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Warwick Langebrink

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Nov 24, 2014, 5:19:29 AM11/24/14

to Warwick Langebrink

Morning everyone

· Bond yields have now decreased further – now by about 50 basis points (half a percent) since beginning October. Yields at 21 November are in RED while beginning October yields are in BLUE

· Yields of the Bonds (RED SQUARE DATA POINTS) remain well above the Yield curve (RED LINE AND TRIANGLES) indicating high credit spreads and international investor nervousness.

· A couple of articles I found interesting (hamburgers for the brain):

· Buffett recommends very low cost S&P 500 index fund e.g. Vanguard in an article from Forbes Magazine. Buffett's Bad Advice

· Active Investing vs Investing into e.g. Vanguard Fund (Passive Investing ) from Seeking Alpha:Dividend Growth Investing, Total Return, And Indexing Revisited

· Acacia Preferences Shares: AA and Pricing.

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Buffett's Bad Advice

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In the modern world of investing, complexity dominates. Thousands of difficult-to-assess choices present themselves, often with the perverse result of confounding us further rather than solving a problem. In response, the principle of “simplicity” is ascendant among advisors, fund managers, brokers, and authors.

But what counts as simple? Unfortunately (and ironically), the answer is elusive.

Having recently authored a book on why we have so much choice, why it’s so overwhelming, and what to do about it, the most common response I’ve received from readers is along the lines of: Come on, just buy an index fund that tracks the market and be done with it!

Indeed, the vast majority of funds are actively managed and many show little sign of beating their bogeys for any meaningful period of time. So go passive and worry about something else in your life you actually have control over. Indeed, no less a luminary than Warren Buffett has frequently advised we do just that. In Berkshire Hathaway's 2013 annual letter, for example, Buffett wrote:

My advice … could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.

Clearly, investors have listened to Buffett, Vanguard founder John Bogle, and other indexing prophets. Morningstar MORN +0.4% recently highlighted the current “bull market” in passive investing, especially in equities. In the decade from 2003 to 2013, the percent of U.S. equity assets that were indexed doubled from 17% to 35%. That more than one-third U.S. equity fund investments sit in passive vehicles speaks volumes to the popularity of this approach.

The trend is clear. But the question remains: Is going passive the “simple” (and by implication, smart) approach?

Not necessarily.

In 2014, buying “the market” is not even close to the simple answer than many investors assume it is. Let me offer several reasons why.

To start, I’ll deliberately pay short shrift to the conventional approach to this topic, which is the age-old debate over active vs. passive approaches. This is a rabbit hole of data and arguments from which it is sometimes difficult to emerge. Thus, briefly, even in passive management’s most hallowed ground – large-cap US stocks – there is compelling evidence that managers with appropriate fee structures can win out over time. The evidence is even stronger in small-cap, non-US (especially emerging markets), and fixed income markets.

Still, even if we grant that many active managers cannot beat their bogey over the long run, there are still ample challenges to the idea that indexing is “simple.”

First, Buffett’s advice flies in the face of the most basic principle in investing, which is diversification. While perhaps intended as shorthand for “go passive” rather than a prescription for parking most of your assets in large-cap U.S. stocks, the one-size-fits all solution hardly resonates as sound financial planning advice. As is well-understood and well-evidenced, exposure to lower-correlated assets produces more optimal portfolios, so venturing away from U.S. large caps to any number of other equity, bond, real estate, and alternative asset classes makes sense.

Second, index investors often assume that because they’ve bought “the market,” they have necessarily diversified their holdings and thus mitigated portfolio risk. But that’s clearly not true. A powerful example of this is that leading up to the 2000 bear market, around 29 percent of the S&P 500 was in technology companies, many of them overvalued. The numbers for the NASDAQ market at the time were even more extreme, and that market hasn’t come close to recapturing its early 2000 highs. Likewise, leading into the 2008 crisis, a meaningful percentage of the S&P 500 was exposed to finance, housing, and mortgage related stocks – many of which contributed to a 37% drop in the overall market that year. Don’t think that owning “the market” protects you from serious losses. It never has.

Third, the right way to define and invest in “the market” is evolving, rendering claims about simplicity tenuous. Keep in mind that the first index fund wasn’t launched until 1971, and like any invented product, it has deliberate design features and potential flaws. Historically, most index funds have been market-cap weighted (i.e., the bigger companies have a bigger role in the portfolio), but that’s not always a good thing, as the bear market losses over the last decade-and-a-half demonstrate. In fact, there are newer indexing approaches – sometimes described as “fundamental” or “smart” beta – which weight certain stocks or risk factors differently. There is evidence to suggest that these newer approaches are better. It may appear, years in retrospect, that we were indexing incorrectly for decades.

