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In Volatile Market, What We Own, and Why: Our Stock Positions

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The market seems to be giving us some relief on Tuesday from Monday’s selloff. However, equities are showing a loss of 14% for the month, and there will likely be additional volatility before August is over. That being said, a review of our positions may be in order. We will start the morning with a discussion of our equity holdings, followed by an analysis of our fixed income and alternative positions later in the day. 

An important part of this conversation is answering the question “Why own stocks in the first place?”  Stocks are, over the long run, one of the best investments for protecting investors from inflation. They are liquid, well regulated, and can provide important dividend income. Clients would be hard pressed to meet their investment objectives without owning some stocks. Even in the face of the “lost decade,” where stocks have lost ground during the 2000s, they have been a good long-term investment for clients able to withstand market volatility. 

The last statement is an important caveat. If investors had too much committed to equities, they tend to exit at the worst possible times due to the extent of their losses. In many cases, they mistime their entry point – which can cause further loss, frustration, and in extreme cases a cessation of investing.  As a result, these clients are unlikely to achieve their investment objectives - a truly unfortunate outcome.

Equities:  We have a strategic “tilt” toward large cap stocks over small cap stocks.  We prefer the stock of larger companies mainly due to the reduced volatility versus that of smaller firms.  Also, larger companies tend to generate more revenue internationally than other firms.  Nearly half the profits from S&P 500 companies are from outside the U.S. Owning large stocks allows us to participate in the growth of developing and established countries.

Of course, we also own foreign stocks directly.  Our current holdings include emerging market equities (EEM) and Japanese stocks (EWJ). We like the former due to the impressive economic growth of many developing economies.  Most of these countries have much better balance sheets than the developed world, with less debt and an impressive trade surplus. Japan represents, in our view, a significant value play. Japanese stocks are some of the cheapest in the developed world. This position has added some value during the year, and specifically during the market deluge, as the modest valuation of this position has acted as a “back-stop.” 

We also have a modest position in stocks from Europe, Australasia, and the Far East (EAFE) regions. This includes the stock of 21 developed countries, but excludes Canada and the U.S. The performance of this position (EFA) has been in line with other large cap developed holdings. 

Our position in small cap stocks is underweight. Typically, small cap stocks tend to outperform large caps as rates head lower. But in our view, this additional return is not worth the much larger amount of volatility that small caps typically generate.

We have favored growth stocks over value-oriented issues, because we felt that the economy would reward companies that are seeking to add to market share rather than those that are trading at or below book value.  We have been able to earn a bit of extra return using this approach, mainly via our position in large technology stocks (QQQ).  

Rounding up the equity portfolio is our position in Fifth Street Finance ( FSC), a specialty lender in the mid-cap space.  Organized as a business development company (BDC), FSC does not have to pay corporate income tax if it distributes at least 90% of its earnings to shareholders in the form of a dividend.  FSC boasts large spreads on loans; an attractive, double-digit dividend paid monthly; and no bad “legacy” debt from the credit crisis.  However, the stock has been battered recently, along with the rest of the finance sector.  The main culprits are uncertainty regarding the sovereign debt of the U.S. and EU, and a flattening yield curve. However, the fundamentals of the stock are still solid, in our view, and the company is trading at a very attractive current P/E multiple.  

FSC was utilized as a portfolio substitute for small cap stocksIt has generated an additional loss of approximately -0.24% based on our position size (2%) for an account that is benchmarked to 60% equity and 40% fixed income.  We are watching this position very carefully.  If there are significant adverse changes to company fundamentals we may take our losses and move on.

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