Stock Allocation: A Way of Increasing Returns

If you are an investor, chances are you would have heard of the term "asset allocation".  The idea is to maintain a certain percentage of your portfolio in different asset classes, for example, stocks, bonds, etc.  Why would you want to do that?  The answer is simple: it increases your return.

Suppose you have Asset Class A and Asset Class B, and you want to maintain the percentage of each to 50%.  Say you had invested $10000 in each and Asset Class A rose 50% in the first year while Asset Class B dropped 30%.  At the end of the first year, you would have $15000 in A and only $7000 in B.  You now have an imbalance.  What you do is sell A and buy B so that you have equal amounts of both (50% of each).  At the start of year 2, you would have $11000 of each of A and B.  If B then rises 50% in year 2 while A falls 30%, you would have $7700 in A and $16500 in B.  This would total to $24200.  If you had not rebalanced your portfolio, you would have had $10500 in A and $10500 in B, totaling only $21000.  Asset allocation works very well when your asset classes are not correlated (i.e. they do not move in the same direction all the time).

The really curious thing is this: your portfolio returns is actually greater than the average of the returns of both investments.  Back to that example above.  A had risen 50% in the first year and dropped 30% in the second year.  Its returns was 5% over 2 years.  B had dropped 30% in the first year and risen 50% in the second year.  Similarly, its returns was 5% over 2 years.  However, the rebalanced portfolio ended with $24200, which works out to be 21% gain over 2 years.  Both only returned 5% over 2 years, but somehow, your portfolio returned 21%! Isn’t that cool?

The key lies in correlation, the lack of it actually, between the assets.  What we are effectively doing is buying low and selling high.  Now, you all know that I am a stock kind of guy (I only hold cash or stocks).  Therefore, instead of asset allocation, I propose doing a stock allocation.  I currently have 4 stocks in my portfolio.  Chances are, they will be slightly correlated.  That is, they tend to move in the same general direction, but some times do deviate.  In Figure 1, you can see the performance of the 4 stocks over the past 2 years.  As you can see, they definitely follow different paths.  The goal is to allocate a certain percentage of your portfolio to each stock.  In this case, I may want to allocate 25% of my portfolio in each stock equally.  It doesn't necessarily have to be an even split.  I may have a belief that True Religion would outperform the other 3 stocks.  In that case, I might want to give it a 40% weighting and the rest 20% each.  It is entirely up to your discretion.

Figure 1: The Stocks in My Portfolio: Google, True Religion, First Solar, Synaptics

Dumb Stock Allocation
So, you now get the general idea of stock allocation.  You can either use a "dumb" stock allocation strategy or a "smart" stock allocation strategy.  The dumb strategy is to simply set an allocation target percentage and every few months (or weeks or years), rebalance your portfolio to that percentage.

Let’s look at a real life scenario to see how that works out.  Instead of 4 stocks, let's keep things simple and use 2 stocks.  The table below shows quarterly price data of Google (Ticker: GOOG) and True Religion (Ticker: TRLG), starting from January 2005.  If you had bought and held the stocks, you would have gotten 193% returns over the 25 quarters.  If you had rebalanced your portfolio every quarter using dumb stock allocation, you would achieve 297% returns over the 25 quarters!  It works alright!

Smart Stock Allocation

"Smart" stock allocation, on the other hand, requires some smarts from you.  I would definitely say that this is a more advanced strategy with a combination of Rule # 1 Investing and pure gut feel.  I'm starting to employ this strategy...So, we're into uncharted territory here!  Ok, ok, I'm exaggerating...investors have done this many, many times already.  In fact, many people do this without knowing it.

Here's a real life example.  If you have followed my trading history, you would have noticed that I started buying True Religion around this time last year and began to sell it just recently.  I have also bought some First Solar recently.  This is me doing some smart stock allocation.  True Religion has run up to the high $20s in the last couple of months.  My cost was $22.55.  Because of this run up, the holding has grown in proportion.  Meanwhile, First Solar spiked up for a little while, but is now trading in the $120s, off its 52-week highs in the $170s.  It has decreased in proportion.  Therefore, I sold some True Religion and bought some First Solar.  The likelihood of First Solar moving back up to $170 is greater than True Religion moving up the same amount to $42; the True Religion stock had already gone up from $22 to $29 in a short amount of time.  If things work out as they should, we should see First Solar bounce back up while True Religion takes a breather and stays steady or retreats a little.  Hopefully, this will work out.  Pray for me!!

Some Major Major Caveats

Whether it's dumb or smart stock allocation you are using, you must have good reason to own any particular stock.  Please do not, I repeat, do not use stock allocation blindly by just picking whichever stocks you like and hope that you will make money.  If you pick 5 overpriced stocks, as the prices tumble 50%, stock allocation won't be of much help.

You need to know the intrinsic value of the stock.  My advice is to use Rule #1 to help you determine that.  Never buy a stock that is ridiculously overpriced.  For that matter, never buy a stock that is fairly priced.  Always buy a stock that is underpriced.

