Security Musings

Security Musings

Market Investment Strategies for Busy People

I have been investing for over 41 years, so at least I know a few things not to do. With this series I'd like to share my thoughts on market investment strategies, and I would welcome hearing about your personal investment experiences, so please write to

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Introduction to a Methodology and Sector Analysis

By Stephen Northcutt

Introduction to a Methodology and Sector Analysis

When you consider investing in an equity there is a lot of uncertainty. Will it be the right equity? Is it the right price? Will the market go up or down? Anything we can do to reduce the amount of uncertainty improves the odds of having successful investments. So, we develop a strategy, a methodology, and follow that methodology in a disciplined manner. In this lesson I am going to share one of the methodologies that I use. I am not an expert in sector investing, so I am going to share my simple trick. Using that trick, has been one of the more successful approaches to market investing that I use. By using different methodologies, I can compare the performance of that methodology to either the S&P 500, if it is primarily a set of US investments, or the MSCI World Index. The equities that are being traded by a particular methodology are called a basket.

Let's review what we already know

Before we go any further, let's review. Because the market is efficient, almost all information about stocks, sectors or world events is known to the traders on Wall Street with their fast networks, big computers and trading models. All of that information is priced into the cost of almost any stock we can buy. We are not going to make any effort to try to trade 100 different equities and beat the markets, because we only want to invest fifteen minutes per evening, Sunday - Thursday. And remember, when the market is going up, we do not want to do much at all; if the market is going up, we must be smart. We can get away with peeking at our portfolio once a week during a solid uptrend.

When the market is going down, that is when we need to work. But we can save a lot of work by focusing much of our investment on index ETFs. We buy them as cheaply as we can and use limit orders and try to buy them on dips in the price of the equities. We take of our new money as it becomes available and buy the best performers, knowing that will change. But if we can get them cheap, no brokerage commission and a slight price advantage each time we buy, we can extract every easy bit of efficiency out of the market. This is a large part of our equity investment.

The only reason we buy individual equities is to try to beat the performance of the index. We have a thesis that a particular sector or asset class is going to beat the index, so we want to have more investment in that sector or asset class than we would get simply by purchasing index funds. The example that we gave is from our Ck basket, Canada ( and also dividends). My thesis is that the MSCI index is underweight on Canada, because they tend to control their debt and they have a large number of natural resources. So I hold some additional investments on Canada, CNDA and EWC, broad indexes, FXC, a currency play and TD and RY two of the five major banks. Not a huge amount of money, their economy is very fragile if either the US or Europe has trouble, it will drag them down, but trying to improve the return of all my investment over just the MSCI index. Now what was true in 2010 and 2011 may not be true in 2014, so I have Google Alerts on various Canadian terms and try to hit the Financial Post from time to time. I invest research time in the hope that if my thesis starts to become incorrect, I can begin making adjustments before I start losing money.

Underweight and Overweight.

The concept of investing a bit more than the index is called being overweight. Obviously, if you think a sector is going to have problems such as Europe in 2012, you want to reduce your exposure, that is being underweight. However, it is critical to have a thesis and not to make huge bets.

The Sector Methodology

Most disciplined traders have a sector methodology as one of their baskets. The idea is that macroeconomic factors will tend to cause more business to happen in a sector than normal. Sectors are often considered to cyclical and that is certainly true for Basic Materials. However, some of the sectors appear to have only one direction in which they can possibly go; health care, given the aging population in the United States and Europe, is an example. It may cycle, but it will be twenty years. The idea is to put more of your investment in hot sectors than the index based ETF would, to be overweight in a sector. Before we start talking about individual equities, please consider putting some of your money in targeted ETFs. If you believe as I do that, technology for health care is the only way to get a handle on costs (you would be amazed at some of the things they are doing in India), then you might want to consider something like IHI, a medical devices index fund. Just remember to check the expense ratio, many of the health care ETFs have an expense ratio of .7% or higher, RYH is .5 and IHI is .47 and I hold XPH which is .35, and be sure to use a limit buy. Here is a list of common sectors:
  • Basic Materials
  • Capital Goods
  • Communications
  • Consumer Cyclical
  • Energy
  • Financial
  • Health Care
  • Technology
  • Transportation
Key Point: The biggest chunk of our money is in a low cost index fund. The next biggest chunk of our money will be invested using ETFs to be overweight where we think the index does not have enough coverage. The riskiest portion of our money will be in individual equities, because when we choose correctly, the individual equities may outperform the index. This takes us right back to lesson 2, The Search for Core Holdings. We do not want to hold hundreds of individual stocks that we know nothing about. We build our core and then use a small amount of money until we think there is a great company that we are not comfortable having as a core investment.

