Over the last several years, the stock market has been through a tremendous amount of ups and downs. Part of the reason for this, is because of the recession that began in 2007, caused the price of stocks to decline sharply from: the global financial crisis and subsequent recession that occurred. This is significant, because it shows how the volatility in the equity markets can become very extreme, as the economy moves between the different cycles.
For investors, this is challenging in trying to find the right areas that can provide significant long-term growth. As most people will often utilize: the latest strategy that is working in the current market conditions. This is problematic, because it can mean that they are purchasing an investment when the price of the stock could be at its all time high. A good example of this can be seen with the various investments surrounding Internet stocks in the late 1990’s. What happened was many of the people assumed, that the economy was shifting. As the advancements in technology, meant that computers were quickly becoming an integral part of daily life. One of the areas, where this change was being felt the most was Internet, which was helping people to: connect and interact with each other on an unprecedented scale. As a result, many people began to invest in a host of Internet related stocks, in an effort to capitalize on the changes that were taking place. However, beneath the surface many of these companies were not making any money. Instead, they were taking the funds that they were receiving from investors, and began to fuel their continuing expansion. The basic idea is that these companies were on the verge of being able to: redefine the way business is conducted. Therefore, any kind of issues (such as: losses) will take care of themselves over the course of time. (Western)
Once this began to occur, was the point that the company would experience tremendous financial problems. As shifts in the economy and the inability to post a profit, had an impact upon the financial strength of a number of different companies going forward. Evidence of this can be seen by looking no further than Dr. Koop.com. This was one of the up and coming dot.com stocks that went public in 1999. At the time, it was considered to be one of the premier health websites by topping out at: number one on the search engine rankings and they had the name of the famous former Surgeon General Dr. C. Everett Koop. This caused the price of the stock to climb as high as: $45.00 per share after going public. As investors, became excited about future profits; especially when it was announced that they had formed a strategic alliance with AOL. At the time, AOL was considered to be: most dominant ISP on the market and the partnership gave the company instant credibility. Yet, beneath the surface they were losing tens of millions of dollar every day. By December 2001, the company was forced into bankruptcy, because their business model was not sustainable over the long-term. (“Ten Big Dot Com Flops”) This is significant, because it shows how many investors will often assume that they can receive above average returns. However, they do not investigate the financial strength of: the company and will often become caught up in the mania. At which point, the overalls amounts of risks to: the portfolio increase substantially.
For investors, this should serve as warning that they need to be watchful of: new trends and the potential long-term benefits / risks of investing in key industries. In the case of the portfolio that is being constructed, we will seek out investments that are considered to have moderate amounts of risk. This is will be accomplished by examining the: investment goals for the strategy, the rational for asset allocations and looking at the performance of each security that was chosen over the past three years. Together, these different elements will provide the greatest insights, as to what kind of strategy should be utilized to: provide consistent long-term growth to the portfolio over the next ten years.
The investment strategy we are using is designed to outperform: the historical average stock market return of 6.3%. (Burtless) to achieve this objective, at least 60% of the portfolio will be invested in equity securities at any given point in time. We will be starting out with $100 thousand in cash and will focus exclusively on stocks. There will be: no direct mutual funds or real estate investments. Instead, the portfolio will be focused on providing stocks that can increase the returns in comparison with the historical stock market average.
As a result, the risk tolerance level for the portfolio will be geared towards: moderate amounts of growth and mitigating any kind of potential losses. This is important, because we are taking a similar kind of approach, in comparison with many of successful investors such as: Warren Buffet and Eddie Lampert. As they will look for outstanding valuations, that can increase their long-term potential growth, while limiting the underlying amounts risk. Over the years, this strategy has proven to be successful, as both men have been able realize consistent long-term returns of 29%. (Berner) This is significant, because it shows how we can use a similar kind of philosophy that will produce the same kind of returns. Therefore, our strategy will seek to mirror, the growth that is realized by these two investors, while being able to outperform the average historical returns of the markets. As a result, we are seeking to have a portfolio that can be able to deliver consistent growth of between: 6.3% and 29% a year.
When you put these different elements together, this is illustrating how our approach will be based on: finding those companies that can provide above average growth and consistent dividends. These factors will help to prevent us from: purchasing those stocks that are experiencing temporary surges and focusing on companies that can provide an above average return over ten years. Once this takes place, it will ensure that the portfolio has a balanced strategy that will deliver higher amounts of growth, while reducing the underlying risks.
