Financial Advice    Mr. Cain will present "Investment Strategies for Weighting Your Portfolio" at the CDA Scientific Session in Anaheim from 10 a.m. to 4:30 p.m. on Saturday, April 10, in the Carmel Room at the Anaheim Hilton and Towers and "Successfully Transitioning Your Practice" from 9 a.m. to 1 p.m. on Sunday, April 11, in the San Simeon Room at the Anaheim Hilton.

Target Weighted Portfolio Approach to Investing

A variety of investment strategies are used in the purchase of stocks and bonds. Because of changing market conditions, what has been successful in the past decade may not be in the next. In this paper, the author discusses theories of investing, explains his view of the dynamics that have affected recent market conditions, and outlines his target weighted portfolio approach to investing.

The process of investing money is one of mystery and uncertainty for many people. In the past 10 years, the stock market -- purchase of both stocks and bonds -- has been the most prevalent method of investing money. During the past decade, the majority of all financial gains has been made in the stock market. This trend started after the retrenching of the U.S. economy in the mid to late 1980s, when the government declared $500 billion of real-estate loans as nonperforming and bailed out the savings and loan industry. This retrenchment caused a fundamental re-evaluation of investing within the United States. Many other areas of investing -- such as gold, real estate, farming, oil and gas drilling ventures, and the limited partnerships of the late 1970s and early 1980s -- went by the wayside as the government changed its tax laws and policies. The purpose of this article is to discuss the various investment theories used in purchasing stocks and bonds, to review what works, and to discuss various concerns an investor should have about the stock market investment philosophy promulgated in the past 10 years. Some things that have worked in the past decade may not be appropriate in the future. It is important not only to discuss what works, but also to re-evaluate and consider what may not work.

Investing money is supposed to be a logical, numerically based process. The most common method of measuring one company against another is to look at their relative earnings compare them to the price multiple the companies sell for in the stock market. This multiple of price is usually based on the positioning of the company within its industry, the outlook for the company's growth, and predicted future earnings. The price/earnings ratio of companies has a relationship to the value of what can be purchased elsewhere outside the stock market.

The most common barometer people use to measure return is the price they are able to pay for a stock compared to the yield and safety of a bond. Usually, the lower the interest rates, the higher the multiple people will pay for stocks. This is an "opportunity cost of money" approach to investing. Why would someone purchase stock in a company that is only growing at 5 percent per year, costing a multiple of 20 times earnings, when he or she could purchase a very safe corporate bond yielding 9 percent? Many times stocks can become overvalued, so people consider purchasing bonds. Currently, interest rates are very low, and it is logical for people to pay higher multiples of earnings for stocks than they have in the past. However, investors should be aware that with the growth in the stock market during the past 10 years, some people have started to purchase stocks without realizing that they can, in fact, lose money. Many of these problems come from unreasonable expectations from the purchasers. Stocks purchases often have no basis in economic reality, particularly when a new company is having an initial public offering. Many times in the past 10 years, new stocks have been issued and the price has raced upward only to plummet when earnings do not meet expectations. This has created an attitude of gambling within the common investor.

The process of investing money should not be viewed as gambling. It is appropriate and important to develop a long-term attitude and a game plan to handle the ups and downs of the stock market. If an investor wants to be in the market to make the gain, the investor also has to be in the market when it goes down. Many investors are happy every year to make a 20 percent return on their money; but in any year where there is a zero or negative return, they want to know why their money was not moved into certificates of deposit or money market funds. An investor can anticipate broad trends in the stock market; however, he or she generally cannot truly "time the market." Timing the market is usually a very poor method of investing money. This is not to say, however, that there are not times when broad macroeconomic situations require an investor to reposition his or her assets.

This paper will discuss positive and negative strategies that are currently used in the investment field. The purpose is to discuss a methodology that the author has used over the past 10 years to produce outstanding results -- the target weighted portfolio approach. This approach is not based upon making the most money in the stock market. It is based on protecting the money that has already been saved. Dentists need a methodology to invest money that is appropriate for their circumstances. Being in the service profession, they have the ability to save and accumulate money, but everyone fights the fact that their wants and needs exceed the available cash flow. Saving money is unnatural because people have to forego current wants and needs to accumulate money in the hope that by investing it they will have money to live on in the future. Times of uncertainty exacerbate this problem and lead people to wonder whether their method of investing is appropriate. Therefore, an approach based upon targets and goals seems more appropriate than just throwing money into a diversified set of investments and holding on, hoping it works out. It is important to note, however, that investment advice is specific to each person's circumstance. Understanding what is appropriate for an individual investor begins with a basic knowledge of the investment process.

