of fund management companies. From these inputs, I have gathered some observations that have led to successful long-term investment performance. I intend to share these thoughts with our subscribers through forthcoming blogs.
#1 Biggest Contributor to Performance
Rarely in securities analysis courses or books is the importance of weighting portfolio components attributed to long-term performance results. Interestingly, when writing the Investment Company Act of 1940 at the Mayflower Hotel in Washington, the fund industry lawyers recognized the importance of weighting as a characteristic to fund owners.
Most funds are legally designated as diversified funds, which restricts the initial cost for each security to a maximum of 5%. As a practical matter, very few funds are so concentrated that any position exceeds 5% at cost. Additionally, most funds do not want to have any single position represent more than 10% of the voting shares of a company. Doing so would classify them as an inside investor and would impact the tax treatment of the sale of such a position. Most large funds chose to own many positions, with a large position representing 2-3% of the portfolio. An S&P 500 index fund will obviously own 500-plus stocks.
Every stock, at any given time and price, has its own potential risk and reward in the eyes of investors. By combining these stocks with others, the entire portfolio takes on its own risk/reward characteristics. The smaller the number of positions, the larger the impact of a single position. I prefer a concentrated portfolio when I have confidence in a fund or manager and prefer a portfolio with a larger number of holdings if I am less confident but still want to participate in the market or sector. This is the filter many use in their selection of managers.
Over time, as holdings rise or fall due to changing prices, it is not unusual for a portfolio to have a limited number of holdings do very well while another group does relatively poorly. For illustration purposes, take a highly concentrated portfolio with initial positions of 5% each. After a length of time, the 10 best-performing positions might represent 75% of the portfolio instead of the initial 50%, with the bottom 10 representing 25%. The winners will then represent 3 times the amount of the losers. Without a reversal in fortune, you would be far less diversified and could be more at risk of a loss.
Many of us initially take small position sizes when entering a new position, resulting in many holdings over time. However, some of the newbies don’t work out and some of the larger positions decline in relative value, causing wealth to not grow proportionately. We generally own a number of heavy hitters and a farm team. I recently looked at a very successful portfolio which had grown many multiples of its initial cost. Even though there were very large gains in 10% of the positions and 90% of the stocks were unproductive, wealth grew many times its starting value. This result was due to 10% of the stocks producing 90% of the gains.
One can also weight by industry or investment characteristic. For example, turnaround, new product, low cost, good management, takeover potential, local business, yen-based, etc. The important point in terms of analysis is to divide the portfolio into meaningful segments that lend themselves to making useful decisions.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.