The Rational for Asset Allocations
The current environment for investing is becoming very challenging. Part of the reason for this, is because there a number of different cross currents that could have a tremendous impact on the return of the portfolio. Some of the most notable includes: rising inflation, increasing corporate earnings and geopolitical tensions. Rising inflation is problematic, because the sharp increases that have taken place over last years, have brought into question the sustainability of the recovery. A good example of this can be seen by looking no further than the sharp increases in food prices over the last year. As the various weather related disasters, have meant that prices have increased to record highs. The below table illustrates the overall increase in food prices that have taken place throughout 2010. (Hennigan)
2010 Increases in Food Prices
This is significant because, it is showing one of the major issues that will be constantly affecting investors during the next ten years will be inflation. Part of the reason for this, is because of increasing demand from traditional markets (such as: the United States). At the same time, countries that are rapidly developing (most notably: China and Brazil), have been contributing to the overall increases that are taking place. This is problematic, because it means that the possible recovery could be derailed by a sharp increase in inflation. As a result, our strategy must take this into account, in order to achieve higher returns. (Hennigan)
Since 2009, the overall quality of corporate earnings has been increasing. The reason why, is because the economy formed a bottom during this time and has begun to experience a gradual recovery. Recent evidence of this can be seen by looking at the 2010 earnings that were reported by S&P 500 companies. As 85% of them have been beating analysts’ expectations and they have been raising guidance. (Wagner) However, the recovery has been very slow and many sectors of the economy have been lagging. A good example of this can be seen with the unemployment rate, as this number has continued to remain at 9%. (“Job Growth Accelerates”) This is problematic, because it means that the economy could either be: entering an early period of sustained economic growth or it could be going through a similar to the time frame from: 1975 to 1978. In this case, the U.S. economy recovered from a serve recession. However, within a few years it would experience similar kinds of challenges (stagflation), as the recovery was short lived. (Weinstien) This is important, because it shows how the economic growth that is being experienced is very tepid. As a result, either one of the above scenarios could be occurring. However, it will depend upon the impact that rising prices will have on consumer spending and corporate balance sheets.
Geopolitical tensions could have an impact upon the price of commodities most notably: oil and gold. As various uncertainties around the globe, could have an impact upon the availability of oil supplies, which will cause prices to increase. A good example of this can be seen with the different protests that are occurring in: the various Middle Eastern and North African countries. As the numerous acts of civil disobedience have caused a number of countries that are large exporters of crude oil (such as: Libya) to suspend production. The reason why, is because they are: having to wrestle with their own internal security situation. As a result, oil prices rose to above $100 per barrel, on concerns about available supplies. This would have an impact on gold prices, because many investors will often seek out these assets during times of: political or economic uncertainty. This is problematic, because it is showing how the various geopolitical concerns, can often have an impact on: commodities prices and possibly inflation. At which point, this has the possibility of derailing any kind of tepid recovery that this taking place. (“Gunfire at Saudi Arabian Protests”)
Therefore, the strategy that we will be using will be purchasing areas that can benefit from: increases in commodities prices over the long-term. While at the same time, it will be positioned in those areas that can take advantage of the stronger than expected economic growth in the future. As a result, our strategy will focus on a number of different industries / sectors that can achieve this objective.
Asset Allocations and Industry Selection
Like what stated previously, the majority of the assets from the portfolio will be invested in equity securities. Therefore, we will take an approach that will provide: consistently strong growth and balance to the account. The best way to do this is to invest in a variety of areas that can take advantage of these specific scenarios. At the same time, the underlying amounts of risk could be reduced through: the use of sell stops (at key points) in select securities. This will help to provide the portfolio with moderate amounts of: risk and it will increase the overall returns.
As a result, there are a number of different industries the strategy will be focused on. The most notable include: precious metals, oil / gas, ADRs, consumer staples, industrials, select technology and cash. The below chart illustrates the overall asset allocation that was selected for this strategy at the current time.
Total Portfolio Allocation by Industry
The current asset allocation that was selected for the portfolio includes: 10% in precious metals, 10% in industrial related stocks, 20% in oil / gas, 10% in consumer staples, 20% in ADRs, 20% in technology and 10% in cash. Precious metals were selected because it will give the portfolio stability during times of: political uncertainty and inflation. The investments in oil / gas were chosen for similar reasons as precious metals, due to the fact that the sector will benefit from higher prices (contributing to greater profit margins). A heavier asset allocation was selected, as this could provide the account with: enough leverage to benefit from rising prices. Consumer staples were chosen, because they can ensure that the portfolio is able to invest in companies. That will see, increasing demand for their products regardless of what is happening with economic conditions. ADRs or American Depository Receipts can be used to purchase some of the largest foreign-based corporations in U.S. dollars. In this case, the idea of purchasing in this area is that: the overall risks can be reduced and there is greater transparency. This is because these companies are subject to some of the stringent U.S. listing standards. Therefore, they will have greater amounts of transparency. In this case, we are going to be selecting ADRs from some the fastest growing emerging economies. We have allocated a larger percentage in this area, because the developing economies have been providing superior economic growth during the recession and recovery. Technology was selected, because of the tremendous advancements that are taking place. This can provide the portfolio with above average growth by: purchasing those companies that are investing in areas that will be in demand in the future. As these shifts in technology will create changes in how everyone is living their daily lives. The 10% in cash will be placed in various money market funds that can be liquidated for purchases in the future. At the same time, it will serve as a vehicle for: various dividends and trading capital. Once the strategy has been implemented this will provide the portfolio with: above average growth and balance.
