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Four Ways to Make More and Lose Less
Posted by: David G. Dietze, JD, CFA, CFP (IP Logged)
Date: August 9, 2012 03:26PM

Amid the long hot days of the summer our thoughts turn to vacation, with languorous days on the beaches or in the mountains. But, don't let your nest egg also kick back.

Unfortunately, too many of us are doing just that. CNN reports that investors pulled another $2.1 billion out of domestic equity funds in the week ended July 25. That continues an ugly trend, with over $57 billion yanked from those portfolios in the first half of this year, accelerating a similar pattern from the first half of each of the prior years: In 2011, these funds saw outflows of $13.6 billion, while 2010 saw withdrawals of $24.6 billion.

Where is the money going? Bond funds are getting the lion's share, with $129 billion added to those portfolios in 2012's first six months, outstripping the $35.4 billion deposited there in last year's first half.

Although fixed income is an important segment of all investors' portfolios, as high quality bonds reduce volatility and provide income, based on current interest rates this behavior seems odd. After all, interest rates are at their lowest levels ever, going all the way back to World War II. So, why would you want to stock up on something whose prices have never been higher and income never lower?

No question, there are concerns out there. The European sovereign debt crisis seems the most intractable. In a nutshell, the southern European countries have spent beyond their means, and appear unlikely to be able to discharge their debt.

Unfortunately, the eagerness to let them bear the consequences runs smack into the reality that their failure will have dire repercussions on the rest of Europe. So, the bullish case is that ultimately, for the sake of jobs, political elections, even peace, the Euro printing presses will get cranked up to help. Indeed, Mario Draghi, the current head of the Euro Central Bank, recently vowed to do "whatever it takes to preserve the Euro". Naysayers were then warned "believe me, it will be enough."

A second concern is the so called fiscal cliff when, on January 1, absent legislative action, taxes will soar and spending slow. That, according to most economists, will produce immediate recession. Fortunately, our lawmakers can avert this predicament. In that sense, the fiscal cliff is totally avoidable.

Consider what happened last year. We faced a similar cliff, as Washington debated whether to continue honoring US debt. While we stared into the abyss, and one major rating

agency downgraded our debt, lawmakers did what they had to do, which is to honor our national obligation. Investors who stayed the course were well rewarded. One year from the height of the controversy, August 6 of last year, the S&P 500 has returned 18% while long dated US Treasuries provided a total return of nearly 30%.

Needless to say, abandoning your long term investment plans in fear of the next fiscal cliff is a grave error. Attractive ideas for the long term are below:

Stick with the Blue Chips

Despite US equities having risen nearly 13% so far this year, they are poised to continue to reward. On an absolute basis stocks are still attractively priced, with the Dow sporting an earnings yield of over 7.5%. Historically, earnings have risen close to 6% annually, so that type of return plus growth makes domestic equities deserve a cornerstone role in any well diversified portfolio.

Relative to fixed income, stocks are a steal. Few realize how rare it is for the dividend yield on the S&P 500 (2.1%) to exceed that of the ten year Treasury (1.6%). It's only happened a couple of times since World War and invariably that was a good time to buy stocks. That makes sense, too. An interest rate on a bond is fixed, while dividends have historically risen at over 5% annually. So, now not only are you starting out with more income, but historically that income has grown.

Intel (INTC) is a good example of a blue chip whose common stock yields more (3.2%) than its bonds (ten year at 2.3%). Stick with the blue chips.

Go Overseas

Several years ago the mantra was invest offshore; overseas bourses were less exposed to our subprime crisis, droopy dollar, and struggling economy. Countries overseas were going from donkey to SUV and carrier pigeon to cell phone in one generation; thus, their stocks offered tremendous opportunities.

Fast forward. The overhyped virtues of investing overseas have been replaced with worries about recessionary, debt ridden economies (Europe), infrastructure challenges (India), and slowing growth (China). A pullback in commodity prices has hit countries like Brazil hard, while Japan's nuclear disaster further weakened confidence.

You might have thought that the debt showdown last August would have queered sentiment on the United States. Actually, it did just the opposite, as investors increasing viewed the US as the cleanest shirt in the dirty laundry pile.