Finally, none of this indexing strategy immunizes an investor from its greatest risk: himself. Investors tend to buy high and sell low – exactly the opposite of a wise approach. As a result, it’s painfully clear that the listed returns for funds far exceeds what investors actually earn. Index funds, just like actively managed funds, are highly volatile, which means they can induce just the same level of suboptimal behaviour, which belies the somewhat folksy impression that indexing is simple. Those who believe the latter might sacrifice vigilance for complacency.

Are there worse paths to follow than just buying the Vanguard 500 Fund, or something like it? Of course there are. There are terribly overpriced and mismanaged funds that lard up too many portfolios. And it is hardly Buffett’s or Bogle’s fault that the marketplace has been inundated with choices, or that we are our own worst enemy when it comes to investing. That said, there is really nothing passive about “passive” investing. It involves a series of choices, some much more complicated in both financial and behavioral terms than the casual observer might recognize.

Dividend Growth Investing, Total Return, And Indexing Revisited

Summary

· Does dividend growth investing as a primary strategy always produce optimal total return?

· Does dividend growth investing provide total return superior to index investing?

· At least during the current bull market, the answer to both of these questions is no.

The topics of dividend growth investing and total return have been intermittently revisited in these pages, particularly in recent articles by Part-time Investor, Mike Nadel, Dale Roberts and David Crosetti, and in the innumerable comments that they have engendered. It is also probably accurate to say that many of the authors and commenters in this section of Seeking Alpha (Dividends and Income) regard index investing as a pursuit for those who are not financially sophisticated, are not interested, or are too busy.

There is extensive incontrovertible evidence (accessible to anyone who wants to Google for it) that the majority of professional financial managers cannot provide consistent equity returns which exceed market-indexed investing. Despite all this evidence, there are persistent claims by both professional and amateur investors that some special systems of investing (short of insider trading or high-frequency trading) will produce market-beating results.

Whether one invests for growth early in one's life or for income later when one is retired, total return is ultimately the bottom line for both. The question as to whether investing for growth or income or a combination of both producesoptimal total return can and will be endlessly debated.

In the recent article, "Dividend Growth Investing IS Total Return Investing," the author makes the claim that dividend growth investing leads to "market-beating returns." That article led to seriously unpleasant arguments about cherry-picking of data. The article was not an academically professional statistical analysis of data - but it did not pretend to be. But its claims probably exceed its methodology.

In the recent article, "The Real Nifty 50 for Dividend Growth Investors," the author raised the question as to whether or not the "Nifty Fifty" portfolio proposed by Mike Nadel, as an amalgam of stocks proposed by experienced SA dividend growth investors, could be replicated by a single fund. That article also led to discussion which at times was unpleasant.

As a straightforward and not particularly difficult exercise, I decided to compare a sampling of those Nifty Fifty stocks with major market indices (arbitrarily VTI and SPY) for their total return over 5 years. I chose five years because it is a reasonably long time frame which generally corresponds to the current bull market. I did not try to back test it for 20 years through our last two major recessions for a simple reason. I do not think that stock-picking is the best way to protect a portfolio through a major draw-down such as occurred in 2000 or 2008. That is the role of cash, gold, bonds, and bond equivalents (utilities and preferred stock) in appropriate proportions. You cannot create an all-equity portfolio with a beta of 0.5 and have reasonable alpha.

So, for the purposes of this simple non-academic analysis, I chose those Nifty Fifty stocks which had been chosen by 10, 9, 8, 7, and 6 of Mike Nadel's contributors which conveniently happened to be 30 stocks. The index exchange traded funds I chose for comparison were Vanguard Total Stock Market ETF (NYSEARCA:VTI) and SPDR S&P 500 Trust ETF (NYSEARCA:SPY), for reasons which I hope are obvious.

Surprisingly, or not surprisingly, depending on your perspective, only 8 of the 30 stocks outperformed the indices for total return over the last 5 years, and two stocks had equivalent performance. Thus, only 33% of the stocks matched the indices. The other 20 all underperformed to varying degrees.