Individual Stock Selection
The selection of stock in the portfolio; means, that we must find specific companies that can fit in line with the different sectors that were mentioned earlier. Based upon the research that has been conducted there are a number of companies that should be purchased. The most notable to include: Newmont Mining (NEM), Caterpillar (CAT), Valero (VLO), Molson Coors (TAP), Biadu.com (BIDU), and Amazon.com (AMZN). The below chart illustrates the overall allocation in the account.
Total Stock Allocation
These different companies were chosen, because they can provide the portfolio with: balance and above average growth.
However, there are some stocks that are volatile, which could increase the overall amounts of risks. To address this issue, we will be using sell stops on select securities. Simply put, this is a sell order that is placed in advance, to limit the overall downside. For example, if company’s stock declines to the sell stop price, it will become a market order and is sold. The basic concept behind this strategy is: to place these orders on volatile stocks. (Perunia) This will reduce the possibility of: buying / holding equity securities at all time highs and it will help to maximize the returns in the portfolio.
Newmont Mining is gold and silver producer that has been seeing consistently increasing earnings per share (EPS) over the last several quarters. as, the EPS for the company increased from: $.83 cents to $1.16 (on a quarterly basis). The net income is $2.03 billion and it has a book value of $27.08. The current price earnings ratio is 10.77 and the current price to book ratio is 1.86. The company is paying a dividend of $.60 cents or 1.10%. The 52-week high is $65.50, while the 52-week low is: $48.20. The total amounts of stockholders equity are: 22.20%. The beta on the stock is .40 (below the market average of 1.00). In comparison to the industry, Newmont Mining is considerably stronger. Evidence of this can be seen within the industry itself, as it has a PEG ratio of 1.84 versus 15.00 for Newmont Mining. When you look at the industry in correlation with the company, it is clear that Newmont Mining has greater amounts of increasing profit potential and lower risks. This is significant, because it meant that the company is an ideal candidate that can benefit from the increases in gold prices. While at the same time, they have taken the steps necessary to: lower their underlying costs and increase their profit margins. Over the next ten years, these two factors will help to provide consistently increasing returns and stability from a host of situations. (“Newmont Mining”)
Caterpillar is a heavy industrial manufacturer of construction equipment. The purchase of this security over the next ten years will help to provide above average growth. The reason why, is because they are rapidly expanding into many developing regions (such as: Brazil). As a result, they have a number of different strengths. The most notable include: net income of $2.07 billion, quarterly EPS between $.36 to $1.47, a book value per share of 16.94, a current PE ratio of 12.94, a current price to book of 5.93, an annual dividend of $1.76 / 1.70%, a 52-week high of $105.86, a 52-week low of $54.89, stockholders equity of 26.74%, a total market capitalization of $65.88 billion and a beta of 1.88. When you compare this to the industry, Caterpillar is a much stronger company. Evidence of this can be seen by looking no further than contrasting the PEG ratio and the quarterly year over year growth. In the case of Cat, they have a PEG ratio of .84 and quarterly year over year growth of 62.20%. While the industry currently does not have a PEG ratio and the year over year growth is currently at zero. This is important, because it shows how Caterpillar was selected, due to increasing amounts growth that it can provide over the next ten years. As they can use the upward earnings momentum, to be able to dramatically increase their overall returns. (“Caterpillar”)
General Motors was selected, because it can provide a way of seeing substantial appreciation in a turnaround (since the company has emerged from bankruptcy), as they were able to eliminate those issues that were affecting their organization in the past. As a result, they are able to: effectively compete and have the possibility of seeing significant long-term appreciation over ten years. As they have a number of different advantages that will help them to see increasing amounts of growth. The most notable include: a net income of $4.76 billion, a book value of 17.19, a current PE ratio of 6.19, a current price to book of 1.85, they are not paying any dividends, the 52-week high is $39.48, the 52-week low is $30.65, the stockholders equity is 19.67%, the total market capitalization is $49.07 billion and there is no beta. While the industry, has been facing a number of different challenges in comparison to the company (after it emerged from bankruptcy). A good example of this can be seen by comparing the revenues and year of year earnings growth. In the case of GM, they have revenues of $135 billion and year over year earnings growth of 14.30%. This is considerably better than the industry which has: average revenues of $166 million and the year over year earnings growth is a -47.30%. What this shows, is that GM has become a stronger company during the bankruptcy process. Therefore, they have greater earnings momentum over the next ten years, which will provide substantial profits to investors who are patient. (“General Motors”)
