Download Equity Investment Approach - Retirement Income Management

Retirement Income Management Equity Investment Approach
Our unique style of dividend investing has been shown by many studies (Ned Davis, Jeremy Siegel,
etc...) to be one of the best ways to accumulate wealth over time and provide a high level of income
in retirement. Each individual equity model portfolio starts with the client's wealth accumulation
and/or income needs in mind and takes into effect risk, return, and tax efficiency.
Screening for stocks
Our screening process begins and ends with dividend paying securities as the focus. Many other
factors come into focus in the screening process including the size of the company, dividend growth,
return on equity, sales growth, cash flow growth, earnings growth, earnings momentum/surprise,
and debt levels. Standard & Poors Quality Rankings (sales, earnings, and dividends) are also utilized
as a 2005 study (Murphy, Santicchia) showed that "A" rated securities showed outperformance in the
period studied. Valuation parameters like price/sales, price/cash flow, price/earnings, and
price/earnings/growth are reasonable screeners to use, but we do not want to immediately remove a
company in a first screen based just on valuation.
Security Selection
At this point of the process, fundamentals are used to further limit the companies to be used in the
model portfolios. At the end of the day, the most important factor is how competitive is the industry
in which the company operates. In other words, does the company have a moat around its business
so that it can continue to grow while expanding margins, net income, cash flow, and dividends.
Secondly, competent management is vital both from an operational and financial standpoint. Steve
Jobs at Apple, Alan Mulally at Ford, John Malone at Liberty Media, Dan Hesse at Sprint, and Sanjay
Jha at Motorola Mobility are examples of managers that can drive value at companies. However,
great management can push a company only so far as negative industry/economic forces can damage
a company regardless of the management. This specifically occured to Nucor in the 1998-2003
period as excessive supply and 19 bankruptcies severely tested high quality managers Kenneth
Iverson and Dan Dimicco. The best managers in a bad industry will always have trouble besting
mediocre managers in a good industry.
In summary, we want to own some high dividend payors with reasonable payout ratios (value
dividend payors) as well as some medium to lower dividend payors (growth dividend payors) that
have the ability to continue to fund growth of the business so that they can increase the dividend
further. It is these growth dividend companies and initiators of dividends that have seen the best
performance in the S&P 500 over the last 40-50 years.
Portfolio Construction
While we, at Retirement Income Management, have a focus on income, diversification is critical in
keeping risk at a manageable level. In the stock arena, we can diversify away non-systematic risk by
allocating to multiple securities across industries and sizes of companies. Longstanding literature will
tell us that most of the elimination of non-systematic risk can be accomplished by holding 10-15
randomly selected securities, but owning about 30 different securities will eliminate almost all nonsystematic risk. However, more recent articles suggest that proper diversification may require
further securities.
Two articles written in 2000 from Surz and Price (The Truth About Diversification By The Numbers),
and Campbell, Lettau, Malkiel, and Xu (Have Individual Stocks Become More Volatile), suggest that it
takes 50+ securities to diversify away approximately 90% of systematic risk. A 1999 article from
Cleary and Copp on Canadian securities suggest that 50 securities also eliminates 90%, 90 securities
eliminates 95%, and 200 securities eliminates 99.6% of the non-systematic risk. The main reason for
this need for a higher number of securities to eliminate non-systematic risk is that correlations
between stocks have increased over the past 20 years. On the other hand, systematic risk, or the risk
of the market as a whole, can only be reduced by owning multiple asset classes like bonds, cash, real
estate, art, jewelry, natural resources, etc...
However, while non-systematic risk can be eliminated almost completely by utilizing 30 uncorrelated
stocks and systematic risk can be reduced dramatically by owning other asset classes, without owning
a larger number of equity securities, terminal wealth dispersion (TWD), or the range of the future
value of your portfolio, can still be high without further diversification.
The theory of time diversification implies that investment risk diminishes with time. While this theory
is true as the standard deviation, or variance, of a portfolio over the total holding period is reduced,
the dollar variation of a portfolio increases over time so there is a likelihood of higher
negative/positive values. It is wholly possible to put together a portfolio of 20-30 stocks that will
have a low standard deviation, but will leave you wondering why a portfolio has lousy returns over a
long period.
In a 2003 study by Hsu and Wei (Stock Diversification in the U.S. Equity Market) discussing TWD, the
authors find that the dispersion of terminal wealth is reduced by 25% when going from 10 to 20
securities and 50% when going from 10 to 50 securities. Beyond that, the benefits from adding
additional securities on terminal wealth dispersion continues to help, but at a diminishing pace.
Conclusion
Given the need to reduce both non-systematic risk, terminal wealth dispersion, and invest across
different sizes of companies (large, mid, and small cap), types of companies (value vs growth), and
geographically, we at Retirement Income Management believe that an appropriate number of
securities is in the 50-100 security range for a diversified equity portfolio.