Asset Allocation – The Future Is Uncertain
The heart of any investment policy is the asset allocation decision. Asset allocation is the most important determinant of investment results – the higher the percentage invested for growth (risky assets), the higher the returns should be, over time. There are three ways to determine what is an appropriate allocation in equities; need for income, time horizon and tolerance for risk. The first two are quantifiable; the latter is subjective. Once a target allocation has been arrived at, we recommend keeping it steady. This constant allocation approach is designed to prevent large ad hoc changes to the portfolio’s mix. We have been trying to find someone or some way to reliably predict the future direction of the stock market and we are still looking. The future is uncertain, we have concluded. Therefore, we want to react to what the markets have done rather than trying to anticipate what the markets will do. As Peter Lynch likes to say, “if you spend five minutes in a year worrying about the economy, interest rates or the stock market, you’ve wasted three of them, because nobody knows”.
To illustrate, if we determined that a 40% to 50% weighting in equities is appropriate and, if stock markets go way up, then the percentage invested in common stocks will have gone up. The discipline will require that no more shares be added, regardless of how appetizing stocks might seem at that time. This disciplined approach leads to small, incremental changes in the portfolio mix while allowing us to remain invested in our favourite companies. We are convinced that the best returns come from investing in successful companies over the long haul.
Fixed Income – The Laddered Maturity Schedule
The basic tenet of our investment philosophy, that the future is uncertain, also has implications for that part of an investment portfolio that is invested for predictable returns. We avoid large switches from long-term bonds to short-term bonds and cash when it appears interest rates are headed higher. A laddered maturity schedule removes any anxiety over whether rates today are ‘good’ or not. By arranging fixed income investments so one comes due in regular intervals, we know that we will get an average return which will be significantly above that offered by short-term notes.
Similarly, we think it is a mistake to reach for yield by sacrificing quality. Top quality fixed income investments maturing at regular intervals provide predictable income. But, very importantly to us, the short-term portion of a fixed income portfolio also provides the liquidity necessary to profit from the periodic bargains the stock market can provide.
Investing for Growth – Importance of Diversification
We live in an era of extreme volatility. The easiest way to manage risk is to diversify. Different types of assets (debt or equity), and a mix of fixed income maturity dates all provide diversification. But diversification is particularly important in the growth component of a portfolio. To choose stocks we do not focus on quarterly earnings, rather we start by identifying social or economic trends that we think will be valid for the next decade and then try to find attractively priced companies that are poised to profit from those changes. Once we have identified reasonably valued companies in attractive industries, we buy and become patient investors on behalf of our clients. Broad diversification between companies, industries and economies protects against the changing fashions on Wall Street and minimizes the risk of large mistakes.
Investing in Value - The Unloved
We are value investors. An important part of our valuation is to identify companies with a history of high free cash flows and return on invested capital. We seek out stocks that have favorable long-term economics but that are inexpensive for reasons that we think will turn out to be temporary. We then determine a reasonable price to pay for those earnings today and then stay with the stock over the long haul. Legendary investors Ben Graham and Warren Buffett have proved the success of this model repeatedly.
Investment Styles - For Individuals
Some investment styles don’t work for individuals. When dealing with individual clients, a portfolio manager must consider taxes – short-term decisions cannot be made based on the investment outlook alone. Money paid out for taxes in the short run affects the total after-tax return for individual clients in the long term. Every dollar paid out in taxes is a dollar not invested.
A style that relies heavily on market timing is probably not appropriate for individual clients. On average, 90% of a full year’s return has been achieved in the single best month of the year. Therefore, transactions for individuals have to be made on a fundamental basis rather than short-term market moves.
Measuring Results – Time-Weighted Rate of Return
The time-weighted Rate Of Return is how we keep score. Returns are adjusted to take into account the timing of any additions or withdrawals from the portfolio so the return is comparable to alternatives. We use a variety of benchmark returns to provide a basis for comparison.
Most individuals drastically underestimate their time horizon. Portfolios should be managed to meet long-term investment objectives and measuring results over too short a time period can distract from that. A regular business cycle is four years and performance should be evaluated each year with that in mind.
Management Fee
Our all-inclusive management fee is based on the market value of your portfolio. There are no additional costs for custody or trading. Our fee-based approach eliminates impediments to efficient portfolio management caused by transaction fees. We believe this is a more professional basis by which to manage your investments.