Basic Education

A large amount of money in the United States is currently being put into savings because the aging population is behind in its savings plans for retirement. Baby boomers are saving for the future, but they are behind. They are finishing paying for their children's educations so they are starting to move their money into the stock market and are expected to continue to do so for at least another 10 years. One of the first things that works when investing money is to do a good demographic analyses when choosing companies to invest in. It is important to identify broad trends within the marketplace and analyze how people plan to spend money. An investor must pick those industries that are going to realize benefits from the changing demographics. Then, he or she must pick the companies within those industries that have good management and are positioned to take advantage of the upcoming trend. This is the most appropriate way to invest because if an investor can identify demographic trends and buy the companies that will benefit from them, he or she has the most likelihood of seeing increased earnings and rising prices. One must also realize, however, that some things that were hot demographically in the stock market recently have already reached their peak. These companies' prices have already been bid up, and they cannot sustain the growth that drives the high prices for their stock. All good things can come to an end. It is important that investors not get trapped in these stocks based on past performance.

Over the next 10 years, the stock market has a good outlook with high productivity taking place in technology within the United States. This will lead to many opportunities for increased growth and earnings within the stock market. However, when investing, one should not ignore basic business cycles that could affect the stock market. Although timing is not an appropriate way to invest money, one can certainly review the most recent downturns in the stock market and see that many of these events were tied to certain economic cycles. The great difference in interest rates between CDs and bonds yielding above 10 percent compared to the earnings of the companies and the multiples of prices that people were paying for those companies, caused the stock market to correct in 1987. Therefore, stocks went down. The government was able to compensate for this turn of events by dropping interest rates, which then effectively lowered the yields on alternative investments such as bonds and stabilized the stock market. That is an example of an interest rate cycle affecting the marketplace.

From 1990 to 1991, the market was down, which was tied to the Persian Gulf War and the speculation that was associated with the United States losing its ability to obtain oil from the Middle East. It is easy to predict that such an incident will affect the stock market. In 1994, there was a temporary downturn in the bond market due to exotic investments called derivatives and various bond failures such as that seen Orange County, Calif. That event also involved the purchase of assets in funds that were involved in very speculative activities. Speculative activities are usually a good way to lose money. Investors should try to stick with value-oriented investing, i.e., buying stock in companies that have good cash flow and a large market share within their industries.

There is a very different situation in the late 1990s for many of the basic business cycles that caused the stock market to decline in the past. In the current situation, people have been pouring money into the Far East and have created a significant overcapacity situation worldwide as it relates to the ability to produce goods and services. In one recent article, it was noted that the current world capacity to produce automobiles is in the neighborhood of 25 million more automobiles than people currently buy per year. This fact is causing automobile companies to sell for very low multiples of earnings because of the uncertainty of their business cycle. In addition to having significant overcapacity, there are many countries all over the world that have very low to no financial controls in place regarding the reporting of earnings. This has caused a situation in the Far East where most of the banks of Japan and other countries are insolvent. However, they have never realized these losses on their financial statements; and they continue to roll over their bad loans from year to year, endangering their depositor's monies. Once this overcapacity situation reached a crisis situation, the majority of people in the Far East, which accounts for more than half of the world's population, lost almost all their money. These countries are unable to sell their goods and services; and they have been dumping all of the basic commodities of gold, silver, oil, timber, etc. into the marketplace to raise cash to meet their debts. This has caused a crisis situation. Many people in the world are now unable to buy U.S. goods and services, which has created a significant trade deficit.

Every day there are reports of ships coming fully laden from the Far East, selling goods at very cheap prices and going home empty. This dumping of basic commodities into the U.S. marketplace means U.S. companies are unable to pass on price increases because their competition can undersell them. If they tried to increase prices, they would lose a significant market share. In addition, low interest rates and low inflation have created a situation of full employment. With full employment, people are seeking wage increases, and companies often have to pay those increases to keep good employees. These companies' profit margins are shrinking they have to pay higher salaries but have no ability to pass on a price increase. This has created low inflation, but it has also created a situation in which the earnings are starting to decline. This is important to note because as earnings decline, the value of the stocks and the multiples they are selling at as a percentage of their earnings are in danger of falling.

