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2015 – 4th Quarter Letter – Building a Stock & Bond Portfolio

January 15, 2016

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Dear Friends and Clients,

Hope the holidays treated you well.   2015 was a year when nothing worked.  Bonds, stocks, commodities, cash…..nothing financial really “worked;” a very unusual zero sum game.  Real estate, depending upon the category, may have made 5%.  All was not lost though.  To our way of thinking a lot of heavy lifting got done.  Losses were harvested, portfolios were rebalanced, and most importantly, all of us grew one year older.  The fullness of time is a significant part of investing success and our positions gained another year of maturity.   Ben Graham once said, “In the short run the market is a voting machine,” tallying up the popularity of a company, “but in the long run it is a weighing machine,” assessing the substance of a company.  The short run is about to take center stage.  2016 has started with a 10% drop in the value of Chinese stocks and a hydrogen bomb in the hands of an immature North Korean despot (not to be confused with a spoiled fat kid in a big hat).   We’ll spend more time on those subjects when it comes time to critique the world at the end of this letter.  In the meantime, we thought this might be a good opportunity to revisit how we build and review portfolios.  The market may or may not be ahead of itself….who knows?  We do know when returns go flat or get lumpy it becomes difficult to stay the course.  A transparent business plan with well documented procedures go a long way toward generating confidence in these situations.

We’re proud of our disciplines, the performance they’ve generated, and how they keep us together as a family unit.  What follows is a tutorial on how we build and manage our portfolios….essentially, how we think.  The emphasis will be on stock and bond accounts where we use a core and satellite structure, further organized by asset class, sector, industry group, market cap, and origin.  Our process is a lot like that of a contractor building a custom home.  Each house is different, but all have plumbing, HVAC, a roof, driveway, garage, and basement.  Builders know from the outset that a degree of standardization must occur if the home is to come in on budget and comply with code.   So the results will be tailored to the owners but will incorporate both hand-made and store bought parts….custom.  Keep this contractor concept in mind as we describe how we build our stock and bond portfolios.

We’ll start with a Site Plan….

 We know we want diversification by:

  •             Asset class –  Equities and fixed income.  We include cash in fixed.  Both classes are built in core and satellite fashion.
  •             Core –   These will be large cap domestic stocks in an equity portfolio and investment grade bonds in the fixed income portion.
  •            Satellites –   Mid cap, small cap, foreign and alternatives in the equity portfolio.  High yield, mortgage-backed, and foreign bonds in the fixed.
  •           Equity Sectors – The Global Industry Classification Standards (GICS) divides all stocks into 10 sectors: information technology, telecom, healthcare, energy, financials, industrials, materials, utilities, consumer discretionary, and consumer staples. We use GICS as the primary diversifier of the core.  Taxable fixed income portfolios are diversified by credit support as well as GICS.  Tax free portfolios are diversified by issuer, revenue source, origin and maturity.
  •             Industry Groups – 24 industry groups, 67 industries, and 156 sub-industries.  A continuum of core diversification.
  •             Market Cap – Mid cap and small cap exposure completed as satellite positions with GICS diversification.
  •             Origin –  Core tends to be domestic.  Foreign stocks in developed and emerging markets are addressed as satellites, same GICS.
  •            Alternatives – REITs, MLPs, venture capital, private equity, hedge funds, precious metals, etc. are addressed as satellites, same GICS.
  •             Fixed Alternatives – High yield, distressed credit, foreign, mortgage-backed, and other esoterics are addressed as satellites, same GICS.
  •             Position Size – Equally-weighted core positions.  Pro forma weighted satellites.  Fixed income in 25m bond increments.

So now we have a financial site plan.  Let’s assume the size of this portfolio will be $1,000,000.  The asset allocation will be 75/25 using tax free bonds.  The client has delivered cash so we have a blank canvas to paint on.  Now our site plan needs to become a blueprint.  A floor plan with engineering specifications, cost estimates, and a bill of materials….its personality will reflect the goals and objectives of the owners.  Once the blueprint is complete it will be time to bring in the hammers and nails.

Blueprints and Carpenters….

