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Nov 15, 2008

Portfolio Repair Kit

By Andrew Mickey, Q1 Publishing

It’s been a long, long year for most investors. Almost no one has been immune from this sell-off. We’re in the midst of a global financial crisis and the world is changing at an incredibly rapid pace.

Wall Street firms that have been around for more than a century have disappeared overnight. Some of the world’s biggest banks have collapsed.  Others are on the verge of collapse. The U.S. government has stepped in with more than $1 trillion in guarantees, loans, and has become part owner in private enterprise.

The Dow has fallen back to late 90’s levels. The once hyper-growth markets of India, China, Russia, and Brazil have dropped 75% or more. There’s been almost no place to hide.

The recent fall-off has quite a few people questioning whether it’s safe to get back into stocks yet. In other words, “Is now the time to buy stocks?”

To be blunt, only you can answer that question. There are a lot of factors to consider like your personal risk tolerance, cash cushion, how well you’ve played this downturn, etc. Despite it all, there is something you can do to get your portfolio back on track.

This time-tested strategy will help you:

- Limit risk
- Get positioned for a big win when the markets recover
- Watch with pleasure as the market drops
- Sleep soundly whichever way the markets head

All without having to buy or write option contracts or engage in any other highly leveraged trading scheme.

In fact, using this strategy will you make fewer trades (pay fewer commissions), get hit by fewer taxes consequences, and ensure you’re on the good side of the markets.

Frankly, it’s the best thing you can do right now. And in the next few minutes you’ll see why:

USA Today says this strategy prevents “your entire investment going down with the ship.

Kiplinger’s personal finance magazine says this is “always a smart move.”

CNN Money says it is “A way for you to get your dollars working on Wall Street with less risk...”

Let’s get one thing straight, you must not blame yourself. What’s in the past is in the past. It’s OK to make mistakes. Repeating your mistakes is the problem. In a “bear market” almost everyone is on a losing streak.

Portfolio Repair Kit: Don’t Blame Yourself

They say misery loves company. If that’s the case, then this party is jam packed. Very few investors have successfully negotiated the market conditions of the last year.

This is no time to dither. Or to blame someone else. Or second guess yourself. You are in very good company. This bear has eaten almost everything in its path.

Commodities, oil, gold, financials – they’ve all come tumbling down. And it’s not just America that’s been hit. The stock markets of Brazil, Russia, India and China have plummeted 36 percent on average. The entire MSCI Emerging Markets Index dropped by 30 per cent.

Perhaps the best way of illustrating the savageness of this bear market is to analyse the recent portfolio performance of four of the most famous powerful“Stock Gurus” on the planet. 

Bruce Berkowitz started the Fairholme Fund (FAIRX) in December 1999. The fund has crushed the competition, achieving five-year annualized returns of 16.51%. But in the 2008 FAIRX shed $1.5 billion in value.

Ken Heebner manages the $9 billion CGM Focus Fund (CGMFX) which has chalked up astounding historical average returns of 25% a year. But this year Heebneer’s fund is down 16%.

Martin Whitman manages the Third Avenue Value Fund (TAVFX). From inception in November 1990 through October 2007, his fund has returned an annualized average of 16.83%. Whitman is a "buy and hold" value investor. His fund is down 23% this year.

Bill Miller runs the $60 billion Legg Mason Value Trust Mutual Fund (LMVTX) which beat the S&P 500 index for 15 consecutive years from 1991 through 2005. But in 2008, LMVTX has lost 40% of its value.

Almost everyone has gotten caught up in this mess. The all-time legends are no different. But they’re not turning tail and running away. They’re facing their problems head on and moving forward.

They’ve been investing for decades and they know there’s a light at the end of the tunnel...as long as you stay disciplined.

Portfolio Repair Kit: Check your Emotions at the Door

Emotions are vitally important in everyday life. They guide us in our relationships, our assessment of co-workers, and our ability to digest a work of art. They make life worth living. But emotions can lead to poor investing decisions.

In fact, what feels right is probably wrong. Money has its own logic. And 99% of the time it trumps your “gut feelings.”

For instance, psychological studies have proven that somebody who loses an $80 football ticket on the way to the game is unlikely to buy another ticket. But if a football fan loses $80 cash en route to buying the ticket, he will probably go to the ATM and take out another $80 and purchase the football ticket.