For the 12 months ending July 31, long dated US Treasuries, despite the Standard & Poor's debt downgrade, advanced 31%, as reflected in Fidelity's Spartan Long-Term Treasury

Index Fund (FLBIX). Our domestic S&P 500 index, including dividends, barreled ahead over 9%. But, the hapless overseas world, as reflected in the MSCI EAFE index, was pummeled over 14%.

That's quite a disparity, with a near 50% performance gap between the overseas index and the Treasury fund, and a near 25% disparity between the two stock indexes. Plus, the overseas index now yields more (3.3%) than both the fund cited (2.8%) and the S&P 500 (2.1%).

Investors should now be rebalancing their portfolio in favor of overseas investments. How to play it? Keep it simple and inexpensive by using an index fund, like Fidelity's Spartan International Index Fund (FSIIX) for broad exposure.

Or target best in class companies clearly cheaper because they are based outside the US. Consider Vodafone (VOD), the second largest cell phone company, a crown jewel of which is its 45% stake in Verizon wireless. Of course, you could get exposure from that stake by buying Verizon (VZ) itself, but then on several important metrics you'd be paying more. Verizon has a lower dividend yield (4.5% versus Vodafone's 4.9%) and a less attractive price to earnings ratio (14.7 versus Vodafone's 14.1). In many ways Vodafone has a more attractive set of assets, since it's not saddled with Verizon's moribund land line business.

Consider also Teva (TEVA). Although based in Israel, it's the globe's largest generic drug company, and boasts operations in 60 countries. Generics have a bright future, as they represent a lower cost way to bring the miracle of drugs at an affordable cost to the world.

You'd think that you would have to pay a premium for the 800 pound gorilla in generics, to reflect its greater marketing, research, and overall financial strength. But, in fact, based on its price to earnings and price to cash flow Teva trades at a discount to two smaller domestic competitors, Mylan (MYL) and Watson Pharmaceuticals (WPI).

You don't have to be a Gold Bug to See Value in Gold Stocks

All commodities and especially gold have been wonderful performers over the last decade. Gold's seen by many as the "anti-stock", a great hedge on overvalued financial assets. It's risen from just $300/ounce in 2002 to over $1900/ounce in 2011 before retreating to close to $1600/ounce.

Where does it go from here? A case can be made to avoid it. After all, it's had its run, it's unproductive, it pays no yield. Or, you can see it as the ultimate insurance hedge against over indebted economies which now have little choice but to inflate away the bad debt.

Stocks in companies that mine gold, however, may be a way to profit even if gold fails to rise. Gold stocks have cheapened considerably in the last year; Fidelity's Select Gold Fund (FSAGX) has dropped nearly 25%.

Although many metrics could be used to measure a gold producer's value, one that has intuitive appeal is simply to compare the amount of ounces available to be mined ("proven and probable reserves") against the company's market capitalization. One of the biggest and best known names, Newmont Mining (NEM), looks very cheap on that basis, effectively just $222/ounce.

To reduce the risk of investing in just one gold miner, buy a basket of precious metal producers. We recommend ASA (ASA). This closed end fund offers exposure to Newmont and other top flight miners in a professionally managed portfolio. We also like that it trades at a near 7% discount to the net asset value of its holdings.

What to Avoid?

We are not fans of social media stocks. Sure, it's fun to have a community bulletin board and shadow your kids. Numbers of users, clicks, and amount of time wasted on the sites are all great metrics, but at the end of the day it doesn't pay the rent. Investors need to see a clear path to profitability, and it needs to bear some reasonable relationship to investment outlay. The rapid transition to mobile devices leaves less room for advertising, and we need to see business models that successfully cope with that.

We are also cautious on long dated fixed income. The now meager yield of just over 2% will not be enough to offset severe losses should interest rates rise.

Fixed income should still play a role in portfolios, as a defensive holding. Investors can stomach low yielding short maturity fixed income as a type of insurance policy if things go wrong. But, to reach for the yield of long dated holdings and thus risk a 30% loss if rates soar defies common sense.

Finally, some defensive consumer staples stocks are overbought. When the global economy rights itself, investors will rotate to more economically sensitive names. For example, Colgate Palmolive (CL), while a fine company, has risen 30% in the last 12 months, far outstripping its just over 7% long term projected growth rate. Its valuation now exceeds both its long term average and the average of the S&P. It and similar companies have served as a safe haven for investors fearing volatility, but may be due for a rest.


Stocks Discussed: INTC, TEVA, MYL, WPI, NEM, ASA, CL,
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