Concepts in Portfolio Management

Ty Hughes Director, D.C. Regional Chapter

December 5, 2016

• Basic Principles

• When to sell a company

• Adequate diversification 

• Using benchmarks to assess portfolio performance 

• Reasonable exceptions for total return

• Tracking your portfolio with Google Sheets

Applying BI Principles

• Growth and Profitability. "Own the best companies in an industry.” Look for quality management. The growth rate should be acceptable for the size of the company.

• Value. Check the Relative Value, — the relationship between the current price-to-earnings ratio (P/E) and the historical P/E for the company.

• Expected Total Return. Use the stock selection guide. Keep upgrading the expected return of your portfolio.

• Safety. This is best achieved by diversification.

Managing a Portfolio

• Review your portfolio quarterly, normally after earnings season

• Update your stock selection guides quarterly

• Look for changes in company fundamentals (moat, sales, and earnings)

• Identify companies with a change in fundamentals

• If there is a significant price drop, determine why

• Compare portfolio performance with a benchmark

When to Sell a Company

• When something is truly wrong with the company business and it won’t likely be fixed within a year.

• When the stock price has risen so much that future gains are unlikely. You can hedge and sell part of your position.

• When you find a better stock. This is a way of exiting a weak holding and increasing the projected average return of the portfolio.

• When you need the money.

Adequate Diversification

Stocks in a Diversified PortfolioSt

anda

rd D

evia

tion

(%)

0

10

20

30

40

50

Number of Stocks0 10 20 30 40 50

16 stocks ± 4

Impact of a 50% Drop in One Stock on Overall Portfolio Return

Portf

olio

Ret

urn

-50%

-40%

-30%

-20%

-10%

0%

Stocks in Portfolio1 2 5 10 12 15 20 25

Stocks Return1 -50%2 -25%5 -10%10 -5%12 -4.2%15 -3.3%20 -2.5%25 -2.0%

Impact of a Single Bankruptcy on Overall Portfolio Return

Portf

olio

Ret

urn

-100%

-80%

-60%

-40%

-20%

0%

Stocks in Portfolio1 2 5 10 12 15 20 25

Stocks Return1 -100%2 -50%5 -20%10 -10%12 -8.3%15 -6.7%20 -5.0%25 -4.0%

Position Size Guidelines%

of T

otal

Ass

ets

0%

5%

10%

15%

20%

25%

30%

Number of Holdings (Stocks)8 9 10 11 12 13 14 15 16 17 18 19 20

Ranges from 1/2 to 2x of the target holding percent

More on Diversification• Should hold at least 16 ± 4 companies.

• Hold companies from four different sectors.

• Mix of fast and slower growing companies.

• Mix of small, medium and large companies measured by revenues — 25% large cap, 50% mid-cap, and 25% small cap.

• Don’t sacrifice quality for diversification.

Using Benchmarks

• “If you don't know where you are going you'll end up someplace else.” - Yogi Berra

• Compare your portfolio performance against a benchmark that is representative of your asset allocation.

• Don’t compare apples and oranges. Bonds and equities behave differently. Large cap, small cap and international stocks have different returns.

• It is easy to create a custom benchmark that reflects the asset allocation in your portfolio.

ETFs Ticker

S&P 500 INDEX SPX

Russell 2000 RUT

iShares Dow Jones U.S. Index Fund (ETF) IYY

NASDAQ 100 NDX

Index Funds Ticker

Vanguard Total Stock Market Index Fund Admiral Shares VTSAX

Vanguard 500 Index Fund Admiral Class VFIAX

Vanguard Value Index Fund Admiral Shares VVIAX

Vanguard Mid-Cap Growth Index Fund Admiral Shares VMGMX

Vanguard Mid-Cap Value Index Fund Admiral Shares VMVAX

Vanguard Small-Cap Index Fund Admiral Shares VSMAX

Vanguard Small Cap Value Index Fund Admiral Shares VSIAX

Vanguard FTSE All-World ex-US Index Fund Admiral Shares VFWAX

Vanguard Developed Markets Index Fund AdmiralShares Fund VTMGX

Vanguard Emerging Markets Stock Index Fund Admiral Shares VEMAX

Vanguard Total Bond Index Fund Admiral Shares VBTLX

Sample Benchmark

Assumes all U.S. equities — 25% large cap, 50% mid cap, and 25% small call.