Choosing an individual equity from a sector

For security reasons, I do not usually name the brokers I work with, but I cannot share this simple idea for sector investing without doing that, so my Cs Basket is with Charles Schwab. The rules for this basket are:
  • The equity must be chosen from a sector that I want to be overweight in, otherwise I try to participate in the sector with an ETF
  • There still has to be a thesis for choosing that equity
  • The equity must not have a large amount of debt, in most of my baskets if the debt to assets ratio exceeds 20, I do not purchase the equity
  • It must be highly rated by the Cs basket's research team, preferably an A, but no lower than a B. I also consider other analyst firms research, we are spending real money after all.
  • It must be profitable
  • Equities that do not pay dividends may be purchased, but bonus points are added to the rubric for companies that have a long track record of paying a dividend.

Needless to say, that eliminates a large number of equities which is a good thing, none of us has an infinite amount of money to invest. But over the years, this basket has performed well.

The Technology Sector

This is a sector that I am often overweight in because I work in tech and at least think it is possible that I know something Wall Street does not. Historically the stocks that I use to be overweight in the sector include: Apple, Cisco, Dell, EMC, Google, HP, IBM, Intel and Microsoft. That does not mean that I hold all of them at any one time, but they are the companies I follow. There are other great tech companies, one that I would be happy to open a position in at the right price is Sourcefire.
UPDATE: June 2012 Apple and Google seem to be pulling ahead of the rest of the competition in a number of dimensions. Over the past two years I have slowly be averaging ( buying a bit here and there ) them into core holdings, the largest single equity positions I have. I say slowly because at the prices for their stock I am buying only a few shares per transaction. On April 20, 2012 I sold 2/5 of my position in IBM after doubling my money to buy a CD at 2.8% interest. Over the next ten years I want to be in a safer, more stable position. On May 30, 2012 I closed my position with Microsoft, I do not think they are going to be able to catch Apple and Google in mobile phones or tablets and again, took the profits to purchase a CD. That was only a 20% profit, but my total portfolio is too heavy in equities, so I need to make several more of these moves in 2012.

Buying a CD

You DO NOT go to your local bank and buy a CD, that is basically throwing your money away. Your online broker has them and if you are patient you can get some decent deals in this time of poor returns. Last week I bought one on the secondary market at a discount ( you don't see that every day in the current environment ), but where the original owner invested a dollar, I could invest 97 cents, of course we are talking about 2.25% interest, but as always, if you made 20 or 30% on the equity, you are not doing badly.

Action Plan and Budget

Review the index section for ETFs in your notebook. What region of the world, country, sector or asset class do you believe will return greater gains than the overall index.
If possible, cover the need with a fairly priced ETF bought with a limit order.
There are times when individual equities make sense to try to get higher returns, but do your research. This is real money we are talking about, and buying individual equities is one of the best ways to lose money in the stock market. If you do not have time to read a Google alert once a week about that company, you probably will be better off investing in an ETF.

Other Related Articles in Market Investment Strategies for Busy People
A Real World Example of the Investment Strategies - Updated Jun 5th, 2012
The Search for Core Holdings - Updated Apr 28th, 2012
A Fundamental Strategy for Investing - Updated Apr 25th, 2012
Introduction to a Methodology and Sector Analysis - Aug 20th, 2011