From 1982 to now, the average stock sold for nine times earnings; and now, in 1998, the average stock sells for 24 times earnings. This is called price/earning ratio expansion. Price/earnings expansion occurs when companies are still growing in their earnings at the same level they've always grown, but are selling for two to three times more than they have historically. This has to do with falling interest rates, but it also has to do with the amount of money flowing into the market. It's important to note, however, that with declining earnings, these multiples become unreasonable; and it is very possible that many stocks could fall significantly. Also contributing to a possible stock price decrease is the fact that many companies in the United States have become dependent on selling goods and services overseas. As these earnings start to fall, there is a danger for stocks. Therefore, it is important to note that the formula used to invest money during the past 10 years -- buying companies that have good earnings growth, cash flow, and expanding sales -- may be changing.

This means, in particular, that the Blue Chip stocks (or what was known in the early '70s as the "nifty 50" stocks) may be at risk of declining. People do not realize that the indices they watch and measure stock market performance by are totally influenced by 50 or 70 stocks. The Dow Jones Industrial Average is made up of just 30 stocks and represents the financial fortunes of just those 30 companies. The S&P 500 index is a little harder to understand. Many people believe it represents the average return of the 500 largest companies in the stock market. This is not exactly true. The S&P 500 represents the 500 companies in the stock market based on their relative market capitalization or the size of the company in the stock market. This means that approximately 70 companies out of the 500 companies are so large that whatever they report as earnings and whatever price they are selling for in the stock market significantly affects this index.

In April 1998 through July 1998, the average stock market stock fell more than 30 percent, but the S&P 500 index remained positive. This sometimes causes problems because people start buying stocks based on brand name recognition. The problem is, an investor may be purchasing a stock that is selling for such a high multiple of earnings that with possible declines in earnings, the investor is at risk of losing a significant portion of money. This has been particularly true of technology stocks and certain companies that have had sales overseas in areas of broad positive demographic industries. This has led to significant speculation.

Most investors are not aware of a phenomenon known as price/earnings contraction. The last time this happened and had any significance was in 1973. The "nifty 50" stocks were selling for price/earning ratios that were close to 18 times earnings compared to the current price/earning ratios of the high 20s. These stocks lost more than 50 percent of their value in one year. Past does not dictate the future. Stocks that have done well in the past may not necessarily do well in the future. One cannot ignore situations in which stocks have been rising to levels that are not supported by underlying value.

People have bought some of the large stocks but do not realize that in 1973 and 1974, many of these stocks that were selling at high multiples declined in value by more than 50 percent and did not come back to the same price for at least 10 years. The investment strategy of "Well, it went down and all I have to do is hold it and it will come back," is a mistake. If one has $100,000 invested in these very large 50 stocks, and they go down by half in value (to $50,000), and one has to wait any period of time for those monies to come back to even, one has lost the impact of compounding the money, which is necessary to be able to build enough for retirement. Therefore, it is important for an investor to look at the earnings forecast and the multiples of the stocks he or she is buying. Over the next several years, these large company stocks will be vulnerable to significant price declines.This does not mean that the company won't be vibrant, growing, and employing people. It could grow in its earnings 10 percent to 15 percent per year. But, through what is called price/earnings contraction, the multiple that the stock sells for of 25 times earnings could decline to say 15 times earnings and even though the company continues to grow, the stock price could go down by half and stay down. Many people are not aware of this phenomenon, particularly when one considers the large mutual funds that have done well. Many times they have put most, if not all, of their investments into this small group of stocks with high price/earnings ratios.

Human nature is to find a good stock and hold onto it for a long time, riding it up, and then ignoring the circumstance when the stock declines, having regret, but continuing to hold the stock just hoping to get back to the high point of the stock price. Human nature is that no one likes to lose. Sometimes what one has to realize is that the stock has already gone up, and it is time to look for something else. The tobacco industry is an example. Many of those stocks have made a lot of money over the past 10 years; however, with the mounting state lawsuit settlements in tens of billions of dollars, an investor would have to ask "Do these companies have the ability to pay these judgments?" The risk of making an investment in this area is too great. It violates one of the first rules of investing, which is don't just worry about making a return on one's money, remember to keep the money.

Dollar-Cost Averaging

Another way of investing money is to consider dollar-cost averaging. Dollar-cost averaging is a methodology with a systematic savings program. A constant savings program is appropriate because to accumulate money, two things must happen: One, a person must spend less money than he or she earns, and two, once that money is saved, that person must deny its existence. Dollar-cost averaging is a system in which one saves money on a regular basis into his or her savings program. However, there are people who sometimes come into large sums of monies and hold it out of the stock market with some fear that it is the wrong time to buy. This is usually a bad strategy. It is generally better to put all the money into the market at once. However, it is important not to put all of the money in growth-oriented stocks, but to diversify and chose an appropriate asset allocation.

