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The Average Joes Of The Dow

Summary We all know about the Dogs of the Dow. Last week I wrote about the Dow’s lowest-yielding stocks – the Gods of the Dow. The next step was to look at the middle-yielding stocks – the “Average Joes of the Dow.” See the results. In the past week I released an article, exclusively on SA, called ” The Gods of the Dow .” The main thrust of the article was to compare the performance of the 10 highest-yielding stocks of the Dow (the Dogs) against the 10 lowest-yielding stocks (what I called “the Gods”) over a decade. The Dogs won the contest by quite a margin. Here is a summary chart showing the performance of the investment strategies. The next logical step is to see how the middle 10 stocks of the Dow would perform. I call this cohort of stocks the “Average Joes of the Dow.” I am having a bit of fun running these tests, but I do believe these 3 groups – the Dogs, the Gods, and the Average Joes – act as rough proxies for value investment, growth investment and the middle ground in between. The Average Joes of the Dow Investment Strategy On December 31, buy the Dow’s 10 middle-yielding stocks. Hold these stocks for a year. Sell the 10 positions on December 31 the following year. Repeat the above process annually. Note: Stocks that are dropped from the Dow during the course of the year are still held until year-end — e.g., you would still hold AT&T through December 31, 2015, if you had purchased it December 31, 2014. Another note: The data for the test comes from the “Dogs of the Dow” website. I am not sure what would happen in the event or a merger or acquisition. A current example would be Pfizer: Allergan has proposed acquiring Pfizer in 2016. If you bought Pfizer on December 31, 2015, you would most likely sell the merged company or acquirer on December 31, 2016, but I am uncertain as to how such events were handled in this historic data set. The Dogs of the Dow Investment Strategy The same as above, but you buy the 10 highest-yielding stocks of the Dow year after year. The Questions What was the annual performance of each strategy on a total return basis? What was the overall performance of each strategy over a 10 year period? Some Sample Data The Dogs of the Dow on December 31, 2014 were: (NYSE: T ) AT&T 33.59 5.48% (NYSE: VZ ) Verizon 46.78 4.70% (NYSE: CVX ) Chevron 112.18 3.82% (NYSE: MCD ) McDonald’s 93.7 3.63% (NYSE: PFE ) Pfizer 31.15 3.60% (NYSE: GE ) General Electric 25.27 3.48% (NYSE: MRK ) Merck 56.79 3.17% (NYSE: CAT ) Caterpillar 91.53 3.06% (NYSE: XOM ) ExxonMobil 92.45 2.99% (NYSE: KO ) Coca-Cola 42.22 2.89% The Average Joes of the Dow on 31 December 2014 were: PG Procter & Gamble 91.09 2.82% IBM International Business Machines 160.44 2.74% CSCO Cisco Systems 27.82 2.73% JNJ Johnson & Johnson 104.57 2.68% MSFT Microsoft 46.45 2.67% JPM JPMorgan Chase 62.58 2.56% DD DuPont 73.94 2.54% INTC Intel 36.29 2.48% BA Boeing 129.98 2.25% WMT Wal-Mart 85.88 2.24% The Results The total returns each year of the Joes vs. the Dogs is shown in the chart below: 2005 2006 2007 2008 2009 Joes 7.65% 18% 16.60% -24.81% 26.65% Dogs -3.46% 25.80% 2.10% -36.56% 17.19% 2010 2011 2012 2013 2014 Joes 16.40% 9.25% 13.19% 33.77% 11.63% Dogs 21.43% 16.85% 8.95% 28.54% 6.45% Here’s a year-by-year comparison of the Joes Vs the Dogs in an easier-to-read graphic. The true outperformance is best explained by considering how well a $10k investment in each strategy on December 31, 2004, would have fared, as shown below: Over the 10-year period, the Joes strongly outperformed the Dogs. The Dogs strategy would have nearly double your money in 10 years, turning $10,000 into $19,320 — not bad. But the Joes strategy would have performed much better, turning $10,000 into $30,320! Conclusion First of all, I want to qualify the above analysis with the observation that it is only based on 10 years of data. As such, the Joes may have had a few exceptionally good years at the start of the decade which then exaggerates out-performance in the later years of the decade. Indeed looking at the Joes cohort from 31 December 2014, one would be concerned by some of the picks: P&G has lost 14% TR YTD IBM has lost 11% TR YTD Wal-Mart has lost 28% TR YTD But despite the above, the Average Joes has only lost 3% YTD on a total return basis. The Joes has included some good performers: MSFT has gained 20% TR YTD Boeing has gained 15.5% TR YTD JPMorgan Chase has gained 10% TR YTD The Dogs have had a better 2015 so far, with just a 1% loss. I have to say it is quite comforting to know that with such big individual losers in the Joes, that the overall loss is not too bad. I know in my own portfolio that I have had big losers this year, and it is quite easy to dwell on those underperformers. When I look at my total performance, it’s actually okay — it’s breaking even — and I need to focus on the big picture.