 Diversification in more detail:

  •              Asset class –   Equities and fixed income, cash is included in the fixed income…..75% Equities and 25% Fixed Income….tax free bonds.  Equities will total $750,000 with fixed income weighing in at $250,000, we manage asset allocations to plus or minus 10% of target.  We like to build our fixed income positions in increments of $25,000.   At the current time we are favoring shorter term maturities and always want to use investment grade securities. $50,000 pieces will work pretty well for this portfolio.  Fixed income is diversified by maturity date, revenue source and then GICS.   It is our preference to equally weight positions by asset class and we will tentatively size a portfolio like this with 3.0% positions.   That will give us 33 x $22,500 positions to work with before considering satellites.  If we find ourselves in need of more diversification we will go to 2.5% positions or 40 x $18,750.  At this point we ask ourselves, “What did we do for the client?”
  •               Satellites –     Mid cap, small cap, foreign, and alternatives.  Large cap stocks are a self-fulfilling prophecy for us….our core is full of them.  We seem to pick up a number of foreign     securities and mid cap stocks in the same fashion.  Small cap exposure always requires more effort.  Alternatives are a strange lot but there are certain ones we want to make sure we get into our portfolios.  A standard satellite ration for us is 5% mid cap, 5% small cap, 15% foreign, and 5% alternatives.  Fixed income follows a similar pattern.  Once these allocations are in place we ask ourselves, “What did we do for the client?”
  •              Sectors –         Every month we hold a Research Committee meeting and decide which sectors we like the best.  Based on the Committee’s opinions, we build a pro forma sector model.  If we favor technology stocks, that group is overweighted.  Likewise, if materials stocks are out of favor, we underweight that sector.  At the end of the day, our pro forma model             is fully invested in the sectors preferred by the Research Committee and we ask ourselves, “What did we do for the client?”
  •             Industries –   There are 24 industry groups.  The energy, telecom, materials and utility sectors have only 1 group apiece.  Health care has 2, while information technology, consumer   staples, and industrials each have 3.  Financials have 4 and consumer discretionary has 5.  The industry groups are then divided into 67 industries and 156 sub-industries.  All of these different sets are considered as our Investment Committee selects stocks that enable the portfolio managers to weight and diversify portfolios.  Our portfolios are built bottom up, meaning we look for the best companies first.  Once this section of the portfolio is built we stop and ask ourselves, “What did we do for the client?”
  •            Market Cap – Mid cap and small cap.  The core of our equity portfolios is made up of large cap stocks.  We own some mid cap stocks and a few small cap stocks, however, these groups have too much growth potential to ignore and they almost always earn satellite status, which we fund with ETFs and managed mutual funds.
  •             Origin –           Domestic and foreign, the latter being divided by developed and emerging markets.  US stocks represent about 40% of global equities so a fully diversified portfolio needs to acknowledge foreign securities.  Most of our core stocks are domestic.  Since we want our portfolios to be fully diversified, we use individual securities, ETFs and managed                     funds to create exposure to different origins….think foreign.  Virtually all our fixed income is domestic.
  •             Alternatives – REITs, MLPs, venture capital, private equity.  We approach these investments through individual securities, ETFs, mutual funds and limited partnerships.  The more   esoteric they become the more likely we are to use a managed product.
  •             Positions –     We like to equally weight individual security positions.   Due to their inherent diversification we are a little more subjective about mutual funds but generally use increments of the portfolio’s individual security positions.


Once all the moving parts have been assembled we stop and ask ourselves, “What did we do for the client?”  As you can tell, we ask ourselves this question a lot; we continue that habit through all the review sessions.  It is important not to get caught up in the process and forget about client goals and objectives.  Once the blueprint is complete and the bill of materials is populated (stocks and bonds from our approved list), construction occurs under the watchful eyes of our Investment Committee.

 Moving in….

The portfolio has been built and the owners move in….. cash deal, no mortgage.  You might be familiar with this couple, The Core family, Mr. Stock and Mrs. Bond.  They’ve been married quite a while and get along like most married couples.  The four kids are wild as mountain scenery, Mid Cap, Small Cap, Alternative Assets, and Foreign…. all proud satellites of their parents.  Knowing we can’t do much about how these people behave in their own homes, the portfolio is built to accommodate the long term forces acting on financial markets.  This list includes cyclicality, seasonality and secular trends, plus global terrorism and foreign exchange upheavals.  We know the ride will be lumpy.   There’s a bonus with this approach, since we are fully diversified, we can make allies out of the 80/20 rule as well as the equity market’s natural desire for reversion to the mean.

