Dirty sex, your spanked portfolio and planning for “the next market”

Many and many a year ago, in the kingdom of ABC, Woody Allen was one of my very first guests. And we consented to take questions from an eager audience of mostly young people. Like ourselves.

The questioner looked like a high school girl and shouted to Woody from the balcony, “Do you think sex is dirty?”

Allen: “It is if you do it right.”

(Dick Cavett, “As the comics say, These kids today! I tell ya.” New York Times, 9/13/2013)

I’d rather hoped that the observation originated with someone rather more wholesome, Groucho Marx or Mae West for example, but we’re stuck with what the historical record gives us.

We might equally ask:

Does your portfolio look like Mistress Cruella just tied it up and took after it with gusto and a flogger?

Answer: Only if you’re doing it right.

Periodic painful losses are not a defect in the investing system. They are a central feature of it. They are utterly integral to any system that attempts to produce returns greater than the projected 3% rate of US GDP growth over the next half-century. As such, they are unavoidable in any portfolio that wants to achieve “real” growth; that is, growth that is something more than running in place.

Sadly, those losses can crush an individual’s dreams and flatten returns for ten years or more, the so-called “lost decades.”

How might you respond to the current bout of painful bruising?

1. If you have a well-designed strategic investment plan, do nothing. All of the calculations in such plans account for the fact that periodic drawdowns occur. The vaunted “in the long-term the stock market returns 10%” claim includes the effects of long, bloody stretches in the short- to medium-term. In short, if you got it right in the first place, don’t screw it up now.
2. If your portfolio is an unplanned collage of things best described as “it seemed like a good idea at the time,” build a plan before executing the plan. That is, think before you act. Selling in a panic or buying a fund because it made 30% so far this year – a half dozen unleveraged funds have achieved that – doesn’t get you the 30%. It just compounds the problem you’ve already got.
3. If your portfolio is taxable, start identifying the cost basis of your shares. You might save further pain in April 2023 by planning some strategic sales now to harvest tax losses. As a reminder: even funds with deep losses can nail you for large tax bills if the managers engaged in frantic trading while the losses occurred.

In general, stock-lite portfolios have outperformed stock-heavy ones this year, though at the price of dramatically lower long-term returns.

The simplest illustration of that trade-off comes from the Fidelity Asset Manager funds, whose portfolios are identical except for the degree of equity exposure they incur. In each fund’s name, the number (Asset Manager 20) corresponds to the amount of stock in the portfolio.

Many believe that market conditions have fundamentally changed. The zero-interest / zero-inflation environment that favored speculative investments, growth companies, disruptive tech, and minimal earnings is gone. Reasonable commentators – from T Rowe Price and Leuthold to GMO and Warren Buffett – have argued that your greatest returns now might come from focusing on undervalued, high-quality companies that are growing dividends and are grounded in real assets.

At a time when there are historic discounts for small vs large, value vs growth, and quality vs momentum, we asked the folks at Morningstar to look at which small-cap value funds had the highest quality portfolios. They track 160 portfolios, ranking each on a quality scale of 1 (highest quality) to 100 (junkiest).

Only 10 SCV funds or ETFs earned a quality grade of 50 or lower. Ranked from highest quality down, the top 10 are:

Of those, we have profiled Aegis Value on a couple of occasions – a truly distinctive microcap value fund that is even on the year and holds a 10% cash stake – and have expressed concern about Auer Growth. The standout of the group is Royce Special Equity, whose managers have a deep commitment to high-quality small-cap names. It has the lowest Ulcer Index score of any SCV fund over the past 20 years, which means it subjects investors to the least-bad worst-case while still producing annual returns over 8%.

Folks wanting exposure to the highest quality companies that also embody reasonable environmental, social, and governance qualities might check the five-star Northern US Quality ESG Fund (NUESX). It has pretty handily tromped its large-cap peers with no greater volatility.

The estimable Dan Wiener warns, “The second half’s going to be a doozy.” Planning now will make the immediate pain more bearable and the long-term gain more pronounced. Dashing about squealing will do neither.