What Is In Store For REIT ETFs Ahead?

As the timeline of the first rate hike after a decade is approaching this month, interest-rate sensitive sectors like REITs are falling out of investors’ favor. REIT ETFs emerged a winner last year thanks to widespread volatility, but are mostly in the red this year as the Fed liftoff is looming large (read: Top ETF Stories of November ). Notably, REITs own and operate income-producing real estate. They are required to distribute at least 90% of their taxable income to shareholders annually in the form of dividends and can in turn deduct the payout from their corporate taxable income. The basic idea is that a rise in interest rates will undoubtedly lead to a high borrowing cost on which the REITs are highly dependent. Moreover, high-dividend yielding stocks like REITs usually become less attractive when treasury yields rise. At this point of time, we can say that a policy tightening is unavoidable in the mid-December Fed meeting; at least the Fed officials and economic progress are giving such cues. Minor lack in some economic readings wouldn’t come in the way of the Fed decision. Recent comments from the Fed have certainly influenced Treasury bond yields too. With the yields increasing, several investors may now be turning away from REITs. But do REITs deserve such negligence? Are investors overreacting? Let’s find out. Short-Term Yields Rising Faster Investors should note that the 10-year benchmark Treasury bond yields jumped 21 basis points to 2.33% (as of December 3, 2015) since the start of the year, a relatively slower ascent than what we saw in 2013 due to Fed taper talks. It was the short end of the yield curve that was hit hard (read: Short-Term Bond Yields Rising: Timely ETF Bets ). Yields on the six-month U.S. Treasury bonds surged 34 bps to 0.45% (as of the same date) since the start of the year as the Fed hikes the benchmark rate. In such a situation, investors can very well bet on the income-producing securities like REITs as long-term Treasury yields are not rising as fast as feared. Moreover, the Fed repeatedly asserted that it will take a slow stance in policy tightening giving yet another reason not to worry much over REIT securities. As investors continue to search for income, REITs can give them some market-beating yields which will in turn make up for capital losses also, if there is any. Economic Strength to Bode Well The negative correlation between rising rates and REITs, in all cases, is a common misconception. Notably, when rates rise on the back of a pickup in the economy, REITs actually outperform. As per reit.com , “in the 16 periods since 1995 when interest rates rose significantly, Equity REITs generated positive returns in 12.” The REITs business is associated with basic consumer requirements like apartments, shopping malls, warehouses, lodging and dining, office, hospital among others. In a growing economy, people consume and spend more in malls for discretionary purchases. An uptick in the U.S. housing sector is now a known fact; job growth will push office REITs and hospital REITs are always a stable area, irrespective of the market condition. Now, as the Fed is viewing the economy as strong enough to gobble up the first rate hike, there should not be much downside risks in REIT stocks and ETFs. After all, the job market is healing and inflation is inching up. REITs stand to gain with growth in occupancy and hike in rents. The consistent increase in rent will also help REITs to keep pace with inflation. Overvaluation Concerns However, there are hurdles in the path too as REIT ETFs are not all cheap investments. The popular Vanguard REIT Index ETF (NYSEARCA: VNQ ) trades at a P/E ((ttm)) of 34 times against the SPDR S&P 500 Trust ETF’s (NYSEARCA: SPY ) P/E of 19. So, just as the Fed pulls the trigger, a correction, probably a short-lived one, is expected in the REIT space. Below highlight three REIT ETFs that were relatively less hit by rate worries in the last one-month frame and proved sturdier in the pack. iShares Residential Real Estate Capped ETF (NYSEARCA: REZ ) The $319-million fund is heavy on Residential REITs and Health Care REITs. The 37-stocks fund charges 48 bps in fees. However, the fund has concentration risks as its first two holdings take about 23% of the basket. The fund yields 3.25% and was down just 0.02% in the last one-month frame (as of December 3, 2015). IQ U.S. Real Estate Small Cap ETF (NYSEARCA: ROOF ) The fund holds 60 small-cap stocks in the basket. It is an unpopular choice with about $86 million in assets. The ETF charges 69 bps in fees per year from investors. The product is less concentrated across its top 10 securities as no stock accounts for more than 3.50% of the basket. ROOF was down 2.5% in the last one month and yielded 5.68% as of December 3, 2015. The fund currently has a Zacks ETF Rank #3 (Hold) with a Medium risk outlook. iShares Cohen & Steers REIT ETF (NYSEARCA: ICF ) This $3.57-billion fund holds 30 securities. Industry-wide, retail, residential, specialized, office and health care REITs get double-digit weights. The fund charges 35 bps a year in fees. The fund lost about 2.9% in the last one month and yielded 3.22% as of December 3, 2015. Link to the original post on Zacks.com

