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July 2016 Portfolio Reporter: Earnings Are the Fundamental Driver

Banner 2016 July - Long

SUMMARY

At this point in the economy, stock market growth is unlikely without earnings breaking out of its two-year lull.

In this edition, we will cover the most significant drivers indicating the current status of the market. Second, we will offer a Strengths, Weaknesses, Opportunities, and Threats analysis of the Capstone investments.

CORPORATE EARNINGS

If earnings meet expectations, we can expect a decline for the fifth consecutive quarter. The decline in earnings is led by a drop in revenue that — if persistent in the second quarter of 2016 — will be the sixth consecutive quarter of declines (Source: Factset).

While on recent upturn, expected earnings (blue line) have been in an overall decline since July 2016 (below). In total, earnings have been range-bound (see the orange parallel lines below.)

Earnings Scorecard Capstone Reporter July 16

S+P 500 Change Capstone Reporter July 16

ECONOMICS

The economy is growing at a rate that is below average. Industrial production is leading a decline. After being up through April, the industrial production began to sink in May.

Employment is the strongest contributor to the economy. Most recently, nonfarm payrolls reported for June were stronger than expected. Even with the solid monthly showing, employment growth has been slowing down the last six months.

Consumption and housing are more tempered. Housing began to fall with an annualized rate of 1,164,000 units, down from 1,167,000 in April. At this time, the three-month trend for sales, production, consumption, housing and employment are all down.

A report by the Chicago Federal Reserve based on national activity has indicated that growth has been in a slump since December of 2014.

FRED Capstone Reporter July 16

TECHNICALS

The S&P 500 has broken out and reached a new all-time high. The strength is supported overall by the internal market action as the percentage of companies above their 200 day moving average is higher than 60%. A secondary look at internals indicates that the market is being led higher by defensive stocks. Typically, a move higher is led by more growth-oriented sectors. The defensive sectors include consumer staples, utilities, gold and precious metals, and US bonds.

MOMENTUM

Below is the momentum from Value (red) stocks as they began to outperform Growth (blue) stocks.

S&P Graph Capstone Reporter July 16

VALUATIONS

Whether above trend, or based on trailing corporate earnings, the market (as measured by the S&P 500) appears to be expensive. Reports by Doug Short and Crestmont Research (below) show individual valuations are high, allowing for little price appreciation potential.

Crestmont PE Ratio Capstone Reporter July 16

TRENDS

So far this year, the market has been driven by dividend yielding stocks. The SPYDER Dividend ETF is outpacing the S&P 500 18.7% to 6.3%.

While earnings and/or valuations — the two biggest drivers of stock prices — would suggest little upside, the overall trend and technical jump into new highs solidly supports a rising market. We can’t say it will last, but as the saying on Wall Street goes… “The trend is your friend.”

Portfolio Notes

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Portfolio Notes section relate specifically to the Capstone Portfolios and the investment positions.

ETF PORTFOLIOS (Aggressive, Growth, Moderate, Conservative and Income)

The Aggressive, Growth, Moderate, Conservative and Income portfolio returned -1.1%, 0.2%, -0.3%, -0.6% and 1.7%, net of fees over the last 12 months. The S&P 500 (with dividends) increased 5.4%, the DOW (an index of 30 companies) rose by 6.6%, and the Lunt Capital 7Twelve Index saw an incline of 4.2%. The Lunt Capital 7Twelve Index is a diversified, strategic allocation across seven broad asset classes and 12 underlying indices.

The difference is a story of faster ascents after a market decline. At the start of 2016, the S&P 500 experienced a decline of 11.6% while the Aggressive model was down 10%. However, from the end of February to July 31, the S&P 500 ascended by 19%, the Aggressive model increased, and the ETF models all experienced progress, with Growth up by 13%, Moderate up 12%, and Conservative rising by 14%.

The drag in the rebound is a result of the different holdings between the S&P 500 and the ETF models. First, holding Biotechnology — the workhorse of the portfolio with a previous incline of 47% over the past two years — declined 28% from October 2015 to February 2016.  Second, the semiconductors of energy and retail have been the strongest industry groups within the S&P 500, though we have not held either of these industries (some exposure to semiconductors is held within the NASDAQ 100).

Lagging over the last year are the IQ Merger Arbitrage (MNA) up 1.7%, the NASDAQ 100 index (QQQ) of mostly technology stocks with a gain of 4.5%, and the S&P Growth Index (IVW) up by 5.1%. These three holdings accounted for roughly 25% of the portfolio.

Adding strength to the portfolio were three holdings: iShares Cohen and Steer REIT (ICF) up 21.9%, SPDR Consumer Staples (XLP) with an incline of 11.3%, and iShares Edge MSCI USA Quality Factor (QUAL) up by 6.6%.

The holding of bonds has been a net positive to the portfolio. Albeit in hindsight, holding longer-dated bonds with 20- and 30-year durations would have been even better as interest rates have declined over the last 12 months, thereby raising the price of all bonds.

