Is It Time to Rebalance Your Portfolio?
One Stock that Fits All of Benjamin Graham’s Criteria
How Do You Know if Your Stock is Overvalued?
Before I offer any advice on how you can beat the stock market whether it's going up or going down, let's take a look at the current stock market environment, which is interesting to say the least. You are not alone if many of your stocks are down this year. Lots of stocks are getting clobbered every day, company revenues are decreasing, earnings are dropping and oil prices are plummeting.
The Standard & Poor's 500 Index and Dow Jones Industrial Average are down about 8.5% thus far in 2016. Stocks that soared last year are getting clobbered this year. No wonder investors are worried!
But now is not the time to panic! The current stock market is frustrating, for sure, but you can pursue strategies that will lead to better performance in the months ahead.
I recently read an article written by Charles Rotblut, CFA and Editor of the AAII Journal, published by the American Association of Individual Investors. Mr. Rotblut wrote extensively about the different actions that investors take when the stock market is falling. His conclusions are backed up by an impressive AAII study.
Investors' actions generally fall into one of three groups: do nothing, time the market and rebalance portfolios. Charles Rotblut used 26 years of data and concluded that doing nothing, like Warren Buffett, produces the best long-term results.
Most investors sell quickly when the stock market begins to drop, to stop further losses. Typically, these investors sell when the stock market falls 20%, when the stock market officially falls into bear-market territory. Congratulations, if you sold some stocks during the past couple of months to avoid potential damage.
However, as Mr Rotblut points out, "if you fail to get back into stocks when the market starts rebounding, lasting damage to your portfolio will likely occur. A very large and significant forfeiture of wealth happens when an investor locks in losses (selling in a bear market) and misses out on big gains (failing to repurchase stocks when the market starts to rebound)."
The Best Strategies
What is the best strategy to use when the stock market begins to deteriorate? Taking no action produces the best results, although rebalancing your portfolio annually generates good results, too. For the 26 years from 1988 to the end of April 2014, taking no action outperformed typical market timing by 58%. Rebalancing every year beat typical market timing by 55% during the same time period.
When to Rebalance Your Portfolio
Rebalancing is the process of readjusting your portfolio to your targeted allocation. For example, if your allocation is 70% stocks and 30% bonds at the beginning of a year, but after a bad year for equities, your portfolio's allocation changes to 60% stocks and 40% bonds, you should reallocate (rebalance) your portfolio. Rebalancing would prompt you to sell 10% of your portfolio from your bond holdings and shift the proceeds into stocks, bringing your portfolio back in line with your 70/30 target.
Rebalancing is a buy low, sell high strategy, which encourages you to buy assets after they have fallen in price. This might be difficult emotionally, but rebalancing in a bear market will lead to higher profits in the future. Rebalancing lessens the losses in bear markets and restores a sense of control. Rather than being left wondering what the best decision is for your portfolio based on what the "experts" are forecasting, you can maintain a strategy that prompts you to act and will produce better results.
The Hybrid Solution
A hybrid solution reduces volatility in your portfolio. For equities, this entails switching from stocks with high price to earnings (P/E) ratios (above 35) into high-quality, dividend-paying stocks in less economically sensitive sectors such as health care and consumer staples. For fixed income bonds or preferred stocks, switch into higher credit quality and shorter duration bonds and preferred stocks.
Switching to higher quality stocks and bonds will preserve your allocation model while reducing volatility. You will give up some appreciation potential when stocks and bonds finally rebound in price, though.
Benjamin Graham's Approach
Benjamin Graham is known as the father of value investing. He influenced many modern investors, including Warren Buffett. Ben Graham wrote books, taught investment courses and created several methodologies to help investors evaluate stocks.
I have applied one of Benjamin Graham's methods for the past 12 years in Cabot Benjamin Graham Value Investor with great success. The method is based on minimum price-to-earnings ratios, price-to-book value ratios, and measures of quality. The full description of this analysis is in Benjamin Graham's book, The Intelligent Investor.
Mr. Graham suggested that investors should buy stocks which fit all of the following criteria:
(1) The current price-to-earnings (P/E) ratio is 9.0 or less.
(2) The price-to-book value (P/BV) ratio is 1.20 or less.
(3) The long-term debt-to-current assets ratio is 1.10 or less.
(4) The current assets-to-current liabilities ratio is 1.50 or more.
(5) Earnings per share growth during the past five years is 1% or more.
(6) The company currently pays a dividend.
(7) The Standard & Poor's Quality Rank is B+ or better.
Several stock screening sites and your favorite broker are capable of finding stocks that fit most or all of the criteria.
One stock that currently stands out because it easily fits all of Benjamin Graham's criteria is Prudential Financial (PRU).
Prudential Financial (PRU: Current Price 67.36), a financial services leader with $1.2 trillion assets under management, has operations in the U.S., Asia, Europe, and Latin America. PRU offers investment management, group insurance, and other financial services in the U.S., and life insurance overseas.
The over-65 population is growing three times faster than the 20-to-65 population in the U.S., Europe and China. This bodes well for companies that offer investment management and annuity products and services. Prudential Financial is the third-largest life insurance and annuity company in the U.S. and has operations in more than 40 countries. Higher assets under management and increased pricing in the annuities business is boosting profits.
Revenues increased 15% and EPS advanced 4% during the 12 months ended 9/30/15, aided by the purchase of Hartford's individual life insurance business and significantly higher net investment income. Prudential's integration of Hartford's individual life insurance business is producing better than expected results, and international operations are improving. Revenue will likely be flat for the next 12 months, and EPS will increase 7% to 10.75. Interest rates in the U.S. are expected to rise and could bolster Prudential's results more than expected.
PRU shares are clearly undervalued. The company's current P/E (current price divided by latest 12-month earnings per share) is 6.7; P/BV (current price divided by current book value per share) is 0.73; and the dividend yield is 4.2%. Prudential generates high, above-average profit margins, driven by the strength of its international business and strong asset management, yet its valuation is the cheapest in the sector. I expect PRU's stock price to advance 42% to my 95.54 Min Sell Price within one year. Buy at the current price or below.
Today's Special Offer
Are some of your stocks selling at prices that are overvalued? Currently, 240 stocks in my database of 1,000 stocks are selling at prices exceeding my sell targets. That's a lot of stocks, even though the stock market has declined noticeably during the past several weeks. I have compiled a list containing the 25 largest companies in my database that are overvalued. For example, GE, Home Depot, McDonald's and Starbucks are included in my sell list along with 21 other stocks. If you own any of these 25 stocks, you should sell them. To get the whole list as well as my top 10 value stocks for 2015, consider taking a trial subscription to the Cabot Benjamin Graham Value Investor which I write.
Until next time, be kind and friendly to everyone you meet.
J. Royden Ward
Chief Analyst, Cabot Benjamin Graham Value Investor
P.S. You can read more about Prudential and get continuing coverage of PRU in Cabot Benjamin Graham Value Investor. There you'll not only find my buy and sell advice for PRU, you'll also discover an ample number of stocks selling at bargain prices. In every issue, you'll find my legendary Maximum Buy and Minimum Sell Prices for over 275 stocks plus my up-to-date predictions for the Dow Jones Industrial Average.