The Risk Impact Of Valeant Pharmaceuticals Intl Inc On Sequoia Fund

The Risk Impact Of Valeant Pharmaceuticals Intl Inc (NYSE: VRX ) On Sequoia Fund by AlphaBetaWorks Insights “This is your fund on drugs” The Sequoia Fund’s (MUTF: SEQUX ) hefty sizing of Valeant Pharmaceuticals ( VRX ) dramatically changed the fund’s risk profile from historical norms. With the proper tools, allocators would have noticed this style drift back in Q2 2015 when Sequoia’s key factor exposures moved two to three times beyond historical averages. What’s more, allocators would have noticed a predicted volatility increase of 25% and a tracking-error increased 70%. Though this analysis would not have anticipated Valeant’s subsequent decline, it would have warned fund investors that Sequoia’s risk was out of the ordinary. Sequoia Fund’s Risk Profile Below is a chart of Sequoia’s major factor exposures , spanning a ten year history through June 2015: (click to enlarge) Sequoia Fund – Historical Factor Exposures (Note that this analysis and our model do not include Valeant’s recent heightened volatility: we are using the AlphaBetaWorks Statistical Equity Risk Model as of 8/31/15 and SEQUX’s positions as of 6/30/2015. In short, we are looking at the world prior to Valeant’s subsequent downside volatility.) Sequoia’s stock selection and allocation decisions result in certain factor bets such as market beta (“US and Canada”, above), other factors (Value, Size), and sectors (Consumer, Health). The red dots above represent factor exposures in a particular month, the red boxes represent two quartile deviations, and the diamonds denote current (i.e. 6/30/15) exposures. Several sectors/factors are circled for emphasis: they are current exposures as well as outliers versus history. More importantly, these outlying factor bets are the direct result of Sequoia’s large percentage ownership of Valeant. The Impact of Valeant on Sequoia Fund’s Factor Exposures We examined Sequoia Fund’s factor exposures with and without Valeant. We assumed that the pro forma Sequoia Fund without Valeant would have increased all other positions proportionally to make up for the void. For example, we increase Sequoia’s next-largest position in TJX Companies Inc. (NYSE: TJX ) from 7.3% to 10.9%, and so on for all longs for the pro forma non-Valeant Sequoia portfolio. Below is a chart comparing the most salient factor exposures of Sequoia Fund, with and without Valeant: (click to enlarge) Sequoia Fund – Factor Exposures With and Without Valeant Valeant has had a significant impact on Sequoia’s factor exposures. The factors with the highest delta are the same as those highlighted as outliers on the first chart above. This is significant in several ways. First, the large Valeant holding increases Sequoia Fund’s overall volatility by 25%. Second, Sequoia’s tracking error is increased by its Valeant holding by 70%. Sequoia Fund volatility estimates with and without Valeant are below: (click to enlarge) Sequoia Fund with Valeant – Absolute and Relative (to S&P 500) Estimated Risk (click to enlarge) Sequoia Fund without Valeant – Absolute and Relative (to S&P 500) Estimated Risk Valeant increases Sequoia’s overall predicted volatility (tracking error) by 26% (from 9.73% to 12.31%, annualized – gold boxes). Likewise, Valeant increases Sequoia’s tracking error by 69% (from 5.19% to 8.76% – brown boxes). Increases in both Absolute and Relative volatility are due to the incremental Residual Risk contribution of Sequoia’s large Valeant holding (graphically shown by the larger blue boxes in the “with VRX” charts, in contrast to smaller blue boxes in the “without VRX” charts). Conclusions In the end, this analysis is not about Sequoia or VRX. It is a single example of decisions that could have been avoided by a portfolio manager or questions that would have arisen to an allocator with the proper risk toolkit. Sequoia’s decision to make Valeant an outsized position did not go unnoticed from a risk standpoint. Increases in factor exposures of two to three times outside historical bounds were an early warning. The impact of this was increased predicted volatility – both on an absolute basis and relative to the S&P 500. A framework that warns of a fund taking large factor and idiosyncratic bets aids greatly in avoiding negative surprises. Disclosure : None.