Valero Energy is involved in the refining / marketing of: gasoline and ethanol. Over the past several years their earnings have been following the up and down movement in the price of oil. However, since the economy has begun to recover, is when the underlying profits have begun to stabilize. As demand for gasoline, began to increase, with the improvement in economic activity. This has given the company a number of different advantages to include: net income of $922 million, EPS of $2.77, a current PE ratio of 8.09, a current price to book of 1.04, a dividend of $.20 cent / .20%, the 52-week high is $30.42, the 52-week low is $15.49, stockholders equity of 6.21%, it has a market capitalization of $15.88 billion and it has a beta of 1.16. These different elements are important, because they are showing how this company can take advantage of sharp increases in the price of gasoline. As it is remaining at high levels which are providing them with: increasing profit margins. Therefore, an investment in the stock over ten years will help to give the portfolio higher returns. (“Valero”)
Molson Coors was selected because it can provide the portfolio with protection against sudden shifts in the economy. as, we are purchasing a company that: manufacturers and markets beer. The reason why, is because these kinds of products will remain in demand regardless of the underlying economic conditions. Therefore, this company was selected because it can provide the portfolio with above average returns and balance. This has given them a number of different advantages to include: net income of $688 million, EPS of $3.83, a book value of 41.75, a current PE ratio of 10.70, a current price to book of 1.03, dividends of $1.12 / 2.60%, a 52-week high of $51.11, a 52-week low of $39.89, stockholder equity of 8.98%, a total market capitalization of $8.08 billion and beta factor of .72. These different elements are important, because they are showing how the company has: higher amounts of long-term growth and lower risks. When you compare this with the industry, Molson Coors is a stronger player. Evidence of this can be seen by looking no further than, PEG ratio which is: 1.34 for Coors and 1.10 for the industry. At the same time, the underlying amounts of year over year growth are stronger at the company. As Coors has 1.70% growth; while the industry is experiencing 1.00%. This is significant, because it shows how Molson Coors can be able to provide that consistent long-term growth, without having the volatility like other industries. (“Molson Coors”)
Biadu.com was selected, because it can provide the portfolio with above average growth. As the company is a Chinese based ADR; that is considered to be the largest search engines in China. This will allow the portfolio to participate in: the above average strength of many emerging economies (such as China). As a result, there are a number of different advantages that this company has going for it. The most notable include: a net income of $536 million, EPS of $1.54, a book value of 32.84, a current PE ratio of 33.77, a current price to book ratio of 34.88, there are no dividends that are being paid, the 52-week high is $131.63, the 52-week low is $56.08, shareholder equity is 53.58%, a market capitalization of $42.39 and a beta of 1.61. These different elements are important, because they are showing how the company can provide the portfolio with higher than normal returns. Evidence of this can be seen by comparing the operating margins and year over year growth within the industry in contrast to the company. In the case of Baidu, they have an operating margin of 50.02% and year over year revenue growth of 94.4%. While the industry, is experiencing operating margins of 50.02% and year over year revenue growth of 8.50%. This is significant, because it shows how Baidu can provide the portfolio with above average growth, in one of the strongest economies in the world. (“Baidu.com”)
Amazon.com was selected, because it can provide the account with above average growth. As it one of the top retailers on the Internet, with a track record of innovative marketing and delivering proven earnings results to shareholders. As the company has number of advantages in its favor to include: net income of $1.15 billion, EPS of $2.53, a book value per share of 15.22, a current PE ratio of 36.25, a current price to book ratio of 10.82, the company does not pay any kind of dividends, the 52-week high is $105.80, the 52-week low is 191.60, the shareholder equity is 19.01%, $72.06 billion and a beta factor of .94. This is important, because it shows how Amazon.com has the ability to provide consistently increasing earnings over the next ten years. Evidence of this can be seen by: comparing the operating margins and gross profit margins for the company with the industry. As Amazon.com, has operating margins of: 4.11% and gross profit margins of 22.35%. While the industry, is seeing operating margins of -264% and gross profit margins of -123%. These different elements are significant, because they are showing how the underlying profit margins for Amazon are considerably stronger than the industry average. Therefore, this will provide the portfolio with added amounts of long-term capital appreciation over the next ten years. (“Amazon.com”)