Expected Return

0.3%

26.6%

-8.8%

22.6%

16.4% 12.4%

-10.0%

23.8%

10.8%

-8.2%

3.6%

14.2% 18.8%

-14.3%

-25.9%

37.0%

23.8%

-7.0%

6.5%

18.5%

31.7%

-4.7%

20.4% 22.3%

6.1%

31.2%

18.5%

5.8%

16.5%

31.5%

-3.1%

30.2%

7.5% 10.0%

1.3%

37.2%

22.7%

33.1% 28.3%

20.9%

-9.0% -11.8%

-22.0%

28.4%

10.7% 4.8%

15.6%

5.5%

-36.6%

25.9%

14.8%

2.1%

15.9%

32.1%

13.5%

1.4%

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

S&P500AnnualReturn

Historic Returns Geometric Average

S&P 500 3 mo. T-bill 10 yr. T-bond

1928-2015 9.50% 3.45% 4.96%

1966-2015 9.61% 4.92% 6.71%

2006-2015 7.25% 1.14% 4.71%

Decline % NumberAvg. Length of

Decline in Months

Avg. Recovery Time in Months

5-10% 41 1 1

10-20% 11 4 3

20-30% 4 11 8

30-40% 2 9 15

40+% 3 23 60

Declines in the S&P 500 from Jan 1950 - Nov 2016

The 3 pullbacks of greater than 40% all occurred during recessions: 1973-74, 20000-02, and 2007-08

Source: Delta Investment Management

S&P 500 Observations• The market is volatile year-to-year but has always gone up

in the long term.

• The market has always recovered from its lows and then reached new highs.

• Selling when the market has dropped or buying because the market has gone up guarantees poor return.

• Trying to time the market is a sure way to lose money.

• If you don’t have at least a 4-5 year time horizon, don’t invest in equities.

Beware the Prognosticators• Trump will not be president. Corollary: The Republican Party is in

disarray.

• “Sell everything! 2016 will be a cataclysmic year for the stock market” – Royal Bank of Scotland (RBS), January 12, 2016

• “A recession worse than 2008 is coming” – CNBC, January 15, 2016

• “Oil will slide to $20 per barrel” - Morgan Stanley, Goldman Sachs, Citigroup and Bank of America Merrill Lynch, January 11, 2016

• “China is Headed for a 1929-style Depression” - The Economist, May 2016

Source: Delta Investment Management

Equity ReturnReturn = EPS Growth + Dividend Yield + ∆ P/E

In applying this formula consider:

• GDP is generally correlated with EPS growth for the total market.

• Average dividend yield from 1960-2015 was 3%.

• P/E for a stock is generally correlated with growth and quality but market P/E tends to refer to the mean over the long term.

Example - Market Return

Gr EPS Div ∆ P/E Total Return

Current P/E 2.5% 2% 0 4.5%

P/E RTM (5 yrs) 2.5% 2.5% -9.0% -4.0%

P/E RTM (3 yrs) 2.5% 3% -14.5% -9.0%

Assumes market EPS growth equal to GDP. Note impact of P/E reversion to the mean

P/E reversion to the mean is from 25 to 15.6.

Example - Growth Stock

Gr EPS Div ∆ P/E Total Return

Current P/E 10% 1% 0 11%

P/E RTM (5 yrs) 10% 1.3% -9.0% 2.3%

P/E RTM (3 yrs) 10% 1.5% -14.5% -3.0%

Assumes a growth stocks with 10% EPS growth. As P/E returns to the mean, dividend yield will increase.

P/E reversion to the mean is from 25 to 15.6.

What is the likely total annual return for equities

over the next 5 years?

Tracking a Portfolio with Google Finance

• Google Sheets has a robust set of financial functions for building custom spreadsheets

• There are separate functions for stocks and mutual funds. They are easy to learn.

• Google Sheets are private unless you share them. But don’t include identifying information.

• Learn more at the Google Sheets help page

• Here is the Google Finance documentation

Click on chart to go to the Google Sheet

Click on chart to go to the Google Sheet

Google Finance Tips

• Use the Google finance functions. Sometimes Google historic data throws an error. Use iferror([formula], “-“).

• Add colors with conditional formatting.

• Take the time to format your spreadsheet.

• Learn the difference between A1, $A1, A$1 and $A$1 and use it to replicate formulas.

• Create a dashboard linked to multiple sheets.

• Experiment - you can’t break the spreadsheet, use the “undo” function Control+Z to go back.

Questions?

Backup Slides

Equity Risk Premium

Stocks - T-bills Stocks - T-bonds

1928-2015 6.05% 4.54%

1966-2015 4.69% 2.90%

2006-2015 6.11% 2.53%

The equity risk premium is the expected return on stocks in excess of the risk-free rate

Theoretically, return on equities should equal the risk free rate + the equity risk premium

Examples - Risk PremiumT-Bill Risk

PremiumTotal

Return

Currently 0.8% 4.5% 5.3%

RTM 4.7% 6.1% 10.8%

Above returns include inflation. Nominal returns would be somewhat lower. Current rate of inflation is 1.6%. The102 year average is 3.18%.

Average Annual Inflation by Decade

Source: InflationData.com