Trading large cap US mutual funds for individual company stocks

January 31st, 2009 · No Comments

I write a lot about our plans and strategies to reach “geographic independence”, but it is important to keep in mind that we’re also simultaneously pursuing a “traditional” retirement plan.  That is, investing in our 401k and IRA options for asset and income growth.   This past week my wife and I talked and we agreed to make some changes in those accounts.



One thing we noticed upon starting our review was that we still had some money invested in mutual funds charging relatively high management expenses.  Ugh!  Over the past year or two we have been slowly selling these off in favor of a diversified portfolio of dividend paying company stocks (for US large caps) and sector targeted, index-based ETFs (for everything else.)  We need the ETFs to still have some diversification within those sectors where we can’t economically (transaction costs!) diversify ourselves due to the amount we want to allocate there.  The mutual funds we had left were charging a management expense fee just under 1.0% — we have long ago sold off anything higher.  But that is still much higher than the expense rate on the ETFs we use, which average around 0.3%, and we pay no management expenses at all on the individual company stocks.  We figured now was as good a time as any to sell out the mutual funds and buy something that we believe will give us better returns due to lower expenses.

The mutual funds in question were part of our US large cap allocation, so we’d be looking to replace them with individual company stocks with a goal of gaining further diversification in this sector.  We currently only have around 6 positions and probably need somewhere around 10 to 15 if we spread them out across industries properly.  Writing this post up now, I realize that we’re staking our money on a belief that we can do just as good of a job in picking individual companies as the “trained” mutual fund manager and I’m wondering if we truly believe that?  I’ll have to talk to my wife about this some, but I do believe that we can.  And that is primarily because our goal is to buy, on the dips or otherwise at a discount, “mature” companies with good management that we can hold over long periods of time.

So, I’ve spent the week doing research and placing some buy orders after liquidating one mutual fund position.  For the research part, I started out by taking the S&P Dividend Aristocrats list and grouped the listed companies by “sector” and “industry” classifications.   Then I did the same for our existing holdings in our IRAs.  (Unfortunately our 401k is still the kind where our only investment options are mutual funds so we just worry about overall asset allocation strategies there.)  I then looked for sector/industries in the Dividend Aristocrats where we are under-allocated in the IRAs.  This gives me a list of companies to do more research on.

From that list, I then start recording things like price-to-book ratio, 5 year dividend growth rate, dividend payout ratio (last 4 quarters), 5 year EPS growth rate, 5 year cash flow growth rate, current dividend yield, long term debt/equity ratio, beta, and annualized operating margin.  This gives me a matrix from which I can get a feel for each company.  An overarching concern with this data is to try and find investments that will give my wife and I a good long-term “yield on cost” measurement, which means I’m looking for yields that grow well over time compared to the entry cost of the investment.  But after that, my evaluation becomes somewhat subjective.  I’d like to have an algorithm to help us be consistent here but we have yet to come up with one.  That being said, we do generally like the 5 year dividend growth rate to be over 15% as that means dividends would double every 5 years.   Anyway, as we’re focused on diversification at this point, what I looked for was the best companies in the sectors/industries we had no coverage in already.  This requires more subjective research than just the matrix, as I want to ensure I’m aware of recent news and/or earnings announcements, etc.

Having picked some companies out from that screening, I then went about figuring out what sort of price was a reasonable entry point for each one.  Again, I’d like to improve our calculation for this to take a wider, more consistent, view but right now all we’re doing now is trying to ensure that we buy in at a desired dividend yield (greater than 3%) and at least a 2:1 ratio of 5-year-P/E average vs current P/E ratio.  We figure the latter gives us some room on the “return to mean” theory.   Typically, I take the price that fits both qualifications and treat it as the price to enter for the limit purchase orders I’ll place for our accounts.  However, the current economic situation means I found a number of opportunities where the current price was already below that!

Rather than buy at the market price, I then did a subjective survey of price volatility for that stock on both a 5-day scale and 30-day scale.  What I was looking for is a price that gives me a good chance of buying in on a short-term dip, yet having a very high chance of filling the order within the next 30 days.  In some cases, I found that we were already in the lowest dip of the 30-day range so I went back and worked harder to dig up more news to understand why.  In one case, I talked myself out of purchasing this stock — but I’m not convinced that was a good move as all the numbers looked good according to our analysis.  Only time will tell.   It also occurs to me as I write this up that we might do better using options to buy-in to a position rather than using the price to place a limit order.   But for now, all I did was place limit orders.

Apparently my limit orders weren’t quite low enough as 3 out of 4 of them were triggered within 3 days.  We now hold positions in AFL, DOV, and PEP and are waiting for a position in ADM to fill.  Yes, we’re now in stocks with companies that we feel will give us good long-term returns, but still, it feels like we overpaid given how quickly our orders were filled.   I guess the take home lesson is to be more aggressive about the yield we’re looking for and/or the P/E ratio we demand, or to look at the volatility differently somehow.  It’s also possible our valuation method needs to be refactored.  I’ll have to think about this some more but I’m also open to any hints anyone has!

Tags: Equities · Investing · IRA

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