Q&A

Based on some recent conversations with readers, I thought that it might be worthwhile to review my thoughts on a few common questions:

I'm sitting on some cash.  When should I buy?

My core belief is that the stock market will be much higher in 5 years-- that's 2014.  I think that the Dow and S&P can double over that time.  If the S&P 500 index, which closed at 850 yesterday, can get to 1700 in 5 years, it will have appreciated at a compound annual rate of about 14.87% .  Add to that any dividends.

That's a pretty good rate of return.  Of course, the market won't go straight up.  Also, you won't get in at the bottom.  It's just not possible to accurately predict the market's short-term moves.

So here's the answer:  First, decide how much of that cash you can truly afford to invest for a five-year horizon.  Then, invest 1/3 of it today.  Look for opportunities to invest the rest over the next few months.  But don't focus on "the market."  Buy very high quality companies with strong balance sheets and truly talented management, and look to add to positions on dips.

I know of some really cheap small cap stocks.  Should I have some of them in my portfolio?

No.  Now is not the time to be buying small cap, or emerging market, or other more risky stocks. It's not that they can't or won't work-- in fact, if the economy and the market improves more quickly than I expect, those stocks will significantly outperform my high quality portfolio.  But that potential of higher reward comes with higher risk.  If the economy continues to weaken, you could see significant losses.  The sweet spot in the risk-reward tradeoff lies in high quality stocks. In my opinion your upside is 15% per year and your downside is fairly small.

What stocks should I be buying now?

My core portfolio consists of ABB Ltd, Boeing, Caterpillar, Cisco Systems, DuPont, General Electric, Google, Goldman Sachs, Intel, New York Times, Procter & Gamble, Slumberger, Sysco Foods, and Walgreen.  I chose them because they are big companies with strong balance sheets and a dominant position in their industries.  I believe that they have minimal risk of being put out of business by a new invention or regulatory change or lawsuit.  These are franchise companies that are rarely available at present valuations.  (please note that New York Times is a special case and an exception; see prior posts for more on NYT).  

I have several names on a watch list, and I'm looking for a chance to add a few if/when prices fall.

Why can't I just buy ETFs or mutual funds?  If the market doubles in five years, won't I do just as well with them?

I want to own individual stocks (and individual bonds when the time comes).  If I lose money on my investments, I want to know that it's because Caterpillar didn't sell enough tractors rather than some failed correlation bet by some fund manager.  And I don't like ETFs because they almost certainly include stocks that I wouldn't want to buy outright.  Take the SPY (S&P 500 index ETF).  It's got lots of financial stocks, and I still think they're too risky at this point.  I want to select my own stocks, not own them simply because they're part of an index or ETF.

As far as mutual funds or other actively managed vehicles, keep in mind that the most managers' objectives are not the same as yours.  You want to grow your net worth with an appropriately limited amount of risk.  The manager wants to beat some benchmark.  That's why, in extreme years like 2008,  your manager can look like a star  while you lose a quarter of your investment.  Forget about benchmarks.

Speaking of 2008, how would your strategy have performed?

Large cap high quality stocks got hit hard last year.  That's why I'm buying them now-- because they're very inexpensive.  I wasn't recommending this portfolio 12 months ago.  It was a much different environment, and much harder to read.  I think that we're now in a unique position that has only come along a few times in my career.  The dramatic recent selloff coupled with ten years of flat-to-down performance has finally put the odds in my favor.  Stocks aren't guaranteed to go up in the next five years, but I'm pretty certain that they won't keep going down.  At some point in the future-- maybe it's two years rather than five-- the valuation disconnect will swing back to a more normal level and the outlook will become less clear.  When that happens I'll likely have a different strategy.

What about bonds?  There are some pretty attractive yields available.

True.  You can buy some high quality bonds with yields around 6 or 7%.  Compared to treasury bonds, spreads are at record highs.  Also, some have pointed out that 6 or 7% isn't much less than the long-term average return in equities, and with much less risk.  

My problem with bonds:

1)  you lock yourself into a maximum return.  DuPont has a 10 year bond that yields about 6%-- that's the most that you'll get.  However, I think that DuPont stock could double, and it pays a dividend yield of 5.84%.  Of course, the stock is riskier, and the dividend could get cut.  But I think that the risk-reward is decidedly in favor of the stock.  

2)  interest rates are unlikely to go down much from here, but there's a pretty good chance that they'll go up due to the massive government stimulus and an improving economy.  I don't want to make an interest rate bet, but that's clearly a negative for those who lock in today's rates with a bond purchase.

3)  although spreads are high, you can't spend spread.  Absolute yield levels of are roughly at the midpoint of where they've been in my career.  

That's not to say that I would not own any bonds.  I wouldn't put all of my eggs in any one basket, including a basket of stocks.  But at current prices, I have a strong preference for stocks. My hope is that my stock portfolio will double as interest rates slowly rise, and I'll then be able to shift a significant part of my portfolio into bonds to lock in a secure income stream for my retirement years.

That's it for now.  If you have any other question, please use the comment function below and I'll respond.  You can comment anonymously if you wish.

and thanks to reader Lisa for some thoughts that prompted this post.