 What do P&A’s tools look like?

 Take a look at Appendix A.  You will find a portfolio review sheet example that displays a profile of the account, realized gains/losses, loss carryforward, a performance matrix, plus a current core and satellite allocation.  The GICS Sector Allocation describes the pro forma weights recommended by the Investment Committee, the actual portfolio weights, and their variation.  Our Research Committee is a subset of the Investment Committee and has an individual stock focus…it meets constantly.  Fixed income expertise is hard to find these days and our company is generously staffed.  This group meets on demand, usually 3 or 4 times a week.  The Investment Committee meets daily for the last 2 weeks of each month and reviews 1/3 of our portfolios each month, which equates to 4 times annually.  We also review accounts when securities call our attention to them, when funds are deposited and when funds are withdrawn.  This format insures that all of our stock and bond accounts are reviewed no less than 4 times per year and on average 6-7 times annually.   Our portfolio review sheet and the logic required to create it are front of mind for every P&A Investment Committee member.

From time to time we will employ the back side of the portfolio review sheet, so far the work we have done there has been enlightening but inconclusive.  We keep trying to perfect attribution analysis and it is not a simple process.  After failing 2 or 3 times we are about to embark on a new approach which will probably take a year to bear fruit.   We are hopeful.  Since 1995 we have calculated relative strength a number of different ways….no joy so far.  We keep approaching the altar but never leave with a bride.  Still we are optimistic.    Keeping track of measured retreats from recent highs is something that shouldn’t elude us but it does.  We are curious.  The front page of our review sheet, however, does work and it has become the fabric of our being.  When we see a Colgate advertisement, we all think “consumer staples.”  When we need to buy a new computer we all think, Hewlett Packard or Apple (information technology).  This is a 24/7 deal with us.  We are constantly making mental notes of the companies that affect our day and categorizing them by sector and industry group.  Eventually repetition will leave a mark or the novelty of a product will create curiosity.  Those companies will become research candidates which may or may not make our watch list.  Research is a topic I should write about some time.

Model Portfolios….

In June of 1995, P&A was born with an intent to manage stock and bond portfolios.  We had a $500,000 minimum and a number of existing clients from our brokerage days.  Our minimum was tested from multiple directions early on….the markets moved too fast.  We attracted a number of prospects that just plain didn’t have $500k but wanted to escape the traditional stockbroker business plan.  We also had a number of clients who met the minimum but had their assets divided into smaller retirement and trust accounts.   A third unanticipated category came from long term clients who asked us to manage their company retirement plans for them.  This meant multiple smaller employee accounts that were not well-served by our stock and bond disciplines.

After several so-so attempts to satisfy these needs we started using a computer-driven, mutual fund model portfolio system offered by Charles Schwab.  Since the mutual funds generated internal expenses, we created a reduced fee schedule and dropped our minimum to $100,000.  Our goal was to continue to delivering professional management to smaller accounts at a price of about 1.00%.  It worked, the results were better than anticipated and we continue to re-engineer the product we call “Fireball.”  These accounts provide the level of diversification we are comfortable with and are reviewed semi-annually by P&A and constantly by their internal managers.

Subsequently (as my grandmother would say), the market presented us with a new wrinkle.  The Exchange Traded Fund (ETF) industry grew precipitously and their internal expense ratios fell to drill bit sizes…small drill bit sizes.  Simultaneously, the major custodians perfected a stable of ETFs we could trade without commissions.  Not coincidently, during 2014 we changed portfolio management software products.  Out with Advent and in with Tamarac.  If you have changed the spine of your software suite you know how big an undertaking this can be.   Tamarac offered a model portfolio rebalancing tool good enough to cause us to pay them $18k per year and to forsake Charlie Schwab’s product priced at $0.  We still offer Fireball along with an ETF product we call “Cannonball” which is reviewed monthly.   Oddly enough, ETFs and traditional mutual funds do not co-exist well in a model portfolio environment.  They have different settlement dates and the mutual funds carry nasty little short-term redemption fees instigated by the SEC in 2003.  The policies and procedures used to create Fireball and Cannonball portfolios have the same intentions as those used in our stock and bond disciplines….however, the fund nuances make them just a little different.  I am 100% certain that these products will continue to morph and change to the advantage of our clients; we’ve got our best people on the project.

