September was painful.
And if you’re like many investors, you look at your portfolio and wonder if it needs pruning.
After all, when the markets look south, mediocre stocks that were profiting from a bull market are often exposed for the impostors that they are, because they fall quickly.
So what is a powerful yet simple approach to portfolio maintenance?
This is what our macro specialist and the editor behind Investment report, Eric Fry, details today. As he writes below, “You don’t want to strive for success in your investments by betting on luck. Instead, you want to put the odds in your favor as much as possible.
If the weakness of September revealed that you have “luck” in your wallet, it is the Digest for you.
I’ll let Eric take care of this.
Have a nice week end,
Your “Spark Joy” portfolio?
Marie Kondo, the “decluttering” guru, has made millions of dollars by devising and popularizing a common sense method for purging a house of unnecessary and unwanted “stuff”.
Kondo’s decluttering strategy – called the KonMari method – follows six basic steps. It begins with an explicit commitment to tidying up and asks a key question: do the items you want to keep “bring joy”?
Those items that stir up joy should stay; those who don’t should go. And this method isn’t limited to the dusty, unread books in your collection, the waffle iron you haven’t used since your wedding, or the contents of your attic …
Investors could also get rich, just by applying some of Kondo’s clean-up tactics to our portfolios.
Even some of the most seasoned and savvy investors fail to tidy their portfolios the way they should. Indeed, tidying up a wallet requires an explicit commitment to do so … as well as an unbiased analysis that poses a version of the question: “Does this item bring joy?” “
Of course, not all worth the investment “will bring joy”, but it should trigger some sort of powerful and obvious positive response.
Remember, like the KonMari Method, your goal is to identify the items you want to keep, not the items you want to throw away. The discard is simply the by-product of what you want to keep.
Spark “Yes! “
If you look at every stock in your portfolio and honestly ask yourself, “Will this stock make me rich?” Or “Will this stock be a 10-bagger?” “, The answer should always be” Yes! Resounding!
But if the answer is “No”, the stock does not belong to your portfolio, even if it is a safe bet or a household name.
These kinds of investments can be good. But very few investors focus on the “good”, because in the investment world, “good” is synonymous with “opportunity cost”.
It’s certainly not good in my book.
“Opportunity cost” is a term of regret which refers with regret to “what could have been”; it describes the consequences of an erroneous or sub-optimal choice between competing possibilities.
Analysis of opportunity costs can and should be part of an investment discipline that emphasizes buying extraordinary investments, rather than ordinary or “quality” investments.
Obviously, none of us know exactly what the future holds. Therefore, opportunity cost analysis is an inaccurate science. In fact, that’s an educated guess.
Based on decades of stock market history, we know a few key details about what produces successful investing over time. For example, we know that:
- Fast growing companies tend to produce better investment results than slow growing ones …
- Cash-rich companies tend to produce better investment results than heavily indebted companies …
- And companies with a formidable “gap,” as Warren Buffett calls it, tend to produce better investment results than companies without any particular competitive advantage.
So, when we look at stocks in our portfolios, we should favor those that have one or more of these winning traits.
Now, some stocks that have serious flaws will still counter the odds and perform well anyway. Sometimes heavily indebted and slow growing, companies find a way to reverse their decline and become major successes. But companies like this are rare outliers.
You don’t want to continue your investments by betting on luck. Instead, you want to put the odds in your favor as much as possible.
And I found a way to do it …
The “Purge of the portfolio” formula
Calculate the size of a company’s net debt, then divide that number by the company’s annual revenue … to produce a simple ratio:
[Net Debt Divided by Trailing 12-Month Revenues]
Generally speaking, the higher the ratio, the more likely a stock is to perform worse over the next five years. The lower the ratio, the better the performance of a stock over the next five years.
That’s it. This is the whole process.
I regularly use this simple test to identify potential investments. (Obviously, my research doesn’t end there.) But once I identify a potential investment, I qualify that title by conducting additional targeted qualitative and quantitative research.
Some investment candidates are making the cut. Most don’t.
But here’s the craziest: This simple two-part test, on its own and without any additional research, can produce impressive investment results.
As you know, investors always make something worse – whether it’s success… or mistakes… or boredom. This is why smart stock to avoid is as important as smart stock picking.
Knowing which stocks to avoid can do wonders for your portfolio – and can protect you from the dangers of opportunity cost.
But what many investors don’t realize is that the opportunity cost is often hidden in what appears to be good stocks – well-known and popular stocks. Openly risky securities claim few victims. Everyone knows they are risky and is preparing accordingly. But familiar “safe” headlines are often the ones that produce disappointing or even disastrous results.
The secret ingredient
This “Portfolio Purge” formula becomes even more effective by adding a little refinement.
I’m not going to reveal this specific refinement because I consider it unique to my investment process, but it turns out that by adding this refinement, the predictive value of my debt / sales analysis becomes even more reliable.
Moreover, my refined analysis does not just identify a “last 10”. It also identifies a “Bottom 25”… or an even greater number of diseased stocks, depending on market conditions.
At the end of 2019, I ran my refined debt-on-sales filter on the S&P 500, ex-financials, and it produced the “Bottom 25” list below. Based on historical trends, these slow growing, heavily leveraged stocks, as a group, will struggle to keep pace with the broader stock market over the next five years.
Then, on June 30, 2021, I calculated their results for that period. On average, this group performed as poorly as I expected. 80% of them performed worse than the S&P 500 during the measurement period, including nine of the 25 stocks that produced a loss.
Therefore, even though five of the 25 stocks managed to outperform the S&P, the average return of all stocks in the group was 12%… or only a third of the 36% gain of the S&P 500 over the same period.
A few weeks ago, I again went through all of the NYSE’s mid and large cap stocks through my exclusive filter, and it eliminated the 12 stocks you see below. Already, most of the stocks on this list are misbehaving. Since the date I created this list, only two of the 12 stocks have outperformed the S&P 500 Index.
If these companies continue to go into debt faster than their income, they will find it difficult to maintain their dominance. The trash of financial history is full of famous American companies that ended up being lost… and perished.
Surprisingly enough, this updated list includes iconic American names like McDonald’s Corp. (MCD), IBM Corp. (IBM), and The Coca-Cola Co. (KO). But even world-dominating companies like these are subject to the basic laws of economics.
To be clear, I’m not suggesting that McDonald’s or Coca-Cola are in immediate financial danger. But what I’m suggesting is that these companies have become so heavily leveraged that their stocks are likely to perform relatively badly over the next several years.
This is the essence of a portfolio purge: avoiding underperformers in order to make room for outperformers.