Two trades that have worked well since the beginning of March (when the market was down) were the purchase of VanEck Vectors Gold Miners (GDX) and SPDR Utilitites (XLU). These holdings increased by 53% and 10%, respectively. However, holding just 7% of GDX and 5% of XLU weighed down the portfolio. Upping them to a full allocation of 15% each would have added growth to the portfolio.

Analyst Upgrades declined 1.9%, while the S&P 500 increased by 5.4% in the last 12 months. The decline in January clearly impacted this portfolio. As of now, the rebound is mimicking the S&P, but is not strong enough to catch up to the S&P at this time.

Drilling and mining hurt Analyst Upgrades with declines from ENSCO PLC (ESV), falling by 51%; FREEPORT-MCMORAN INC (FCX) down 26%, EQT CORPORATION INC COM (EQT) dropping 21%, and EOG RES INC (EOG) down 22%. Additionally, financial holdings such as Huntington Bancshares (HBAN) declined 11.9%, Northern Trust (NTRS) fell by 9.6%, and Legg Mason (LM) experienced a decrease of 8.1%.

Strengths came from HEWLETT PACKARD CO (HPQ) up 71%, Nvidia (NVDA) rising by 45%, DOLLAR TREE STORES INC (DLTR) with an incline of 23%; DOW CHEM CO (DOW) up 14%, and Duke Energy (DUK) climbing by 9%.

Analyst Momentum declined 19.8% versus the S&P 500 gain of 5.4% over the course of the last 12 months. Similar to what the Analyst Upgrades experienced, the decline in January was torturous, and the rebound is not yet benefiting the Analyst Momentum portfolio.

Losses were led by CENTURY ALUM CO (CENX) down 19%, FIDELITY NATIONAL FINANCIAL IN (FNFV) dropping 15%, MARATHON PETE CORP COM (MPC) falling by 18%, PBF ENERGY INC (PBF) down 20%, and TRIUMPH GROUP INC (TGI) declining by 21%. Certainly, buying into energy stocks was like catching a falling knife; they continued to decline even further rather than increasing.

Strengths were found in Grief Brothers Corp, with a gain of 21.5%, APOLLO EDUCATION GROUP (APOL) up by 23%, CST BRANDS INC COM (CST) rising by 15%, JOY GLOBAL (JOY) up 16%, and Aarons (AAN) climbing by 7%.

Focused Strength gave up 8.4% in the last 12 months as the S&P increased 5.4%. Holding bonds has saved the account in the downturn, but with the rebound in March, the Focused Strength portfolio has been left behind. Currently, 50% of the holdings are in iShares Barclays 20-year bond (TLT), which has risen by 9%. The other 50% is in PowerShares Commodity Index (DBC), currently down by 2.3%.

MaxBalanced is up 1.5% over the last 12 months versus the Lunt Capital 7Twelve Moderate Index up 4.2%. The MaxBalanced portfolio is Capstone’s most diversified portfolio and is structured like a university endowment; investing in more than 12 asset classes. The idea behind this investment is that we cannot predict the market, nor can we accurately forecast how assets are measuring up at any given point.

Most assets outside the US are weak and continues to be reflected in the MaxBalanced fund. The weakest of the assets are WisdomTree International High Dividend (DTH) down 21.7%, iShares Malaysia (EWM) with a drop of 21%, WisdomTree Japan falling by 21%, Guggenheim Multi-Asset Income ETF (CVY) declining by 23%, and PowerShares Global Agriculture Portfolio (PAGG) down 20%. The few strengths in the portfolio are coming from Consumer Staples Select Sector SPDR ETF (XLP) up 22%, and Schwab U.S. REIT ETF (SCHH) rising by 19%.

Equity Income is down 0.9% over the last 12 months versus the S&P 500 with dividends up by 5.4%. The goal of the Equity Income portfolio is for a total return over a three-to-five year investment horizon. Performance has been hit with allocations to Cameco (CCJ) and Honda Motor (HMC), down by 20.4% and 5.2%. Strengths are supported by Reynolds American, up by an impressive 108.6%, Altria (MO) up 87.2% and Crawford & Company (CRD.A) rising by 56%.

Earnings Momentum is up 3.3% over the last 12 months versus the S&P 500 with dividends climbing by 5.4%. The philosophy of the Earnings Momentum portfolio is to invest in companies with good or improving return on capital, and to acquire management teams that make good decisions about the resources they have, all while stock is selling at a reduced priced relative to generated cash flow.  Strengths in the Earnings Momentum came from Constellation Brands (STZ) with an increase of 220%, Fiserv up by 131%, and Equifax (EFX) rising by 120.1%.

