responding to a question

A short while ago I wrote about how professional equity portfolio managers, who are evaluated (and paid) based on their performance vs. a benchmark index approach the task of constructing their holdings. …or at least how most managers, me included, do so. I found during my career that about half my outperformance came from the sectoral layout of my portfolio–which sectors (and in many of my portfolios, countries) I had a larger weighting than the index and which I had smaller. The other half came from individual stock selection.

One point I was trying to make–and didn’t do a very good job of it–was that sometimes my strongest convictions were about what I didn’t like. I’ve never been a big fan of Financials, mostly because I find their accounting practices too opaque. I don’t like Utilities much, either. Energy is also a sometime thing for me. If these negative ideas are my strongest convictions and I want to remain fully invested (which I do), then I’m automatically going to be overweight the rest. In a sense, my portfolio is constructed backwards.

A long time reader asked how an individual investor should structure equity holdings. This is my answer.

–investing is a craft skill, like being a housebuilder or a shoemaker. You create a blueprint through sector structure, and then you also have to figure out where the studs and nails go. The latter (theme or stock selection) is a function of time and experience. Paper portfolios only go so far, in my view. I’d create one and look it every day. But I’d also start getting experience with small amounts of money in one or two stocks or funds/etfs.

You should also examine your performance periodically. Two reasons: to catch mistakes quickly (everyone makes lots of them but good managers don’t let them fester) and to figure out the kinds of things you’re good at and what you’re not.

–risk preferences are more important than you might think. You don’t want to create a situation where you can’t get to sleep at night, if the market turns down–which it does periodically. It’s important, as well, that your equity holdings be set in the context of your overall financial situation, so you don’t encounter financial problems during a bear market.

I had a brilliant but eccentric uncle, for example, who walked away from his job at a brokerage house one day (the family legend is that he was fed up paying taxes, but I think the fact his ethnicity prevented him for being considered for a job as a securities analyst was the key) and supported himself by stock trading until he died thirty+ years later. He started with $400 and ended up with $1 million+ (which was a lot back then). But he continued to live in the ghetto neighborhood he grew up in and he only bought utility stocks. He was comfortable with utilities, he needed the income they generated and their bond-like character made them relatively safe. So he balanced the enormous career risk he took by quitting with an extremely conservative portfolio.

–I have a bunch of old posts on how to get started. I’ll post links to them next week. For most people, having 90% or more of their equity money in index funds and actively managing the rest is probably a good way to start. (To be clear, however, I don’t know any reader’s individual circumstances well enough to be able to say what is right for you.) I wouldn’t hold to the professional formula for portfolio construction I wrote about above. I’d experiment with individual stocks and sector funds/etfs. The former are more work, since you’ll be reading the financial reports about your company on the SEC Edgar site. You can also look at reasonable, though abbreviated, reports from Merrill’s professional securities analysts if you open a Merrill Edge account. Morningstar is also a good source of factual information about companies and industries. You may be able to get these for free from your public library. On the other hand, if you choose a sector index fund/etf, you’re betting solely on your macro view. If you choose an actively-managed fund/etf, you’re farming out the stock selection to that portfolio manager. It’s certainly worth a look beforehand to see the manager’s track record.

why secondary markets (iii)

throwing away a valuable asset

The depth and strength of the US equity market is unequalled anywhere else in the world. It’s a source of competitive advantage for the companies which can raise new capital here relatively easily and quickly. Wall Street also a big plus for individual and institutional savers (i.e., pension funds), who have access to a broad array of attractive investments, as well as to the professionals involved in investment banking, asset management and trading.

Yes, the fact that a Chinese tech company is able to validate itself to home market investors as well as to raise funds through an ADR listing here is a plus for it. But it’s also a plus for you and me, who can easily buy shares here and who may be able to find brokerage research reports in English that will help us understand the nuts and bolts of a foreign firm’s business. And it’s a negative for China, because corporates have less reason to try to build and cultivate at home the kind of access to capital they can obtain in the US without the same missionary effort. And the threat of a ban has certainly bailed out the Hong Kong market, which is being roiled by Xi’s (crazy, in my view) attempt to accelerate the timeline of the SAR’s full return to mainland rule.

