Investing Articles

This section includes mostly evergreen investing advice.
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Should I keep cash in my portfolio?

Another great question that comes with portfolio management is the question of liquidity. Some investors advise to keep 5%-10% in cash in order to seize opportunities. Others will advise to keep a higher amount around 25%-30% in cash to avoid market crashes and be ready to pick-up the market when it is at its lowest.

I personally think you should keep lower than 2% of your portfolio in cash.

I’ll explain you why in a minute. But first, let’s take a look at the theory of keeping an important amount of cash in your portfolio.

Seizing opportunities

Interesting enough, there are lots of pessimists investing in the stock market. Those people are always looking for the next market crash, the next recession to invest their money. They think they are able to make a better return if they “time” their entry in the stock market.

We have already demonstrated that time in the market is more important than market timing. The problem is that it’s nearly impossible to know when the market is about to drop or jump. Therefore, it is a safer strategy to stay the course and ride the market as long as you can.

Now, if you do not have intention to time the market, but rather use lump sum investments during down time, it might make sense in a few occasions. For example, if you receive a sizeable amount of money to invest (an heritage, sell of another asset or a bonus received at work for example), you might want to wait for the next 10% drop of the stock market. Since this happens on a relatively steady basis, you may end-up waiting only a few months or a year before going in the market. This is probably a strategy that is worth it… as long as the market goes down. For example, if you were in this situation in early 2012, there wasn’t a 10% drop before September 2014… after the market went up by 55%. Even after a 10% drop, you still “lost” 45% of market return by waiting on the side lines:

 

Source: Ycharts

This is the main reason for me it doesn’t make sense to have an important amount of money waiting on the sideline: the downside of missing a bull market is more important for me than getting into a bear market. This is even hard to capture a bull market as only 3 calendar years shows losses over 10% over since 1988:

Source: ycharts (note that 2000 shows -9.10%).

In other words, you would need to follow the market closely to identify the 10% drops during a year as a yearly check-up is not enough to capture any market drops. Chances are you would need to check the market every 2 weeks to make sure you capture one (remember how fast the market recuperated from the Brexit of 2016?). Do you have this much time to spend on your portfolio?

Let the dividend payment convince you

The other reason why I prefer to invest almost 100% of my money at all time is the payment of dividends. Imagine dividend stocks in your portfolio generate 3% on average. This is a very easy yield to achieve for any dividend investors, but I rather use conservative numbers (plus you know my affection for low dividend yield stocks). This is a 3% cheque you receive on a yearly basis no matter what is happening on the stock market. This is quite a good payment to keep you waiting and doing nothing. Does your money market fund is that generous?

If you are not in a hurry to cash your investment, letting dividends getting paid and compounding in your portfolio is a much better investing strategy than waiting to capture a 10% stock market loss. As you can see on the previous chart, the stock market rarely stayed in the red very long. Therefore, if you are patient enough, you will not only see your initial portfolio value gaining in value, but you will also get paid a juicy yield in the meantime. And this, off course, is during the worst investing case scenario where you would enter the day before the market crash. On the other side, if you invest at the beginning of a bull market, your return will only get stronger.

Do you still have any doubts by now?

 

Time Horizon and Risk Tolerance

Risk is a crazy thing. Take on too much and you either crash and burn or make out like a bandit. Take on too little and you either just float along or make out like a bandit. The “trick” is figuring out the happy medium that you will be comfortable with. I have spent some time determining what my risk profile is and have asked myself several questions…

  • Do I prefer stability over high returns?
  • How can I make money without risking too much?
  • Do I feel bad when all my friends are making double digit
  • returns and I’m not?
  • My Portfolio is down by 27% (2008), it hurts… how bad
  • does it hurt?
  • Should I sell my stocks and change my strategy?
  • When is the right time to invest in the market? I don’t want
  • to invest right before a crisis!

The funny thing is that I don’t have the same risk profile depending on why I invest. Therefore I have different answers to these questions depending on which account I invest in. For example, my retirement account is fairly aggressive. Therefore, when I invest in my retirement account, I’m 100% invested in stocks. I’m in the stock market for the long run and I don’t fear a market crash.

On the other hand, I’m also putting money aside for my kids’ education. I’ve added 25% of fixed income to this portfolio because I don’t want to risk losing too much in this account. Furthermore, I’m also saving money for my nephew’s education. Since this money is set aside for a gift, I have put 75% in fixed income and the rest in equity. As you can see, I manage three portfolios from 100% in stocks (retirement account) to as little as 25% in stocks for my nephew.

The time horizon for your project (that you previously defined) will also affect your investor profile. If you plan a trip in 9 months, skip the stock market and put your money in a savings account. If you are about to retire, you can still take a good amount of risk as chances are you will be living off your investment for 30 years (I bet you didn’t think of this one, huh?).

For each account, you should ask yourself the same question. Contextual reasons may encourage you to take more or less risk. Here’s a quick definition of different investment profile:

Conservative:

You have a need for a predictable flow of income or have a relatively short investment horizon. Your tolerance for volatility is low and your primary goal is capital preservation.

Moderate:

You seek a regular flow of income and stability, while generating some capital growth over time. Your tolerance for volatility is moderate and your primary goal is capital preservation with some income.

Balanced:

You’re looking for long-term capital growth and a stream of regular income. You’re seeking relatively stable returns, but will accept some volatility. You understand that you can’t achieve capital growth without some element of risk.

Growth:

You can tolerate relatively high volatility. You realize that over time, equity markets usually outperform other investments. However, you’re not comfortable having all your investments in equities. You’re looking for long-term capital growth with some income.

