I’m Building a Ghost Ship Portfolio for Someone; A Sort of Index Fund on Steroids
I’m putting together a retirement portfolio for several people I know. One of them is proving to be a fun intellectual exercise. Essentially, the mandate calls for me creating a ghost ship of a portfolio that, once it has set sail, will drift almost untouched for the next 30+ years when it will be gifted to the children at the end of the life expectancy of the owner. Beginning in 7 to 10 years, the owner will start taking 3% to 4% distributions to augment an otherwise secure retirement. The portfolio is to be allocated 70% to a collection of 70 to 100 blue chip stocks, 25% to high-grade bonds, and 5% to cash or cash equivalents.
Since I am doing this as a favor guided only by their general desire for diversification both in issuer and asset class, there should be practically no expenses going forward except for the occasional reorganization fee (e.g., someone buys out one of the stocks for cash and the broker assesses a nominal service charge to facilitate the exchange) and a few hundred dollars in initial commission expense, amounting to a few basis points.
For all intents and purposes, this particular portfolio is going to look similar to the research portfolios upon which the work of people like John Bogle and Jeremy Siegel is based when they call for long-term, low-cost, passive equity strategies only, instead of the initial selection being based upon a metric such as market capitalization, it will be decided on the long-term quality of the enterprises themselves, favoring stable companies with above-average returns on capital, strong balance sheets, and dividend histories that go back decades, if not generations. You could practically slap a Vanguard label on it and begin offering it alongside other index funds and I’d wager money it’d perform very well as the component list is much more intelligently devised for an honest-to-God multi-decade investor.
It is, in other words, a privately created index fund operating at next-to-nothing to a degree that an S&P 500 index fund will look like a hyperactive teenager. The closest historical parallel I can think of at the moment is the former ING Corporate Leaders Trust, which has since changed its name as it is the definitive ghost ship portfolio on Wall Street. If you’re unfamiliar with it, it’s a fund that operates at something like 50 basis points (0.50%) in per annum expense and holds a collection of dividend paying stocks chosen in 1935. These were the bluest of the blue chips. Through mergers, acquisitions, removal for the crime of suspending the dividend, and bankruptcies, the number of holdings has declined to 27 companies but now includes businesses like Berkshire Hathaway and Exxon Mobil. It has crushed the market over the past three-quarters of a century. With practically zero turnover, it is far calmer than something like the Vanguard S&P 500 index fund, which typically sees 20 of the 500 components change hands each years as per The Wall Street Journal.
It works because of the concept of total return, which we’ve discussed in the past. Even if you end up owning a business like Eastman Kodak, which gets wiped out after falling from a seemingly unassailable position, you probably make several times your money along the way thanks to dividends and spin-offs. It’s the nature of long-term equity investment when the portfolio itself is intelligently structured. Sears Roebuck is another excellent illustration I’ve been meaning to write about for awhile as it demonstrates how deeply this misunderstanding runs for the average investor. (I saw a message board the other day with people saying you shouldn’t hold individual stocks because you might end up with a Sears, which has experienced a precipitous decline in earnings and store count. They felt very passionately about this, yet their ignorance was profound! If you bother to actually do a case study, thanks to all of the subsidiaries it’s spun-off, and the dividends, acquisitions, and spin-offs to which they have been party, you actually would have beaten the market investing in Sears over the past 20 or 30 years! This particular person was arguing for index funds, which is a good policy for most investors, but completely ignorant of the fact that the index fund did, in fact, hold Sears and this was one of the reasons it worked so well in the first place!)
This means I’m having to make some very interesting discounted cash flow decisions because equity prices are so high. A business like Brown-Forman, which I’ve talked about often in the past, is making the cut because the beginning overvaluation will almost assuredly be a rounding error by the end of a 30 year period. The mandate changed the mathematics.
Meanwhile, more attractively valued businesses that promise less long-term stability are getting discarded even if it lowers the compounding rate in the foreseeable future; a trade-off between risk and return. Not that there are a lot of the latter. I don’t remember seeing stock prices this high relative to cash flows for a long time. Unless we enter bubble territory, I think we’re going to have to either tread water for a couple of years as the earnings catch up to the market quotations or, the more attractive alternative for long-term investors, experience a drop of 30% or 40%. No one can predict which will happen. Do a case study of the 1995-1999 period to see what I mean. Investors can become unhinged. Who’d have ever thought you could buy components of the Dow Jones Industrial Average at 40, 50, 70x earnings then have to wait a decade for that excess to burn off? It was as foolish as the 1973-1974 period when some amazing companies were trading at 3x or 7x earnings. There’s no rule written in the stars that says the party can’t keep going on, no matter how irritating that is to those of us who want an acceptable cost basis for our common stocks just as we do our real estate or private businesses. At least back in the ’90s, investors who wanted to avoid the madness could earn 5% or 6% on their money by holding extremely safe bonds. Good luck with that these days.