The net result would be, I think, a much stronger stock market in China and a consequent loss of business for Wall Street. American investors would sooner or later find a way around the ban, presumably either by working out a way to shift assets out of the US and into a jurisdiction where investment in China would be permitted. This is Pandora’s box opening.

As a pragmatic realpolitik matter, giving China three years’ warning of this impending move is a headscratcher. Yes, it gives US holders of ADRs time to adjust–and to open brokerage accounts elsewhere–but it also blunts most of the damage from denial of access to US capital by giving China such a long time to react. All in all, a brief moment of emotional satisfaction followed by the long-term pain of having shot yourself in the foot.

why secondary markets (ii)

Yesterday I wrote about what secondary markets are.

I didn’t mention perhaps the most important fact–people should be, and are, willing to pay a higher price for a security that they can buy and sell relatively quickly, cheaply and more or less anonymously.

They should, and do, pay an even higher price for shares in a company that is legally required to produce accurate financial statements that are easily accessible to actual and potential holders. That hasn’t always been the case, even in the US. In 1995, for example, I had to pay $125,000 a year to get microfiche copies of companies’ SEC filings, three months late, that are available today online, immediately and for free.

It’s worth even more to be able to see what people have paid for a stock in the past. To me, it’s not really key to be able to see what others are doing minute to minute, but that information is available, too.

It doesn’t hurt, either, if a market can rely on a large number of affluent institutions and individuals with enough interest in stocks and bonds to provide a deep pool of liquidity is all but the most dire of circumstances.

The general point is that in this situation, one where there’s a very robust secondary market, companies can raise capital more cheaply and easily (and are therefore stronger and more profitable). You and I can also become part-owners of these enterprises easily and cheaply and with less risk.

leading economic indicators

Macroeconomists studying the US have a list of indicators experience has shows tend to signal in advance the direction general economic activity, either on the way up or the way down, or both. Of these, the most reliable is the US stock market, which tends to peak six months or so before the business cycle turns down and to pick up half a hear ahead of recovery from recession.

Why is this? I don’t think anyone knows for sure. Personally, I think there are two factors. The more generally accepted is changes in Fed policy intended to slow down or speed up the economy and signaled through changes in short-term interest rates. Pulling back on the monetary reins can be detected immediately but takes a while to be reflected in GDP statistics. Secondly, especially as the economy picks itself up off the floor, companies see on their order books that things are getting better. They start to procure more raw materials and to halt layoffs/hire again. Almost immediately the grape vine signals that everyone’s job is now safe …and that information begins to leak into the stock market.

I mention the special place of the stock market among leading economic indicators because it’s the only motivation I can think of for the peculiar academic notion that there is not only a connection between a country’s GDP and its stock market, but that the market is fully priced when its capitalization is equal to 1.0 x nominal GDP. I don’t see any reason why this last should be. I view it as the logical equivalent of saying that the sun comes up when the rooster crows, therefore the sun comes up because the rooster crows. (Btw, the total market cap of US stocks today is $44 trillion vs. GDP of $22 trillion.)

I first heard this “explanation” of the correlation of GDP with market cap in the late 1980s as a “proof” that the Tokyo market, then trading at 2x GDP, was wildly overvalued vs. the US, which was trading at 1x. The fact that short rates in Japan were at 2.5% vs about 8% in the US was completely ignored by adherents of the GDP link. (Yes, the Japanese market turned out to be a house of cards, but so too did the junk bond market in the US.) Also ignored was the fact that at that time the German stock market was trading at 0.2x GDP (mostly, I think, because Germans have never been very interested in stocks and because the great bulk of German GDP isn’t listed).

the stock market is a place where buyers and sellers meet

This is a truism, but it has two big implications.


One is that the market will be created in part by the firms that want to raise capital. in the US, homebuilding, which is a significant part of the economy, is by and large a cottage industry of independent builders. They put up a few houses at a time and depend on bank financing. Despite their economic heft, they have minimal direct representation in the stock market. Automobile sales and servicing make up about 5% of US GDP. But this industry is dominated by foreign firms. The combined market cap of F, FCAU and GM, all steady market share losers over the past 40+ years is about 0.2% of the Wall Street total. Oil and gas is about 8% of GDP, but the Energy sector, which includes substantial foreign holdings, makes up about 2% of the S&P. Most important, although disclosure is imprecise, as best we can tell about half the earnings of the S&P 500 are derived outside the US.