Another example of human nature is the tendency of people to withhold their money when the stock market is doing poorly. This is poor timing. When the stock market is doing poorly and stocks are down, good stocks also often go down. This is an opportunity to buy those stocks at a lower price. Therefore, even though it is human nature to withhold money during bad times, it is usually the best time to buy. This is an example of how people let their emotions contradict logic.

Asset-Allocation Theory

The next key item in the investment of money is the asset-allocation theory.

Some people think that the fund manager who makes the decisions about investing money is irrelevant. This was probably true in times of increasing price/earnings ratios, but the manager does have some influence on the market, particularly in a time when the market goes down. Individual selection of stocks in certain industries does matter. Some people have used fancy allocation theories based on looking at past performance of the stock market and coming up with a methodology where they put a specific percentage of the assets into certain industries or certain countries or certain types of stocks. With an asset-allocation theory, there is an appropriate time to buy some small companies and a time to buy large companies; but sometimes the purchase of individual stocks in foreign stock market exchanges is inappropriate and too risky.

One of the basic rules the author employs in investing overseas is never to invest in a company based on a foreign stock exchange. Always invest in a U.S. company that has a large market position in the overseas market. This is because the financial systems that ensure the accountability and performance of the earnings of the companies are better regulated through U.S. companies. Also, the average stock market capitalization in many foreign countries is so small that any single event can cause a significant fluctuation in the value of the stock market. This means that some of the high gains and large losses that take place overseas are really a matter of speculation. It is not appropriate to speculate with savings.

One of the problems with an asset-allocation theory based on past performance is that the allocation theory does not anticipate future trends in the marketplace and does not allow for logical reallocation of assets to meet changing situations. For example, when it became clear that the Far East was going to lose most of its financial assets, it was certainly a time to remove some exposure in those industries. Not only is demographic investing important in picking out the trends of what companies to buy, it is also important to look at where the company does business. This requires analysis and research, which has not been happening in the past 10 years. Instead, consumers buy brand-name identification from Madison Avenue, i.e., buy stocks that they have heard about or blindly invest in groups of assets based upon a formula.

People believe asset allocation is some form of magic. Asset allocation is a matter of prudently investing some money into the bond market and playing the cycle of interest rates; and putting certain assets in both big companies and small companies, particularly as these companies become undervalued. Even with an asset-allocation plan, an investor has to be flexible enough to move some money around as events change.

Mutual Funds

There are many well-managed mutual funds in the country, and they are probably the best way to buy stocks and have a diversified investment portfolio. Buying individual stocks requires a lot of research and constant attention. The problem is, with a lot of young investment managers in the country, many who have only been investing money for the past 10 years, there are unusually high allocations to "nifty 50" big stocks, which run up and down the indices of the stock market. Since most people compare the performance of their mutual funds to these indices, many of these young managers have just made decisions to buy the major components of the indices so that no matter what happens, they can point to the index and say "Well, I did as well as the index," or if the index goes down, they can say "Well, you know the index went down, and so did I. You can't always make money." This seems to be the defense of their decision-making. Particularly as the market turns down, many of the smaller companies in the stock market have corrected and gone down significantly. This represents a large buying opportunity. After this correction in the market, which may last until the year 2000, it will be important for investors to make sure that they diversify part of their money with money managers who have experience in small-cap stocks.

Since the timing is unknown, but the stocks have been identified as undervalued, investors should put their money into these funds early and hold through any remaining downturn. This is because many of the small-cap stocks are already down in value more than 50 percent, thereby creating a significant buying opportunity.

Bond Funds

The problem with accumulating money is that ultimately, once an investor retires, he or she must start using that money. The investor needs to start receiving a yield. This is where bonds come in because they are the most prevalent way of receiving checks from investments after retirement. An investor must be wary of the average bond fund. In many cases, whether the market is going up or down, the investor is losing money. For example, when interest rates drop, people who have their money in CDs or other financial instruments are in a situation in which they don't have enough cash flow coming from their CDs or Treasury bonds. So they chase yield. What that means is that people pour money into bond funds, and then they drive up the price of the fund, decreasing its yield. Many times, this decreases the total return for the people who were already in the fund. This has a tendency to dilute the gain of the fund across the people in it and does not give the same gain that would be received if one held individual bonds.

