
Get Your Portfolio in Shape for 2008
During the end of the year, we often hear a lot of banter from the professional investment community about "tax selling" and other backward-looking tax-related strategies. However, I believe that not enough attention is focused on looking ahead to the next year.
As December winds down, there are many tasks that are not tax related that investors can perform that can both optimize
returns for the year about to pass and prepare their
portfolio for the year to come. So this installment of The Finance Professor will focus on a year-end
valuation and
risk-management strategy for closing out 2007 and forging a solid foundation for 2008.
In "
The Finance Professor: Manage Risk Like a Pro," I covered a few techniques for how individual investors can manage risk in their portfolios. One of the key steps is to create a spreadsheet or database of your current holdings. If don't already have one, then now is the best time to get this data in order, because it will come in handy for the rest of this lesson.
Set Your Price Targets for Next Year
Analysts and professional
money managers are always "forward thinking" (see
forward price-to-earnings ratio). With next year around the corner, now is the perfect time for you to do a little forward thinking of your own.
For each of your holdings, set a price target that reflects expectations for next year. So if you are working off of "trailing" data, it is time to revisit your investment assumptions. Here is how to do it:
Step 1: Determine a target earnings per share for your stock.
This can be achieved through reading one or more analysts' opinions (see "
Investment Research: Ignore the Ratings, Read the Reports"). You can also seek out the consensus estimate for a company's
earnings. A consensus estimate is the average estimates for all analysts covering a particular stock. These estimates can be found on Yahoo! Finance's individual stock quote pages, by clicking "Analyst Estimates."
However, do not rely solely on those analysts' opinions (see "
Ask TheStreet: Target Practice" and "
Investment Research: Ignore the Ratings, Read the Reports"). Make any necessary adjustments to their estimates based on your own research or macro-level opinions. For example, if you are looking at a general merchandise
retailer and the analysts whom you have read believe that the company will increase earnings by 10% in the next year, but you believe that overall consumer spending will slow down, then adjust the analysts' estimates accordingly.
Step 2: Determine a target price/earnings multiple for your stock.
This is not a straightforward task and it will require some assumptions, but it's nevertheless possible and definitely important. So how does one determine a
forward P/E for a stock? Here are a few techniques:
- Use the company's historical P/E ratios. While P/E ratios are not static, they do tend to move around a mean (average) value. This mean P/E should provide a good grounding for this analysis.You can use TheStreet.com Ratings to provide you with historical EPS and growth rates for individual stocks.
- Compare the company's P/E with that of its industry or closest competitors. There should not be a big discrepancy amongst competitors with an industry. However, the better companies will garner a premium multiple to that of their lesser competitors (see " Cramer's 'Mad Money' Recap: The Pizza Connection").
- Look at alternative investments. Consider the P/E for a risk-free investment. Let's say the five-year U.S. Treasury Note is yielding 5%. The P/E for this note will be the 20 (1 divided by .05). If you can earn a 20 P/E on a risk-free investment, then the P/E on a riskier investment needs to be considered in the context of its relative risk. In other words, why pay more for a riskier investment than a less risky one?
- Look at growth rates. This is what I refer to as the Cramer Rule. Jim Cramer states that you should never pay twice the growth rate for a stock. By that he means that the P/E should never be more than two times the expected growth in future earnings per share (see price/earnings-to-growth ratio). You can use this benchmark as a rule of thumb. For example, if a company that you're invested in is expected to grow earnings at 15% next year, your forward P/E should not exceed 30 times earnings.
Step 3: Calculate an overall price target.
Having your forward earnings estimate and P/E multiple, take the two numbers and multiply them to arrive at a price target for next year. For example, with
(GOOG) - Get Report
, I have estimated that the company will earn $21.25 EPS in 2008 and have applied a 40 target multiple (or P/E) on those earnings. This allows me to derive a price target of $850 ($21.25
multiplied by
40) per
share.