The other side of the coin is that the market is also made by what investors want to buy. For the past several years, the preferences of buyers have been very clear–they don’t want to buy stock in traditional companies–especially not ones with status quo-defending managements–in a time they think of as one of substantial, rapid structural change and they do want to buy shares of companies with global reach. The pandemic, and the administration’s failure to cope with it, have intensified this trend.

The upshot of this is that there’s no reason why the dynamic action of buyers and sellers in this marketplace should end up mirroring or mimicking domestic GDP.

In fact, given the unique breadth and depth of US financial markets, there’s also every reason for foreign sellers to want to at least partially finance growing businesses by issuing stock here. This gives us a unique opportunity to hold foreign growth companies. It makes Wall Street an important national asset. Also, to the degree that foreign issuers rely on the US for financing, the domestic stock market becomes a potential force for exerting influence over them and their business practices.

More tomorrow.

why secondary markets

Investors typically divide the markets where securities transactions take place into two types: primary and secondary. The difference:

–in a primary market transaction, the buyer/seller deals directly with the security issuer; in contrast,

–in a secondary market transaction, the buyer/seller deals with someone other than the issuer, who in today’s world is usually a professional intermediary.

primary markets have their problems

Primary markets are a tremendous hassle for investors like you and me. Imagine wanting to buy a share of MSFT and having to call up the company to do so. Once we’ve found the right person to talk to, there are issues to deal with, like how to take delivery of the share and how to safeguard it while we own it. What’s the right price?

Suppose you want to sell: if, say, MSFT doesn’t want to buy the share back, how do you find someone else? again, how do you agree on a price? where’s a record of recent transactions to check? if you’re the buyer, how do you know the seller is offering a genuine share or that he’s the legal owner? who notifies MSFT to send the dividend checks to a new address? what happens if you lose the ownership certificate?

In the early days, this wasn’t so crucial. Securities ownership was for the wealthy, the securities themselves were understood to be highly illiquid and transactions directly with the issuer were common. A single share of a South Sea Bubble venture, for example, would typically cost 10x the yearly wages of the average person. It’s really only in my lifetime that there has been the explosive expansion of secondary markets

(A side note: There are some securities, like Treasury bonds, that can be bought either directly from the government or from the primary dealers who are the Treasury’s main way of distributing government bonds to worldwide investors.)

the rise of secondary markets in the US

The cornucopia of secondary market investment tools that we have in the US today–discount brokers, zero commissions, fractional shares, no-load stock mutual funds, ETFs, index funds, options and other derivative trading, easy availability of margin loans, immediate online access to company financials through the SEC Edgar site—has mostly developed in the US and over the past thirty years.

How so and why the US? Important factors: superior government regulation of public companies and oversight of public markets, the immense expansion of corporate pension plans as investors, regulation of those plans through ERISA, the resulting rise of professional money management as a career, constant brokerage industry innovation, advances in computer technology, the internet, increasing wealth of Americans, high quality of domestic technology/biotech research firms wanting to list here. There’s also the stability of the political system, the clarity of the laws and an openness to the new and different

strongest in the world, by a lot

At $41 trillion, the US stock market represents 46% of the total world market capitalization. China, at 14.4%, is next, followed by Japan at 6% and London at 3.5%.

My experience is that Japan has more public disclosure for companies than the US and a much stronger financial press. But those exhaust its stock market strength. A strong cultural penchant for defending the status quo and a deep aversion to anything non-Japanese make the kabutocho a tough place to make money.

London has attempted to make itself a financial hub to rival New York. Its advantages are its openness to emerging markets’ issuers and the reliability of the British legal system. On the other hand, investor preference is for mature, dividend-paying firms, who are (to my mind, at least) the most vulnerable in a time of rapid technological change. I also think Brexit will continue to be a millstone around London’s neck as it tries to maintain its position as the premiere pan-European financial center.