Here is the data:

*STANDARDS*	*SYMBOL* *(NYSE)*	*5-YR TOTAL RETURN*
Vanguard Total Stock Market ETF	VTI	111.5%
SPDR S&P 500 ETF Trust	SPY	107.1%

*COMPANIES*	*SYMBOL* *(NYSE)*	*5-YR TOTAL RETURN*	*COMPARISON*
Chevron	CVX	78.5%	underperform
Coca-Cola	KO	80.0%	underperform
Kimberly-Clark	KMB	120.8%	outperform
Johnson & Johnson	JNJ	104.0%	equivalent
Procter & Gamble	PG	66.7%	underperform
Exxon Mobil	XOM	45.6%	underperform
McDonald's	MCD	79.1%	underperform
PepsiCo	PEP	83.6%	underperform
Southern Company	SO	88.8%	underperform
AT&T	T	77.8%	underperform
Colgate-Palmolive	CL	81.8%	underperform
General Mills	GIS	78.8%	underperform
Realty Income	O	138.1%	outperform
Target	TGT	77.8%	underperform
3M	MMM	133.3%	outperform
Altria	MO	236.7%	outperform
Genuine Parts	GPC	224.7%	outperform
Lockheed Martin	LMT	201.2%	outperform
Microsoft	MSFT	88.6%	underperform
Phillip Morris	PM	11.1%	equivalent
Walgreen	WAG	94.6%	underperform
AFLAC	AFL	52.9%	underperform
Baxter International	BAX	48.6%	underperform
ConocoPhillips	COP	127.9%	outperform
Deere	DE	87.7%	underperform
Emerson Electric	EMR	76.8%	underperform
IBM	IBM	38.2%	underperform
Kinder Morgan	KMI	55.4%	underperform
Visa	V	225.5%	outperform
Wal-Mart	WMT	74.9%	underperform

So, what conclusions can we draw from this? Five years ago, an investor would have had to be very prescient to have selected a portfolio consisting of only the outperforming and equivalently performing stocks: KMB, JNJ, O, 3M, MO, GPC, LMT, PM, COP, and V. But an investor would not have had to be very prescient, or sophisticated, or even smart to have put all or much of their money into VTI or SPY. And undoubtedly many did. And, at the end of these five years, they would have had more money in their portfolio than even the most disciplined dividend growth investor who disdained index funds.

For those who pursue dividend growth investing, I would only say that one simply cannot ignore the concept of total return. And you certainly cannot assume that dividend growth investing automatically produces optimal total return.

Bob Wells has been particularly diligent among our contributors in writing articles about what his survivors should do when he is gone. See here. I certainly know that my wife and children are not up to serious investing. Warren Buffett usually gets high praise from all investors. He has said that he is going to put all the money he is leaving his wife in an S&P index fund. My assumption is that he agrees with the data I have just presented.

I must confess that I do not have all of my equity investments in index funds. At least managing our investments keeps me off the streets and out of trouble. But I am using index funds more and more. And I strongly suspect that I will be changing my will to follow the lead of Warren.

Acacia Preferences Shares: AA and Pricing.

The ABSA, Standard, Nedbank and FNB bonds and fixed income securities are the cornerstones and building blocks of the Acacia business. If we issue a R100m callable note or debenture, or preference share, then that Acacia issue of R100m is ALWAYS backed by a R100m bond or NCD or instrument from one of the BIG 4 Banks. Banks’ yields are at an all-time high relative to the risk free yield curve. (i.e. Credit Spreads are v favourable at the moment – the chart explains this further.) This means that we can offer investors good yields for our products. Our products are , in a nutshell, Asset Backed Securities (“ABS”), the underlying assets being BIG 4 Bank paper including that charted below: The underlying securities sit at ABSA Custodial Services for the duration of the transaction and are directly Pledged in security to Investor to collateralise the transaction , or in case anything goes wrong (which event has not occurred to date). That is why, in simplistic terms, Acacia has the same credit rating as the BIG 4 Banks.

Please also note that although Banks’ bonds are trading at very favourable spreads (driven by international market forces) , the deposit and investment rates offered by the banks (driven by local bank forces) do not necessarily carry the same yield pick-up. Banks’ bond pricing and Banks deposit rates are driven by different forces and spreads do not necessarily move in lock-step.

I hope you find this chart interesting: Please feel free to get hold of us should you wish to discuss any further ideas in Money Market / Preference Shares..

As mentioned Acacia can play the role of disintermediating the Banks and provide you with yield pick-up, with liquidity. Should you be interested in benefiting from these spreads, Acacia is able to package this return in the form of issuing a Floating Rate / Senior Secured Note or Debenture direct to the client.

As an example, the Acacia redeemable preference share quoted below yields 9.05% on a pre-tax equivalent naca basis, which compares very favourably to the universe of bonds charted above. The reason that the Acacia Preference share is able to offer a higher pre-tax equivalent yield is that dividends are taxed at lower rates than interest, and the pre-tax equivalent rate attributable to preference shares is therefore superior to bonds. Please refer Acacia pricing sheet below for detailed pricing.. The preference share pays monthly dividends, and resets to a unit price of 100% at the end of every month because the investment is redeemable at 100% of the investment value at the end of the term, and secured as described above. The preference share is considered to be operational, and is liquid and therefore sits on the left hand side (short end of the yield curve above)

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