Key points
- Taking advantage of sudden drops in prices isn’t necessarily trading but rebalancing based on mispricing.
- Rebalancing every three months gains precious little over doing so every six months, but rebalancing every six months could be much better than once a year.
- There are many great companies in the healthcare sector but how high can investors push prices with such small dividends?
In my opinion, all sectors had become very reasonably priced or cheap last month. I sold some more Cochlear on May 13 as it looked like its brilliant run might end in tears. As it happened, the stock price has levelled out at around the price at which I sold.
I then ‘pounced’ on Santos on June 4 because it had been really quite beaten up but looked to have a great future – measured by sector forecasts and exuberance in the then equivalent of Table 1 below – and its own broker recommendations. That stock price has too has moved sideways since – for now. I think it has a great future or I wouldn’t have added nearly 50% more to my previous position!
I am hoping that my trade of the month was my buy of Westpac at $31.25 on June 15, following the logic and heat spot chart I showed last month. In effect, I bought back the Westpac I sold at $37.61 on 26th February 2015 but I missed out on the dividend and franking credits amounting to about $1.33 per share. I have set out the history of this parcel of shares in Chart 1 because it so clearly explains how I use my measure of exuberance to gauge market sentiment.
Chart 1: Westpac share price and financials sector exuberance
Source: Thomson-Reuters Datastream & Woodhall Investment Research
Back on the 19th November 2008, I had the financials sectors seriously underpriced – by -32.4% on the day. Many people didn’t take me seriously because being underpriced by 32.5% means that the ‘fair value’ was about 50% higher [1/(1-.324) = 1.48] than the then current price. Fair value for 19/11/08 is shown by the horizontal purple line in Chart 1.
Because the fear index was then so high, it unsurprisingly took a while to reach that estimate of fair value – but then it traded largely sideways for a year or two. That helped me have even more faith in my exuberance measure.
The high-yield play from the second half of 2012 took the price of Westpac up from the mid $20s to the low to mid $30s for much of 2014. Then, at the start of February 2015, the RBA rate cut made the market go wild. I sold on 26th February because I wanted to gain greater exposure to the S&P 500 (i.e. I was rebalancing and not trading) and that looked like a good time to do it.
Then, I had the sector overpriced by +7.9% and ‘fair value’ on 26/2/15 was as shown by the horizontal red line.
I had intended that to be the end of that story, but when Westpac’s price fell sharply to $31.25 – the sector then being underpriced by 5.0% – it seemed too good to be true – especially as the senior executive was going through a very interesting shake-up.
The Cochlear sale from a while earlier funded the buy. But I do not call this behaviour of mine trading – it is rebalancing based on mispricing. I now have very little spare cash (1%).
The best rebalancing strategies
In a very different line of enquiry, I presented a paper at the 2nd Annual Asset Allocation Conference on June 12th. It’s a long story but the conclusion (so far) is that rebalancing my portfolio every three months gains precious little over doing so every six months (and it requires a lot more effort and increases the risk of making a mistake!).
However rebalancing every six months would have been much, much better than once a year over a dozen different start dates for these monthly portfolios. Portfolios get tired and my results-to-date suggest that once a year is too infrequent. Of course, investors who pay tax need to take any CGT into account.
Readers might recall I rebalanced the particular portfolio that I first invested in late June 2014 after about 9 months (March 5th, 2015) based on a less rigorous assessment of the situation. So I now do not plan to rebalance that portfolio until September 2015 after the next reporting season. I so love having evidence – even if it is preliminary – to back my behaviour in the market!
Sectorial review
So while I am sitting on my hands, I plan to evolve a suitable strategy for reducing my equity exposure for when the future looks bleak – as one day it certainly will. My thoughts so far centre on around how I currently populate my sectoral allocations of the S&P/ASX 200 with stocks. Since a stock has to pass certain hurdles to get selected from the total number allocated by my algorithm to that sector, sometimes a sector gets no stocks allocated at all.
There may be no standout stocks in a sector even though the sector as a whole is reasonable. In that case I currently redistribute the sector’s potential allocation across those sectors containing quality stocks.
As a first pass, instead of redistributing potential allocations to vacant sectors, that wealth can be assigned to cash. At a second pass, if there are insufficient stocks to fill the prescribed quota for a given sector, then the excess allocation too could be re-assigned to cash, rather than to the surviving stocks.
This path seems preferable to just selling a portfolio in proportion across all stocks. I want robustness! But I do think it is far too early for me to go to cash. However, the day will come.
It is one thing to set (or buy from cash) a portfolio in times that might become turbulent but another to sell-down a legacy portfolio that was bought in happier times.
There seems to be to me two guiding principles. One is to sell down as in accord with the rules outlined in the previous paragraph. Another is to partially sell down stocks in sectors that are over-exuberant. I reckon I have at least a few months to a year before I need my cash strategy in place! I’ll let you know what I think is best – and hopefully in time – but I am not inclined to make up ideas on the fly just because they sound good.
For interest I am showing my current sector forecasts and exuberance – and for the index – in Table 1. I can’t stress enough the importance of having a great sectoral allocation plan before one tries to populate it with stocks but, with that proviso, all of the high yield sectors have yields between 4.8% and 5.3% with modest prospective capital gains for FY16.
Staples look great, but the water has been muddied by the possible influx of competition from European supermarket chain and Woolworths’ woes. Energy, too, looks excellent but the big boys can move commodity markets quickly. I still own, and like, Santos and Woodside.
It’s hard not to want to own some BHP (and now, also, South 32) and Rio but I won’t dig in any deeper. But I do worry about Healthcare stocks. There are many great companies in the sector but how high can investors push prices of them with such small dividends? I went through most the GFC with about 30% healthcare stocks (which served me very well) and now I have a negligible proportion – after selling lots of Cochlear and CSL at a nice profit.
I could well be proven wrong but I don’t want to manage my super on the roll of the dice. I just feel a big correction coming in that sector – and sometimes gut feeling should influence hard-headed stats. Resmed took a big hit recently based on one adverse clinical trial. The sector has a great future – but isn’t it going to take a breather and/or correction sometime?
Table 1: 12-month-ahead sector forecasts of exuberance, yield and capital gains
Source: Woodhall Investment Research; at close 22nd June 2015
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