Why 2 and 20 are bad for your Portfolio.

Yesterday I wrote about Essentra and promised a note on why I had exited my investment and sell disciplines. So that is the reason for today's title, which refers to yields and PE's on stocks. As you know i like to achieve a decent yield on my investments and this tends to be a key part of my approach. Since I want at least some income I tend to put a lower limit of 2% on stocks that I consider for my portfolio to just about cover inflation, with growth hopefully to provide some real returns. Therefore to be consistent, if I am reluctant to invest in stocks that yield less than that, then it follows that I should be wary of holding stocks when their yields fall below that level.

Thus I use that as one of the potential valuation triggers for a sale of a stock from my portfolio. However, I will also look at the growth rates and the potential going forward, so sometimes the yield will be below 2% on a historic basis but a bit above prospectively depending on the expected growth. However in the case of Essentra the yield was still sub 2% even with 2014's 15% forecast dividend growth. Thus for me that was the first potential trigger for a sale, although the prospects still looked good.

The second one related to the 20 aspect of the title and in this case I'm referring to the Price earnings ratio or PE. Again here I would not tend to buy a stock on more than 20x earnings so again I get twitchy if one of my stocks re-rates onto more than 20x, although as we saw yesterday it is a nice ride when it happens as a result of earnings growth and a re-rating. Then again I'll look at the growth, quality and prospects etc. and weigh these against the rating. Simplistically P/E can be viewed as being in cheap territory if they are less than 10x about average around 15x and over 20x is expensive in my book. However, all of those need to be considered against the quality and prospects of the business you are assessing.

As markets move up and down through bull and bear cycles stocks can bounce around within this range and when investors get really excited about something it can go onto a much higher rating like ASOS (ASC) which is now on 75x.
I obviously don't tend to play in this space as my value and yield instincts are too strong, but if people want to play that game - good luck to them. The problem with highly rated stocks is that they give you little protection on the downside if they disappoint. With ASOS for example recently having coming back from £70 to around £45 in just over a month on a recent disappointment. Thus I tend to look to rotate out of expensive stocks and recycle into cheaper stocks with better yields to try and repeat the process and limit the downside should things not turn out as expected.

Value and yield stocks conversely have less extravagant expectations built into their share prices so any disappointments there are not so harshly treated as expectations are already low. But if they surprise on the upside then that is where you get good things happening as the stock can then benefit from a re-rating, although sometimes you have to be patient and just enjoy the yield. Filtrona / Essentra was a classic case of this and I'm not saying it won't go higher than the 900p+ I sold at as the prospects still look good, its just I'm looking to reinvest the cash into a better value stock with good prospects. This sell discipline is easier to implement when a stock gets to this type of rating and then starts to show signs of slowing down or plateauing in terms of its performance then it is a much easier call. So there you go don't forget 2% and 20x and I don't think you'll go too far wrong, or buy low, sell high as the old saying goes, but as I found with Essentra it is easy to say but not so easy to do.

In addition on the subject of 2 and 20 I referred once before to a great article by Terry Smith which highlighted how badly investors would have done if Warren Buffet had set up as a Hedge Fund. In fact if they had invested $1000 in 1965 with Buffet on Hedge fund terms 2% and 20%, Buffet would have ended up with $4m and the investor just $300,000. This is the second reason for the title of this piece in so far as buying Hedge Funds on 2% & 20% terms is generally bad for your portfolio, but good for the hedge fund managers. If you are not familiar with the 2% & 20% terms they basically mean that they charge 2% on the funds in total and take 20% of any of the profits, although sometimes there will be a minimum hurdle rate (quite often low) and a high water mark. The problem with this is they make out like bandits in the good times, but then if they blow up and have little prospect of being paid because investors are underwater, they then shut up shop and leave the investors drowning in losses.