The World According to Pitt and Dan….

Global stock markets have had a real poor start to 2016 with China being the principal culprit.  The Shanghai Composite Index has hit its 7% trading curbs multiple times so far this year while being down another 5.3% on Monday 1/11/16.  The trading curbs are new, installed by a government that thinks it can mandate control over things like human reproduction, air pollution, and social media.   Traders did a turn tail and run on Monday 1/04/16 and haven’t looked back.  Here is the price activity that precipitated the trading curbs.


06/03/14 Shanghai Composite Index =  2,038.30                      S&P 500 =  2,114.07

06/12/15 Shanghai Composite Index =  5,166.35   +153%         S&P 500 =  2,094.11           -1%

08/26/15 Shanghai Composite Index =  2,927.28   -43%          S&P 500 =  1,940.51           -7%

12/31/15 Shanghai Composite Index =  3,539.18     +21%          S&P 500 =      2,043.94    +5%

01/04/16 Shanghai Composite Index =  3,296.25     – 7%          S&P 500 =  2,012.66          -2%

01/07/16 Shanghai Composite Index =  3,125.02      – 5%          S&P 500 =  1,943.09          -3%

There are several takeaways from this chart; buying the SCI on 6/03/14 and selling it on 6/12/15 would have been a good trade. Owning the SCI would have increased volatility for virtually any portfolio and the S&P is not highly correlated to the SCI.  Conclusion….it’s the Chinese economy causing problems in our domestic markets, not the Chinese stock market.  Financially, China is still a closed market.  Westerners can’t have direct ownership in Chinese companies and there is no way for them to own the SCI.  They can, however, buy ETFs like the iShares China Large Cap ETF…. which does a woefully inadequate job of correlating to the SCI.

At P&A we have yet to take the China “bait.”  Our pro forma weight for emerging markets is 5% of which China represents about 1%.  This has not been a great place for money as of late so no complaints.  The Chinese economy, however, is embedded in almost every U.S. company that does business there or in the Pacific Rim.  So therein lies a pretty significant conflict.  Financial investors are locked out of the investing side of China but trade partners participate in all the peaks, valleys, and potholes.  Kind of like being able to do business in Kansas without being able to own a business in Kansas.

So as the Chinese economy slows, investors in the Pacific Rim and other Chinese trade partners feel the pain.  As those stocks decline in price there are no natural buyers for them…..the man on the street in China is not allowed to buy them and the westerners who already own them have a basketful.  But liquidity demands do not go away…..investors can decide not to buy but they can’t decide not to sell.  When investors and trade partners need cash, they need cash.  To that end, they sell what they can sell and more often than not, that means U.S. stocks and bonds.  I subscribe to the idea that it takes a 16% decline in the Dow or S&P to end a bull market and a 19% rally to kill that bear and initiate a new bull.  If you like to play with numbers, these two values are the compliment of one another and they set up the historical events that surround most corrections quite nicely. The financial press likes to chatter about 10% corrections.   I think they like that number because it is simple and they are too impatient to wait for the 16/19 setup.  We are close to another 10% correction from recent highs and it is getting a lot of press.

2016 is looking like a bitter sweet year.  I will not be surprised if we are able to do quite a bit of loss trading as the year goes on.   I will also not be surprised to see the popular averages finish higher in December….think high single digits.  As discussed in this letter, we are constantly reviewing and rebalancing portfolios.   Consistent with that process but not discussed in this letter is our search for new investment candidates.  As the markets correct, stocks become easier to pick.  Look for downgrades by major brokerage houses, they make stocks easier to pick.  The stock market is one of the only markets that customers flee when prices go down.  As that happens, stocks become easier to pick.   The gains earned in 2016 will not come easily and they will test your patience.   They will test ours, too.  We continue to “Really Like” stocks and are closer to “Love” than “Like.”

As Always,


James S. Pittenger, Jr,                                                    Dan Anderson

Chairman/CEO                                                                President

CFP®                                                                                   CFP®



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