If you are using smart stock allocation, use technical analysis to help you figure out when to buy and sell.  Rule #1 talks a bit about the "3 tools", but from my own experience, I prefer using supports and resistances.  However, the 3 tools in Rule #1 are more objective and require less experience.

Lastly, know that stock allocation might not increase your returns.  If your one stock does really, really well for an extended amount of time compared to the others, you would end up selling more and more of it prematurely.  Therefore, study the movement of the stock.  If it tends to gyrate between supports and resistances, then it would be wise to rotate in and out of the stock as it moves up and down.  However, if the stock tends to be steadier and rises constantly, stock allocation may not end up helping you.  I would recommend doing some back testing to see how stock allocation works out.  By back testing, I mean running a simulation of the past few years of data and see if the returns are magnified or decreased (similar to what I did above with Google and True Religion).

Let me know how this works for you!

Good Bargains Available!

There are currently some good bargains available.  First, we have First Solar (Ticker: FSLR) which is getting hammered for no apparent reason, aside from just pessimism and bearishness.  Google (Ticker: GOOG) is also seeing the $510s, also for no apparent reason.  Fundamentals for both companies look great.  Since I have already bought both of these companies recently, I will be holding out some more.

If FSLR drops below $105, I will start to buy aggressively.  Same with GOOG if it nears $500.  If you don't currently have either of these stocks, you may want to begin thinking about buying some.

USCCB Socially Responsible Investment Guidelines - Part 6: Protecting the Environment

The fifth area covered by the investment policies of the USCCB is "Protecting the Environment".

This is one of my favourite categories.  I moved to Canada from Hong Kong when I was 8 years old in 1987.  Just shortly after I had arrived, Toronto started the curb side recycling program.  Initially, it was only a small "blue box" program where you had about 3 cubic feet of space to place your recyclables each week.  The idea that your garbage was really not garbage was really revolutionary.  There was also a big push in education in the schools.  Over the years, the recycling program had really expanded.  Currently, in Toronto, there are now 3 types of boxes for recycling.  The blue box still exists, but is now a big wheel barrel.  Items such as aluminum cans, glass, and Tetrapaks go here.  There is also a grey box which take paper products.  Similarly, it is a big wheel barrel.  Most recently, a green bin program was started.  Compostable material such as food scraps go here.  These items are all picked up weekly by the curb.  The goal of the city is to divert 70% of garbage from landfills.  A large majority of Canadian cities run similar programs and I would say they have been largely successful.

The same cannot be said for our friends in the US.  I work with many customers from the US and from the anecdotal evidence I have gathered, curb side recycling is still an exception rather than the norm.  I'm not here trying to trash my American friends, but the point I want to make is that the protection of the environment cannot be achieved, at least efficiently, unless there is governmental and corporate support.  This is where our investment comes into play.  We should be using our investment as our voice.

The USCCB's policy for their own investment is to actively promote and support shareholder resolutions that encourage corporations to act responsibly.  Just recently, I had exercised my shareholder right and obligation and voted, by proxy, on the various matters to be discussed at the annual shareholders meetings.  However, what I found was that most of the questions on which I voted were very broad.  They usually revolved around executive pay, use of certain accounting firms, and other shareholder resolutions.  Therefore, I have concluded that it would be difficult as an individual investor to voice peripheral concerns such as the protection of the environment, unless the company's business was directly linked to it.

How to Invest to Protect the Environment

As a result, our obligation is really to select companies that are already environmentally conscious, or better yet, have products or promote technologies that protect the environment.  We should also avoid in investing in companies that harm the environment, whether through their manufacturing processes and business practices or by the use of their products.

I will use my own portfolio as an example.  First and most obvious is my investment in First Solar (Ticker: FSLR).  It makes solar panels which produce electrical energy with no byproducts.  The only impact to the environment would be the manufacturing process and also the panels' disposal at the end of life.  One solar panel produces in the vicinity of 4000 kWh in its lifetime, which is equivalent to 14400 MJ, or 413 L worth of gasoline.  I hardly think one would need to burn a fifth of 413 L of gasoline to produce 1 solar panel!  Solar energy, is without a doubt, green energy.  First Solar is not without some problems.  It uses cadmium telluride in its panels.  Elemental cadmium and cadmium telluride in its own form are toxic to humans.  It is important that First Solar is able to recycle these panels at the end of their lives.

The second and less obvious green investment I have is Google (Ticker: GOOG).  To many people's surprise, Google is actually a very green company.  It invests heavily in solar and wind energy, for example.  It also uses goats to "mow" their lawn, instead of traditional lawn mowers.  There are many good things that Google is doing with regards to helping the environment.

