It seems like yesterday. I remember when my daughter Sydney came home from school and shared with us that she had been picked to be the lead part in the 2nd-grade musical. Sydney was given the part of the frog that wanted to get into the canopy of the rainforest with the help of her friend the tucan. She was the star of the show, acting and singing. I was a proud papa.
Rumpus in the Rainforest was a production all three of our kids participated in when they reached 2nd grade. Jack was a jaguar and Walker was a monkey. We enjoyed watching all three of them for many years and we talked about going to Central America to visit the rainforest in person one day.
During the summer of 2022, we flew south to Costa Rica. Everyone was excited to go to the beach and visit the rainforest in person. We saw brightly colored tree frogs, lots of monkeys, sloths, tucans, parrots, and even a snake or two. We saw everything the kids had studied except the jaguars.
For the trip, we packed rain jackets and boots, swimsuits, and sandals, as we would be staying close to the beach but within the rainforest. When it was raining, we would need the jackets, but when it was sunny, we’d be able to have fun at the beach. Visiting Costa Rica required us to have more changes of clothes. It was the rainy season, and I remember that even paper left in the open grew damp due to the extreme humidity.
Costa Rica was a place where we could spend time at the beach or watching dolphins in the morning and go ziplining or hiking in the Jungle in the afternoon. It rained almost every day so we had to make sure we had both the beachwear and be prepared for the rain at all times.
Swim Trunks or Rain Jackets?
Consider opening a clothing store close to the beach but also at the edge of the rainforest. At this store do we choose to inventory rain jackets & hiking boots or swim trunks and sandals? Many retailers would choose to sell all these items. What if it doesn’t rain for a month? Do we get rid of all the boots and rain jackets or do we keep them in inventory knowing that eventually rain will come?
A smart retailer may pay close attention to the weather forecast to overweight beachwear when the forecast is for sunny skies and order inventory accordingly. But let’s assume we choose to specialize in rain jackets and hiking boots and forego beachwear altogether. We are much more likely to have periods when it’s raining and sales are great and when it’s sunny and no one visits the store. We might be envious of our retailer friends who diversify their inventory more when it’s sunny.
Consider growth stocks contrasted with high dividend-paying value stocks. Growth stocks can be likened to swim trunks and sandals. They do well when everything is sunny and we don’t see a cloud in the sky. But many investors want to invest for income. They may buy dividend stocks that do great comparatively when it is raining but lag when the sun is out. Just because it’s been sunny for a time does not mean that it will never start raining again, but it may make sense to consider having growth stocks as well as income-producing value stocks in the portfolio to avoid these drought periods with lower profits.
Should we cut our Best Performers? Sunny Days Ahead?
Growth has been far more popular than Income Stocks and Value Investing over the last couple of years. Investments in AI Technology and Blockchain investments have outperformed all else during this period. The Magnificent Seven has become a huge percentage of the S&P 500 and especially the Nasdaq 100. Nvidia has done the best of the seven over this period with only a handful of investments performing better. Most of these better performers have been somehow related to the blockchain.
Technology has never been a greater percentage of the S&P 500 than it is now. The last time it had grown to dominate the markets this much was in March of 2000 before the dot.com bust. This leads us to be wary of an AI bust as well as a digital currency bust. But do we sell these investments just because they have done so well and become a much greater percentage of the portfolio?
History will tell us that many of the best performers of years gone by have continued to do well, long after many may have been tempted to sell them. Many advisors want clients to sell their best performers because they believe a holding that has come to dominate a portfolio causes the portfolio to be subject to too much risk. They define risk as the volatility associated with owning these high-flying stocks and measure volatility on the upside as well as the downside. What many fail to realize is that the best performers are many times some of the most volatile. We don’t want to throw out those that show higher upside volatility, it’s the downside volatility we want to be more concerned about. Some end up pulling the flowers in the garden and keeping the weeds. They want to keep winter coats in the closet just in case it grows cold in the summertime.
Warren Buffett defines risk as “Not knowing what you are doing” and buying companies without an adequate “Margin of Safety.” Warren Buffett has shared time and again that “You would not sell off Michael Jorden just because he has grown so important to the team.” In fact, Apple Computer had grown to over 50% of his stock portfolio in 2023 before he started trimming it back. He may feel it is overvalued at these prices compared to companies and pieces of companies he may want to buy within the next couple of years. The end of this bull market may be near, and Warren Buffett is preparing for this. However, Buffett cannot invest in many smaller companies and it takes longer to free up cash when you have a $500 Billion portfolio than if you working with a fraction of this.