Aggressive:

You can tolerate volatility and significant fluctuations in the value of your investment because you realize that historically, equities perform better than other types of investments. You’re looking for long-term capital growth and are less concerned with shorter term volatility.

Action of the day: Setup your investing profile

To answer this tricky question, there is nothing better than answering a questionnaire. I’m sure you have answered this sort of thing before. They seem cheesy sometimes but trust me; it will help you put things into perspective. Based on my experience, I feel that most people believe that they are braver than they are! The real investor in you tends to show up when the market crashes. Speaking of which, I found this investor questionnaire over @ Vanguard . I’m in no way linked or paid by this group to refer you to their risk profile questionnaire. I just find it is one of the best around since they help you relate to 11 questions that include practical facts that happened in 2008. With no surprises, I finished mine with a 100% stock profile:

What’s yours?

 

Valuation Guide for 2017 + 3 Undervalued Companies

I personally think 2017 will be a good one for the stock market. After going sideways during 2015 and the first couple of month of 2016, the economy has been put back on track with solid numbers and the stock market follows. However, after a strong bullish market since 2009, buying opportunities are getting rare. This is why a strong valuation process is important.

My Favorite Tool for Valuation

There are tons of methods to value companies. Each of them have their pros and their cons. My favorite one is the Dividend Discount Model. It helps me looking at each company as it was a money distributor (I kind of like this idea!). By discounting the value of each dividend payouts, I get an idea of how much I should pay for shares of company XYZ.

The DDM is relatively easy to use, but could sometimes be misleading if our assumptions are to optimistic. By using a low discount rate (meaning you don’t expect much return) or by boosting expected dividend growth rate, you could easily find deals everywhere on the stock market. Therefore I’m offering a small refresh on how I use it.

How to adequately select your discount rate

By definition, the discount rate should correspond to your expected rate of return. If you invest in the stock market, you should expect a minimal return of 7-8%. However, if you use such a low discount rate to make up a value using popular models such as the Discounted Cash Flow analysis or the Dividend Discount Model, you will find that pretty much all dividend growth stocks are trading at a discount. This is not true either.

I try to become more selective in my approach. This is why I use a discount rate between 9% and 12%. When a company is in stellar condition, I will use the 9% discount rate. However, this company must show most of the following criteria:

  • geographically diversified (being a leader in several countries)
  • diversified products (many billion dollar brands)
  • solid balance sheet (low debt and high repayment capacity)
  • unique economic moat (a competitive advantage nearly impossible to replicate)
  • steady and increasing revenue streams

Such companies can be found but they are rare. Most of the time, I find a solid company showing most of those criteria, but there is always something leading me to use a higher discount rate. This is why I pick 10% as a default discount rate. I use 1% less (9%) for exceptional companies and 1% over (11%) for riskier companies. Rarely, but sometimes it happens, I use a 12% discount rate when I think the company has a strong upside potential but also shows some serious issues. I tend to never have more than 10% of my portfolio invested in such companies.

Using a sustainable dividend growth rate

When I see investors using an 8% discount rate, I find it’s not greedy enough. I think they put their investment at risk thinking all their investment will reward them with a 8% return. We all know this is not true and you need stronger picks to compensate. This is why using a 10% discount rate will push many companies aside at the valuation stage.

A similar thinking should be applied toward dividend growth rates. I like using the double stage dividend discount model calculation as I can use 2 different rates. A first one that will be good for the first 10 years and another one that will be used forever after. The first rate could be more generous if it reflects the current situation of a company. When a business is growing in a flourishing economy, we can believe it will become more generous with its shareholders for the time being. After that, it is time to become more reasonable and expect a more conservative rate. The idea is to find the balance between the past 5 years that has simply been amazing and the next 25 years where we can’t really know what will happen.

The Dividend Discount Model – 3 Undervalued Companies

In order to illustrate how I use the double stage dividend discount model (you can check the excel spreadsheet here), I selected 3 companies with undervalued share prices. Those will be a good start for your potential buy list for 2017.

Clorox (CLX) Potential Gain: 43%

The reason an investor would pick CLX to be part of his portfolio is somewhat obvious: it is an ever increasing dividend stock. Clorox is part of the selective group of dividend aristocrats that has increased its dividend for at least 25 years consecutively. In 2016, they have reached their 39th consecutive year with a dividend raise.

The company goals are to support a 3-5% organic sales, improve margins by 25 to 50 bps and to generate free cash flow of 10-12% of sales.

Calculation:

 

Results:

Source: Dividend Toolkit Spreadsheets

Lowe’s (LOW) Potential Gain: +30%

Focus on a recovering U.S. economy and additional growth from acquisitions should continue to push LOW’s stock price higher. Its strong brand and the way it helps its customers to go through bigger projects by offering a “one-stop-shop-&-advice” service will secure LOW’s market share and improve margins over the long haul. Lowe’s has been able to transform a simple home product store into a great service offering for home projects. There is definitely more room for growth in the upcoming years.

Calculation:

Results:

Source: Dividend Toolkit Spreadsheets

Honneywell (HON) Potential Gain +32.5%

Honeywell has made impressive efforts to improve their internal practices over the past 15 years after failing to merge with General Electrics (GE). Those efforts paid well as the company operating margins improved from 7.6% in 2004 to 15.2% in 2014. Those impressive margin increase lead HON EPS to increase by 10% in 2015 as the company is facing a challenging economy. The company was also able to increase its dividend by 10% CAGR over the past 5 years. HON is a leader in the aerospace control and safety systems and should benefit from its leadership position during the commercial aircraft upcycle.

Calculation:

Results:

Source: Dividend Toolkit Spreadsheets

 

Disclaimer: I hold CLX and LOW in my dividendstocksrock portfolios.