Why?

Because the replacement cost feels smaller when it is coming out of a larger fund (your bank account). Strong emotion...Zero logic.

Unless we remain vigilant, it is easy to make similarly poor decisions. Trying to “replace” lost value in a portfolio by taking big swings is one of the worst things you can do.

The most seductive (and therefore common) mistake is to spontaneously sell off a badly performing portfolio. Although pretty much everyone understands the wisdom of “Buy Low, Sell High”, the history of the stock market proves that most investors do exactly the opposite.

Mutual Fund redemptions are always greatest at the bottom of the market (when investors are discouraged) and there is a frenzy of buying at the top of the market (when investors get caught up in the good vibes).

Emotionally, it feels better to buy something “healthy” and sell something “sick.” In the case of a damaged portfolio, the “selling-impulse” is amplified by the desire to make a “bad investment” go away. “I’ll sell this horrible thing, so that I don’t have to look at it.”

The tech bubble is the perfect example. In 1999 and 2000, money flowed into technology-focused mutual funds. At the peak of the tech bubble in March of 2000, about 80% of all money in mutual funds was in the technology funds. All of that new money pushed the Nasdaq to a peak of more than 5,000.

When the downturn came, the leading technology mutual funds lost about 80% of their value. The Nasdaq plummeted back to 1,000. And most mutual fund investors weren’t selling out along the way.

Ignore your emotions. Sell nothing, do nothing, until you have analysed your holdings, and the markets with a cool head and an empty heart.

Portfolio Repair Kit: Know Your Timeline


More than $19 trillion of global wealth has been eliminated this year. U.S. retirement accounts have shed more than $2 trillion in value so far.

It’s a full-on bear market. But if you take a step back and look at history, you can see light at the end of the tunnel.

If you consider a bear market a drop in the Dow of 15% or more, there have been 25 bear markets in the past 110 years.

Most of the bear markets have lasted between 12 and 24 months. The average decline is between 20% and 40%. The worst one was following the crash of 1929, when the Dow fell more than 89%. And the shortest one lasted a mere 10 months in 1960, when the Dow fell only 17%.

If we consider this bear market started in October 2007 when the Dow hit 14,000 we’re probably looking at between 6 and 13 months and another 10% to 30% or so until we hit bottom.

Now it’s time to discuss what kind of stocks you should be buying in a bear market.

Portfolio Repair Kit: Story Time is Over

During a bear market, “story stocks” die a long and painful death.

The outline of the story is usually a macro-fundamental situation that appears to favour the enterprise in question. Rising zinc prices, planned construction of nuclear power plants, aging boomers etc.

The details of the story explain the particular advantage the company has.  A “story stock” might be a massive tract of mineral-rich land in Mexico. Or a thick vein of uranium in the tundra.  Or a prototype of hot tub jets with energy-saving impellors.

Investors listen to these stories because they occasionally turn out to be true. And when they do, there are huge profits to be made. And even when they are not true, if you are one of the first believers, you can ride the stock up, get out before the enthusiasm dies, and make a killing.

This kind of speculative investing is fun, challenging, and can have huge rewards. But it is not something that you should do in a bear market. It’s risky even in a bull market. In a bear market you may as well toss your money into the wind.

Price-to-hope is not a sensible way to value stocks. In a bull market you can get away with it, but they are always the first stocks devoured by the bear, and the last to recover. You’ve got to find companies which:

·         Produce high amounts of free cash flow

·         Have the ability finance their own expansion through cash flow

·         Are able to expand margins and market share despite a dragging economy

·         Have low P/E, Price to book, and interest coverage ratios

Even more importantly though, look for stocks that pay a sustainable dividend. Regular steady dividends not only provide steady income, they prove how strong a company is. When markets are at their worst, that strength is rewarded.


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In a bear market, a healthy dividend yield ensures that you are receiving some cash flow from the company you have invested in.

Companies that don’t pay dividends are able to spend any excess cash on expansion and acquisitions. This can be beneficial in good times. But when hard economic times hit, companies that are trying to expand are swimming upstream.

Companies that pay regular dividends tend to be businesses with an established customer base and products that are always in demand. They know how to hunker down during rough times.