For the bond component of this ghost ship portfolio, I’m basically buying, or plan to buy (not all of the money has arrived in the account, yet, so I’m having to use cash as it shows up) 5-to-12 year maturities with yields ranging from approximately 1.75% to 4.1%, designed to (I hope) do little more than maintain most of their purchasing power after accounting for inflation. This is not a time to earn real returns on bonds as the mathematics aren’t there unless we slipped into a Great Depression, experiencing deflation. There won’t be any preferred stocks, either, for reasons I don’t have to explain to those of you who work in finance. (The short version, if you don’t: Non-callable preferred are effectively perpetuities with the expected rate of return variable in the intrinsic value calculation highly dependent upon opportunity cost, which is itself measured as a spread to U.S. Treasury bond yields, the latter considered the “risk free” rate you could earn by parking your money and forgetting it. With interest rates at record lows, and the lack of mitigation that comes in the form of a maturity date, preferred shares are extremely sensitive to changes in fixed income yields. The 1940 edition of Security Analysis had an excellent passage on this, explaining that it is often best to buy high grade preferred stocks during panics, when they sometimes yield 15% or 20%, locking them in as quasi-bond income sources; how it almost never makes sense to buy them at full price unless there is some sort of conversion or voting privilege attached to them or you’re structuring it as part of a control deal. All of that is way beyond the scope of this post. If we found ourselves in such a position, I would consider intervening and using the maturing proceeds of some of the bonds to buy preferred issues in blue chip firms but that would be a windfall based partly on luck.)
In Aaron and my personal retirement accounts, I did engage in a relatively small degree of horizontal risk shifting, to again borrow a concept from Benjamin Graham. One of my long-term holdings had appreciated so rapidly, in such a short period of time, that it was trading at a price that would only make sense 3-5 years in the future unless they just blow the roof off the earnings results. Insiders were selling it and Wall Street brokers had issued the rare sell order on valuation. Given that I held it in a tax shelter, I ran some numbers and ultimately opted to divide it into four equally-as-good businesses, some of which were also highly priced, effectively adding the benefit of additional diversification with virtually zero cost. The future return profile was slightly improved and the risk reduced, which as close to a free lunch as you’ll get in money management. Specifically, I picked up shares of Coca-Cola, Hershey’s, and McCormick & Company, only one of which is fairly valued. I was a bit hesitant given that the hurdle for those business is so high as all three of them are on the list of “once these get bought, they are never sold under almost any condition unless we need money for the family or some personal project”. That capital is now likely locked away in shares that we’ll probably leave to our future grandchildren. Maybe I should write about horizontal risk shifting. It’s so useful in bonds, particularly. The danger is people use it as an excuse to trade rather than to lower their concentration when valuation multiples become a bit unwieldy.
Speaking of valuation, I am astonished that Nestle remains slightly undervalued. A lot of businesses are in the “I’m getting nervous” range but it still sits there, relatively neglected because individual investors are incapable of doing international accounting adjustments – they pull up the ADR and see what appears to be no dividend and a 24.15 p/e ratio, which is far from reality caused by the ineptitude of the online financial portal coding – and professional investors don’t want to own something so boring. It’s one of the only things I’m willing to still buy for my own household accounts. I had my parents pick some up last month and will probably do so again in a few days. Even if we experience some catastrophe on Monday and it opens 50% lower than today, the probabilities seem extraordinarily high that they’ll be tap-dancing with happiness 25 years from now. I can’t say the same for something like Intel, which is far less attractive over such a period on a risk-adjusted basis at 15.9x forward earnings and a 2.39% dividend yield.
That might provide a good illustrative lesson on relative valuation … I’d go so far as to say I’d much rather have my entire net worth in a company that is slightly overvalued at the moment, like Hershey’s, than Intel even at what appears to be a cheap p/e ratio with decent dividend. I don’t think it will matter in 15, 20, 25 years for Hershey’s. That is a lesson it took me too long to learn. I’d have made a lot more money in life if I could go back and tell the 15-year-old version of myself to just write the check as long as the earnings yield isn’t half of the Treasury bond yield and the long-term economics are still intact.