For many years I’ve used Hong Kong as a way of gaining equity exposure to the booming Chinese economy. Wholesale market reform of that market triggered by its 50% collapse in late 1987 (a larger-scale version of the Pan Electric scandal in Singapore in 1985) has made it a relatively safe place to invest–meaning reliable financial reporting and selectivity in the mainland firms it chooses to list. Had Xi not decided to reclaim the SAR a quarter-century earlier than agreed, the Hong Kong Stock Exchange might have been able to establish itself as the leading tech financial center in the world, obtaining lucrative listings that now go to New York. Given the extreme political turmoil in Hong Kong, however, that’s not going to happen.

why this post?

It sets up two things I want to write about:

–why I think the commonly held view that there’s a roughly linear relationship between domestic GDP growth and local stock market performance is wrong, and

–why I think Trump’s attack on the nearly 100-year practice of allowing foreign companies access to Wall Street financing, an extension of his shoot-yourself-in-the-foot tariff wars, is a mistake.

More tomorrow.

building a portfolio backwards

Long-time reader Chris’s comment on my post from yesterday prompted me to respond here about why I should be overweighting Consumer discretionary names.

One of the more surprising facts about professional equity management around the world is that almost no one is able to perform better than an index fund–even before subtracting fees from the results. In the US, where professionals keep up better with their benchmarks than elsewhere, two-thirds underperform before fees, six-sevenths underperform after fees, in a typical year. Hence, the phenomenal growth of index funds/ETFs.

Early in my career, I worked right beside the best-performing international manager at my then firm. He had a simple formula. He’d try to find five stocks that he thought had a good chance of doing better than the market and five that he thought would be clunkers. His portfolio would mirror the benchmark names and weightings, except for the ten. For those, he’d sell the prospective losers and put that money into the five prospective winners. Then he’d watch those ten like a hawk.

Not very glamorous, but extremely effective.

Another thing. It didn’t much matter to him whether his highest conviction ideas were the winners or the losers. So he would sometimes find the losers first and let them drive the portfolio.

As for myself, from studying performance attribution reports, I began to realize that about half of my outperformance vs. the S&P 500 would come from sector under/overweighting and half from individual stock selection. So I began to pay a lot of attention to sectors. And, taking a page from my former colleague’s book, I realized that avoiding bad sectors was just as effective a tool as anything else.

Current sectoral breakout of the S&P 500:

IT 27.6%

Healthcare 13.7%

Consumer discretionary 11.3%

Communication services 11.0%

Financials 10.4%

Industrials 8.7%

Staples 6.8%

Utilities 2.9%

Materials 2.7%

Real estate 2.5%

Energy 2.3%.

My back of the envelope thoughts, working from the bottom up:

–unless they’re going to double next year, the bottom four sectors are too small to matter. If I were running a $10 billion portfolio (I’m not) I’d probably look for alternative energy utilities, warehouses and left-for-dead office buildings, and maybe electric car battery materials to keep my head in the game. As a private individual, I can live without all of them

–Staples is a funny one, too. Big international exposure, which I think will be a plus in 2021, but relatively slow-growing and generally not keeping up with changing consumer tastes (although I’ve noticed that American cheese-injected hot dogs have disappeared from the local Weis market). Apart from special situations, no reason to get excited

–Industrials in the US market means mostly companies that make things for consumers, so I think of this sector as an extension of Consumer discretionary. If there’s hope of economic recovery, I think it will happen first in the stores, not in suppliers. Again, if I were still working I’d think I should have something here, if for no other reason than to act as an early warning indicator. I’ll probably begin to pay more attention as next year unfolds, but I see no need for Industrials at the moment

–the Financials story, as I see it, has two parts: fintech as a disruptive force for world-lagging US banks and rising interest rates as the driver for the sector to do well. The second isn’t happening soon and I own the ARK fintech ETF (my worry about that is that it has done so well already). So I regard Financials as another source of funds, not as an overweight

With that, I’m down to four sectors.

–I think of Communication services and IT as either complementary sectors or basically the same thing. My portfolio issue here is that I have a lot and my stocks have performed very well. So I want to reduce my overweight

By process of elimination, i.e. building backwards, I’m left with Healthcare (which I’ve mostly equal-weighted and have farmed out to mutual funds/ETFs) and Consumer discretionary.