Historical analysis of the S&P 500 Index strongly supports the idea that dividend yields can be used to obtain higher stock returns. The portfolio of the investor who bought High Dividend Yield Stocks is worth 400% more than the investor’s portfolio who just bought the S&P 500. The high dividend stock portfolio was worth 700% more than the Low Dividend Yield portfolio.

Type of Stock

Annual Return

Beta

High Dividend Yield

15.7%

.9336

S&P 500

11.2

1.000

Low Dividend Yield

9.7

1.210

 

Portfolio Repair Kit: What to do Now

With the markets in sharp decline, it’s time to make some moves. Our long time readers have been getting prepared for this time for a while now.

We’ve warned of the impending market crash for almost a year. One of our top picks was cash...get plenty of cash. When the markets sell off there will be fantastic buying opportunities.

For all of Q1 Publishing’s new readers, there are a lot of things you can do.

You can sit on the sidelines and wait. That’s safe – and much better than selling in a panic - but your money’s not working for you. You can make a lump sum investment in the markets and hope we’ve reached bottom. But all you really have is hope and luck. The best thing to do is to set up a systematic buying program.

The best thing to do now is to start dollar cost averaging (DCA).

DCA is an investing technique that is extremely useful during any kind of market. But it becomes especially useful in bear, flat, and volatile markets. It reduces the risk associated with making a lump sum investment.

It sounds like a market timing strategy. But in fact its main purpose is to remove the timing investments from the investing process.  DCA prevents you from having to take a big loss if the market drops shortly after making your lump sum investment.

It’s a pretty basic idea: spend a fixed dollar amount at regular intervals on a particular investment, regardless of the share price.

The premise of dollar cost averaging is that the investor is buying insurance against the market losing value shortly after making his investment.

Since the market has a positive mean rate of return, dollar cost averaging usually requires the investor to give up some expected return for the benefit of reduced variance in his eventual outcome.

Dollar Cost Averaging In Action

Investment

Bear Market

Bull Market

Volatile Flat Market

$6,000 Total

Share Price

Shares Purchased

Share Price

Shares Purchased

Share Price

Shares Purchased

$1,000

$20

50

$20

50

$20

50

$1,000

$19

52.63

$21

47.61

$22

45.45

$1,000

$18

55.55

$22

45.45

$24

41.66

$1,000

$17

58.82

$23

43.47

$18

55.55

$1,000

$16

62.5

$24

41.66

$16

62.5

$1,000

$15

66.66

$25

40

$20

50

Total Shares

346.16

268.19

305.16

Ending Value of all shares

$5,192

$6,704

$6,103

DCA - Gain (Loss)

($808)

$704

$103

Lump Sum – Gain (Loss)

($1,500)

$1,500

$0

 

Portfolio Repair Kit: No Guesswork, No Emotion

As stated, DCA is an investing technique that is most effective in bear markets.

It reduces risk while removing a lot of the stress created by the ups and downs of the market. Right now, those ups and downs are extreme. With hedge funds imploding and sparking massive sell-offs, and radical government policy sparking brief rallies, the markets are extremely volatile. DCA helps cut out a lot of the stress that comes with this volatility.

In fact, if you execute a DCA strategy over the next two years, it will help you avoid   some of the most violent market swings of the past 80 years.

DCA will keep you protected, and allow you to benefit from any further market declines.  Most importantly, it will position you for market rally, when it comes.  And history teaches us that it will come. Bear market, bull market, or flat market, DCA will ensure you’re doing just fine.

DCA is not a new strategy, but when panic sets in, it is one that often gets ignored. If you’re like 99% of investors, your portfolio has just taken a beating.  To repeat, this is not your fault. You are not alone. If Warren Buffett’s company Berkshire Hathaway (NYSE: BRK-A) can shed $40 billion in three weeks, there is zero shame in you taking a hit.

The most important thing is to develop a plan and keep a clear head. It’s imperative to remember that no matter grim the market is, it is always possible to take positive action. We are looking forward to providing you with more information and guidance by offering you a complimentary subscription to the Prosperity Dispatch.

Good investing,


By Andrew Mickey
Chief Investment Strategist, Q1 Publishing

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