Likewise, when interest rates rise, bond prices go down. As people see the erosion of their principal start to take place, they panic. This often causes a redemption problem in which people want to take their money out of the bond fund. This flight of capital out of the fund usually causes the manager, who has tried to be fully invested, to sell the best of the bonds to raise cash to meet redemptions. This has a tendency to cause the bond manager to sell the "good bonds" and hold the "dogs" of the fund. This is a problem because the people who are loyal to the fund end up with a portfolio of underperforming bonds. The bonds are not of the same quality that existed when the purchasers initially bought into the fund. One of the things needed for a good investment strategy is an outlet to invest in bonds that are diversified but send a steady check and reward the holder as the market goes up and down, without dilution from other people.

This is important because when it comes time to retire, one cannot own and take yield off of mutual funds as a form of receiving a check during retirement. When the stock market is going up and one keeps buying more mutual funds, the funds expand. Then it will work to sell shares of the fund if the market is rising. An investor can sell some of the shares fund and use that to live on during retirement. However, when the market declines and the value of the shares are declining and the investor is in a position where he or she must sell some of the shares of the funds to be able to live, the investor is losing principal. In that regard, it is important to have an investment strategy that allows one to hold an investment that sends a check. As the value of the investment fluctuates, one does not have to sell the principal to live.

Although a stock can be at $100 per share and fall to $80 per share and never go back up, as long as the investor picks the bond in the right company a bond can decline, but the investor will get his or her money back at maturity. That's important to note as a method of investing money.

Target Weighted Portfolio Approach

The author's method of investing money is to define a goal and emphasize it. Over the past 10 years, he has been using a goal of investment return of 10 percent to 13 percent. He has tried to obtain a 7 percent return above inflation. When setting a target, one of the principal methods is not to try to beat the stock market, but just to achieve a goal. An important part of the strategy is that once that goal has been obtained, the investor must not be afraid to sell his or her investments to realize the gains. This means one should not be afraid to sell at the top. A lot of investment strategy says that this means the investor will miss some of the top end of the market, but as many people have recently learned, the top end of the market is illusive and one can lose a good bit of gain. Since people are not smart enough to always sell at the top and buy at the bottom, the author uses a methodology where once the target has been hit, he starts to lessen the risk. The main tenet of the target weighted portfolio approach to investing money is always to protect the principal. As long as the principal remains, there is still an opportunity to invest. Since the market is volatile and goes up and down, keeping principal maintains the opportunity to make money.

The second tenet of the approach is having a reasonable asset allocation. The author allocates a significant portion of assets to bonds. At any given time, the author puts 40 percent to 50 percent of his clients' money in bonds, mostly high-yielding bonds. These high-yielding bonds require attention, however, because the investor must analyze the individual asset to make sure the company has the ability to pay back the bond.

The third tenet of the target weighted portfolio approach is that when an investor sells but cannot find anything of value to buy, he or she should not be afraid to build up cash. In many people's minds, this is inefficient because the money is not invested at all times; but holding cash is sometimes the best investment.

The fourth tenet is to anticipate that things will go down and not panic. The more the market changes, the more an opportunity arises for a good investor to take available cash and buy when things are down. This approach can make a lot of money if handled correctly.

The last tenet is that discipline is important. The investor much constantly save money and allow the money to have time to grow. One must not expect it to create returns on a quarterly basis and in equal installments, but one must realize that things that have value ultimately realize that value. The investor should not be afraid to realize that he or she must measure the risk and compare that to the value that can be received and, if possible, invest in things that stand in front of large economic trends that will lead to making more money.

Diversification is important. One should never put more than 2 percent to 5 percent into any given thing. In this way, any individual misallocations or bad events will not hurt the investor. Also, one should diversify in industries. It is good to buy value-oriented investments that can be measured in relative values as compared to other economic assets.

An investor should choose a fund manager who is not afraid to sell, someone who is not afraid to build cash and buy bonds and stocks, particularly when they are down.

Outlook for the Future

In the short term, the Y2K problem and the inability of U.S. companies to pass on price increases will lead to uncertainty in the stock market through the year 2000. With this scenario in place, investors should stay in the stocks that are in basic industries and invest regularly in small-cap stocks. Investors should be wary of the price/earning ratio contraction that could arise and therefore lessen their risk in companies with high price/earnings ratios, which have been purchased just based on brand recognition. For the next 10 years, the outlook is good. One must not be afraid to continue to invest and should not stand still out of fear. Instead, an investor should establish a plan and work the targets.

Author

Darrel Cain is a principal in the firm of Cain, Watters & Associates, which works strictly for a fee when giving advice to clients about how to invest money. Cain, Watters & Associates is a registered investment adviser and is currently involved in asset allocations of more than $400 million.

To request a printed copy of this article, please contact/Darrell W. Cain, Cain, Watters & Associates, P.C., 5580 Peterson Lane, Suite 250, Dallas, TX 75240.