Manage Risk and Take Action
With your price targets in hand, you can now conduct the risk management part of your year-end investment strategy. This has two distinct objectives: estimating expected return and managing exposure. Hence, here are the questions to ask as you review the holdings in your portfolio:
Is your expected return worth holding your position?
By comparing the price target for your stock with the current price level, you can calculate a price return for the coming year as follows: (Price Target
divided by
Current Price)
minus
1
multiplied by
100
equals
Price Return.
Last time, I covered
benchmarking and performance measurment. Having set an investment performance benchmark, you can determine if you need to take action on an individual stock. For example:
My price target for Google is $850. The stock now sells for approximately $695. My return on the price target is 22% ($850
divided by
$695
minus
1
multiplied by
100). If you expect the
S&P 500
to rise 8% in 2008, then Google is a stock that you want to hold.
Conversely, I recently sold part of my
McDonald's
(MCD) - Get Report
position at a price of $62.50 because the stock traded at my 2008 price target in December of 2007. The reason I did not sell all of my McDonald's shares is because I still believe that on a longer-term basis, the stock will continue to outpace my target and because of tax considerations (I felt no reason to pay 20%-25% income tax on a stock that I have nearly tripled in and would gladly repurchase if it fell 10%).
If your expected price return for risky
assets falls below that of less risky assets, then you may need to consider changing your risk profile.
If that situation applies to you, then you need to eliminate some risk and get "defensive." Here are a few defensive techniques:
- Emphasize yield over price return. How? Go for solid dividend-paying stocks.
- Lower your P/E. A higher P/E for a stock or a portfolio means more built-in risk. Why? Higher P/E stocks will move in greater increments to changes in earnings and are subject to P/E contraction, which causes steep valuation declines. Another way of thinking about this is to focus on value rather than growth.
- Boost your cash. Consider raising cash until the market moves in such a way that your expected returns exceed your benchmark returns.
Are you overexposed?
Risk management not only involves
diversification, but also
asset allocation. As the old saying goes, "Don't put all of your eggs in one basket."
After a year of allowing your portfolio to age, it is time to re-examine the relative weighting of your holdings (see
overweighed and
underweighted). Let me illustrate: Say you had the foresight to buy
Apple
(AAPL) - Get Report
at the start of 2007 and at the time Apple represented 5% of your portfolio. With all things being equal, now Apple could represent nearly 12% of your portfolio. Perhaps it is worth reducing your exposure to Apple, even if you think it will continue to grow in the future. Here's why:
When a single holding gets too large relative to an overall portfolio, it is prudent to cut the position down. This reduces your portfolio risk to the fluctuations of a single holding, while still ensuring long-term exposure to that investment position. Plus, this allows you to free up
capital for another investment idea with excellent prospects in the future.
Are you underexposed?
Exposure cuts both ways. For example, we are in the midst of multi-year
bull markets in many sectors, such as energy services, agriculture and technology (to name a few). Additionally, growth
outside the U.S is expected to remain stronger than growth within the U.S. for the next year. That said, as the year winds down, take a look at your holdings. If you are
underweighted in some of these investment areas, now might be a good time to increase your exposure to those groups.
In doing this, you may discover that it's time to reduce your exposure to stocks and sectors that are in
secular
bear markets. Example of such markets would be financial services, retail, restaurants and biotechnology.
Homework Time
Following the strategic steps in this lesson, you should be well prepared to tackle the investing environment of the coming year. With just a few days left in the current year, here is some homework to prepare you for the brave new year:
- If you have not already done so, organize your holdings.
- Set price targets for your holdings.
- Compare expected returns to your expected benchmark returns and take defensive action if necessary.
- Reduce exposure to excessive holdings, as well as sectors not expected to outperform in the coming year.
- Increase exposure to forward-looking bull markets.
At the time of publication, Rothbort was long AAPL, GOOG and MCD, although positions can change at any time. Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele. Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities. Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University. For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.