Since this strategy is considered to entail moderate amounts of risks, means that some of the different stocks that were selected could become very volatile. To limit our exposure to the large swings, we will place sell stops at strategic points. One way that this can be accomplished is: by placing the sell stop near acceptable levels of percentage declines that are occurring in the stock. As you could set the downside to 10%, by placing the sell stop at this point. In the event that some kind of sudden amount of selling pressure increases, these different stops will take you out of the position before there is a significant decline in the price. As a result, sell stops should be placed on the most volatile areas of the portfolio to include: Baidu.com, Amazon.com, Caterpillar and Valero. This will reduce the underlying amounts of risk that the portfolio is facing, while ensuring that we are maximizing the profits as much as possible. Once this occurs, it will make certain that the strategy is in line with the overall amounts of: risk tolerance and the potential rewards that were are seeking. (Weinstein)
Clearly, the strategy that has been established can provide above average amounts of growth, while reducing the underlying risks. This is because, it working off the premise of: diversifying in a number of different sectors and using sell stops to limit the downside in volatile areas. These two elements are important, because they are providing the portfolio with: balance and the ability to outperform the historical average return of the stock market. As there were a number of different companies that were selected to include: Newmont Mining, Caterpillar, Valero, Molson Coors, Biadu.com and Amazon.com. These companies are in variety of sectors such as: precious metals, oil / gas, ADRs, consumer staples, industrials, select technology and cash. These areas were selected, because they can provide the portfolio with above average growth, regardless of shifts that are occurring in the economy. This is because there is number of cross currents that could have an impact upon the strategy to include: inflation, rising corporate earnings and geopolitical concerns. This is problematic, due to the fact that there are several different scenarios that could be taking place in the economy simultaneously. As there is the possibility that economic growth could continue, over the next few years. However, beneath the surface various threats to the recovery include: sharp increases in inflation and concerns about geopolitical issues in select areas of the world. As a result, it is difficult to determine, which direction the economy could be heading. To take advantage of all possible scenarios, the above strategy was selected. As this will provide balance to: the account and it will ensure that the overall amounts of risk are mitigated as much as possible. This means that we must use various sell stops on some of the most volatile positions to include: Baidu.com, Amazon.com, Caterpillar and Valero. Once this has been implemented, it will limit the maximum possible losses to an acceptable amount that is determined in advance. While at the same time, the portfolio is diversified enough that it can provide above average growth. Therefore, the current strategy that we are using is embracing moderate amounts of risk with above average growth. At which point, the long-term returns will be greater over a ten-year time frame, in comparison with the historical average return of the markets.
Amazon.com. Yahoo Finance, 2011. Web. 17 Mar. 2011
Baidu.com. Yahoo Finance, 2011. Web. 17 Mar. 2011
Caterpillar. Yahoo Finance, 2011. Web. 17 Mar. 2011
General Motors. Yahoo Finance, 2011. Web. 17 Mar. 2011.
Gunfire at Saudi Arabian Protests. Arabian Money, 2011. Web. 17 Mar. 2011
Job Growth Accelerates. RTT News, 2011. Web. 17 Mar. 2011
Molson Coors. Yahoo Finance, 2011. Web. 17 Mar. 2011
Newmont Mining. Yahoo Finance, 2011. Web. 17 Mar. 2011
Ten Big Dot Com Flops. CNN, 2010. Web. 17 Mar. 2011
Valero. Yahoo Finance, 2011. Web. 17 Mar. 2011
Berner, Robert. “The Next Warren Buffet.” Business Week, 2004. Web. 17 Mar. 2011
Burtless, Gary. “Returns and Risks of Stock Market Investments.” Brookings Institute, 1999. Web. 17 Mar. 2011
Hennigan, Michael. “U.S. Department of Agriculture Says.” Fin Facts, 2011. Web. 17 Mar. 2011
Perunia, Chris. “Placing Sell Stops.” Ezine Articles, 2005. Web. 17 Mar. 2011
Wagner, Hans. “S&P 500 Corporate Earnings.” Market Oracle, 2010. Web. 17 Mar. 2011
Weinstein, Stan. How to Profit in Bull and Bear Markets. New York: Simon and Schuster, 1988. Print.
Western, David. Booms, Bubbles and Busts. New York: Routledge, 2004. Print.
MLA Format. http://owl.english.purdue.edu/owl/resource/747/01/
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