On the flip side, we want to avoid investing in companies that do the environment harm in one way or another.  One obvious example is oil companies like Exxon Mobil (Ticker: XOM) and British Petroleum (Ticker: BP).  BP has become the poster child for companies to hate, with its recent oil spill in the Gulf of Mexico.  Aside from oil spills, the burning of fossil fuels derived from crude oil releases huge amounts of carbon dioxide and other pollutants.  Fossil fuels, in and of themselves, are not evil, but in today's world, humans rely so heavily on them that there may be irreparable damage done to the environment if we continue to consume them at the current rate.  Our insatiable thirst for crude oil is simply not sustainable.  We should direct our investment elsewhere.

Conclusion

It is really not that difficult to evaluate whether a company is environmentally friendly or not.  Just look at its products and how it is made and used.  If you find that it's not that easy to evaluate, try multiplying its current volumes by 10 or 100.  That may make things more obvious.  Or, you can try googling the company name with "environment" and see what results come up.  The internet is really a great place to do research in this area.  In the end, using common sense is likely all you need to do.

I Bought Some First Solar (FSLR) Today!

Good day!  First Solar (Ticker: FSLR) seems to be finding a nice support around the $120-125 area.  I bought some more shares today as I continue to take this as a great buying opportunity.  I also recently started a naked put option on First Solar.  See my trade history.

So what happens if it continues to fall?  I'm buying more!  Overall, Q1 has not been a nice quarter to a number of solar companies.  Evergreen Solar (Ticker: ESLR) is on the brink of bankruptcy.  So, the fallout is beginning! This is a good thing!  Why?  As I have said before, the smaller players will die out, leaving the field for a handful of larger players, such as First Solar.  We know the solar sector will flourish in the current and next decade.  Having stake in the best company in the industry will help you ride the wave.

Also of note, Sunpower (Ticker: SPWR) is being bought out by Total.  This means well for the industry in general.  If an oil company is investing in clean energy, you know it's got a future!  Who knows, maybe some other company like Exxon or BP would be interested in First Solar?  A takeover will send shares very high!

Quick Comparison: First Solar (FSLR) vs. JA Solar (JASO)

JA Solar (Ticker: JASO) impressed investors today with its earnings report and its stock was given a nice 6% jump.  I was a little less impressed.  Here's why.  I am a big fan of huge gross and profit margins.  Why?  Large margins indicate one thing: a huge moat!  People are willing to pay a premium for the product relative to the cost of the product.  Ok, so you say, what's the big deal about profit margins anyway?  A company can still make money and grow revenues/profits even with low margins.  Yes, that is true, but the safety factor for companies with small margins is small.  Let's do a quick comparison.

First Solar 2011 Q1 Results
Revenue: $567 million
Gross Profit: $260 million
Gross Margin: 45.9%
Operating Margin: 20.4%

JA Solar 2011 Q1 Results

Revenue: $556 million

Gross Profit: $96.3 million

Gross Margin: 17.3%

Operating Margin: 15.0%

You can see that both companies made about the same amount of revenue, but the gross profit of First solar was more than double that of JA Solar.  This essentially means that the selling price of JA Solar's products were just a bit above that of its cost.  The one big risk that everyone talks about in the solar industry is falling average selling prices (ASPs).  It means that because many companies are ramping up production, the supply of solar cells/panels will exceed the demand.  As a result, the price of the cells/panels drop.  Because First Solar has a large gross margin, it is more insulated from dropping prices.  If ASPs dropped by 15%, you can bet JA Solar will be losing money.  First Solar may still be able to make money, but just less.

It is a little unfair to do this comparison, however, because First Solar makes panels and JA Solar makes cells.  Solar cells are essentially commodities and are typically a low margin business.  I guess this makes my point even stronger.  First Solar has proprietary technology that lowers its cost significantly.  However we spin it, First Solar's business is superior to that of JA Solar's.

Another interesting point...JA Solar has a very, very low SG&A component, about 2.3% of revenues (gross margin minus operating margin).  The company used only $12.8 million for sales, general, and admin expenses in the quarter, which is suspiciously low.  I'm wondering if there are any accounting tricks that were used.  You can compare this with First Solar's $145 million.  While this is high, it seems much more reasonable.

All in all, it is no surprise that JA Solar's P/E ratio is at a low 4.0.  Investors know this is a risky play.

Volatile Stock: First Solar (FSLR)

First Solar reported earnings earlier this week.  They beat estimates by about 15%, but investors weren't pleased with the outlook, which was the same as their guidance last quarter.  Talk about illogical!  Mr. Market is having big mood swings.  It was less than 3 months ago that the stock hit $175.  Now, it's $128.  This, ladies and gentlemen, is volatility for you!

Take a look at their earnings press release and also earnings call transcript.  I got a sense that Q2 will be another tough quarter, but sailing should be smoother in the second half.  Be prepared for a bumpy ride for the next few months.  On the bright side, some positive outlook they've given include 3.0 GW capacity by end of 2012 and cost per watt down in the $0.52 to $0.63 range by 2014.  This means their capacity would be doubled of what it is today in about 18 months.  In the meantime, I am planning on selling a naked put and maybe also buying some shares (both are bullish positions).