The graphic below shows the top three performing stocks of all US companies over the past 20 years. Those who sold too soon to keep them from being such a large percentage of their portfolios lost out on a good chunk of upside. We are all guilty of this, but consider the best managements and best companies tend to continue to do well over time. The key is to track whether earnings and revenues are accelerating or decelerating as well as the current price compared to what we feel is the true value of the company.
Those companies that are growing and selling below the intrinsic value allow us to win in two ways. If we see a lot of future growth out of a top-quality company, it makes sense to pay a little more. Over time Buffett has shifted from buying good companies at great prices to buying great companies at good prices. The game becomes easier when we don’t have to make as many decisions owning great companies with good growth prospects. Owning quality affords us this luxury.
The “Dogs of the Dow” Strategy – A Rainy Day Approach
The Dogs of the Dow have been proven to perform well over a long period of time. This strategy was most popular in the 1990s but has continued to provide better performance than the Dow itself over the last 25 years. Those investors who like to own companies paying the highest dividends of the Dow, not only receive the income but also receive strong appreciation of the beaten down Dow components as the prices recover most years. The chart below shows how this strategy performed versus the Dow from 1999 to 2017.
One of the first reports of the superior performance of high-yielding DJIA stocks appeared in The Wall Street Journal on August 11, 1988. John Slatter, an analyst with Prescott, Ball & Turben, Inc., examined the total returns of the ten highest dividend yielding Dow stocks for the years 1973 through 1988 and found that they outperformed the DJIA overall. This report showed that investing in the top 10 dividend paying Dow stocks outperformed the average by over 7 percentage points.
A follow up study conducted in 1997 was conducted to show that this strategy was not always as beneficial, and some said the outperformance may not easily outpace that of the Dow when considering trading costs and taxes on dividends and capital gains. However, both taxes and trading costs have come down substantially since then.
In recent years, the worst period to invest in the “Dogs” has been the “AI boom” of the last 6 years and the “dot.com” boom at the end of the nineties. The best performing period for the “Dogs” compared to the DJIA was right after the dot.com boom. Likely, this best-performing period could eclipse soon when the “AI boom” turns into an “AI bust” and the “Dogs” start hunting again.
2024 and 2020 were the worst performing years for the “Dogs” when comparing against the Dow itself. The only other year when the “Dogs” underperformed by over 11% was in 1999, just before the period when the “Dogs” outshined the Dow by the greatest degree.
Winter Is Coming: Time to Start Buying Bonds?
Stocks tend to perform well when Spring is here, the market has gone through a bottoming process and the Federal Reserve is done cutting rates. Stocks also tend to perform better than bonds during the Summer period when the Fed is hiking rates to curb inflation. Even in the Fall period when the Federal Reserve has finished hiking rates, Stocks tend to perform better than bonds.
Those who study the economic cycles know when we are approaching winter and the economic cycle is coming to an end. When unemployment is rising and the Fed starts cutting, usually winter is coming. Its growing colder and it may be time to break out the overcoats and winter gloves.
Some may also want own bonds considering they do well when winter comes and the yields start coming down. Not only do we get a decent return from the interest payments but the bond values can increase substantially when interest rates come down. Those who follow the seasons can be more tactical and choose to reduce bond exposures when rates are rising and increase bond exposures when rates start to fall.
Others like to have a large percentage of CDs and bonds during all periods, even when the yields are relatively low because they are considered to be “safer” than stocks. The rapid rise in yields in 2022 and part of 2023 proved otherwise. 2022 provided the worst year for bond performance in the past century as the Federal Reserve hiked rates substantially. Investing tactically allowed investors to own short-term CDs and bonds, which lost less value during the rapid rate hikes in 2022 and 2023. Others did well owning Income-producing stocks that provided profits in 2022, while growth stocks and longer-term bonds suffered.
Diversification is a great idea for many. Choosing to create an “All Weather” portfolio and owning a little bit of everything will help protect from downturns associated with owning what used to be extremely popular when the bubble pops. However, those who can find superior opportunities regularly focus on these opportunities where they have high conviction. Keeping rain jackets, bathing suits, and winter coats in our inventory during all seasons may be good for those who cannot tell when winter is coming or when we are in a rainy versus sunny season. The best investors tend to be more focused when they see opportunities, becoming greedy with the crowd is fearful and fearful when the crowd grows greedy.
Joe Franklin has been named by Forbes as one of Tennessee’s Top Advisors!
Franklin Wealth Management
4700 Hixson Pike
Hixson, TN 37343
423-870-2140