Constellation Brands has improved by accelerating earnings through accretive acquisitions, and is certainly overvalued as a result of the great rise. However, in terms of earnings, we have no reason to sell the holding. Both Fiserv and Equifax have benefited from increased use of data technology in the financial services industry. Earnings have improved well for both companies. Similar to Constellation Brands, Fiserv and Equifax are both overvalued, but fundamentals don’t warrant selling at this time.

For more information about your investments, please contact your financial professional.

The Analyst Upgrades, Analyst Momentum, Target 2015 Conservative, and Bond ETF programs are based on Ready –to-Go Folios selected by Capstone to meet specific objectives of investors. Detailed information on these programs is available from Folio. Prior to 4/1/15, the MaxBalanced program was managed at a predecessor firm but using the same methodology and by the same manager. The performance reported above is model performance reflecting how the programs were actually traded but without any deposits or withdrawals as would be typical in an actual account. The returns are in U.S. Dollars and include reinvested. Past performance is no guarantee of future performance. There can be no assurance that a client’s investment objective will be achieved or that a client will not lose a portion or all of his or her investment. All returns are in time-weighted total return and include dividends. If a dividend is declared but not paid out in that month, then the returns from a previous month may be adjusted higher to account for the dividend payment.

For a list of all recommendations made over the past 12 months, please contact CIFG.

Active versus Passive……versus Common Sense!

Stock Market Graph - Long

By Ted Schwartz, CFP®

The biggest shift (and debate) during my decades in this business is the move from active management to passive. Active management means that your investment has a portfolio manager who is tasked with picking your investment from the universe of choices. His job, obviously, is to be above average in his choosing so that you do better than average in the returns you receive versus the risk that you take. A passive investment merely tries to duplicate an index of investments with no decisions made by a manager. The idea here is to do average with as little expense as possible incurred.

The battle over which of these ideas is superior has raged for more than a decade with both sides presenting evidence that they have the superior position. Both sides have logical arguments to make, but…the field has been tilting towards the passive side. Investors have voted with their feet, leaving actively managed mutual funds for Vanguard low cost index funds and ETFs (exchange traded funds). My belief after watching this for twenty years is… in a good market (where the trend is clearly up), you are probably better off in low cost index investments that capture average returns. The data shows that relatively few active managers outperform in these markets and also shows that these instances of outperformance tend not to persist (i.e. this year’s winning fund is unlikely to be next year’s winner).

So, does that mean we should all only own passive investments with a buy and hold for the long term discipline? I think the answer to this is….use some common sense! Remember, passive investments include zero risk management and you will always capture an average share of all losses in market declines. Let’s say you owned a passive investment in the Nasdaq index in early 2000. Stock prices were well over ten times their normal valuations, but there were lots of pundits explaining that this was a “new paradigm”. Passive investors were set to lose 78% of their principal by sticking to their long term buy and hold strategy. The Nasdaq index was at 5048 in March of 2000 and is at 5058 as I write this in July of 2016. An optimist might say “see, I told you to just hold onto it and it would come back”. A realist would say that, including 16 years of inflation, you are nowhere near having the buying power you had in 2000 when you made this ill-advised investment.

Common sense would tell you that when stocks are selling for over ten times their normal valuations, you should own less of them than normal. The expected future return on investing in those stocks was at an all-time low due to their being so overpriced. To manage your future risk and returns, any rational person should have been thinking that they needed to actively manage their allocation to this passive index. This is common sense. Failing to use common sense in investing can be very costly.

One piece of good news is that we now have thousands of passive indices to invest in and some have been designed to control your risk better than the older indices. These are often referred to as “smart beta” products, a term that annoys me as much as fingernails running across a blackboard. That said, they tend to reduce your exposure to investments that have gone up the most (think overpriced) and therefore are worth considering as you allocate your money. They do not replace common sense! It is the investor’s job to manage risk and return by deciding how to allocate money in a portfolio. Diversification is definitely step one. You want to own assets which have low correlation to one and another, so you don’t end up with all your eggs in one basket. Second, it is an investor’s job to buy the eggs that are on sale and sell a few of the eggs that are overpriced.

Unfortunately, this process is neither simple nor always immediately pleasant. An investor who decided that technology stocks were way overpriced in early 1999 and sold some of his tech stocks would likely be kicking himself by the end of the year. Almost all of the returns that year came from tech stocks. The rest of the market languished all year and posted disappointing returns. In hindsight, that investor would have saved themselves a great deal of capital in the long run by sticking to the simple discipline of using their common sense. Market returns do not reflect common sense in the short term, but the long term payoff can be tremendous.

Our common sense answer is that a good portfolio…..is actively managed and makes use of as many low cost, passive investments as possible. The old adage that most return come from asset allocation decisions seems to be right on. However, the world is not static and your portfolio requires attention as the world turns.

The Hunt for More Time — Do You Really Want it All?

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The idea of having more time appeals to most, if not all, individuals. In a life dominated by taking kids to soccer games, attending PTA meetings and satisfying the demands of your boss, free time can seem obsolete.

Retirement typically means freedom and more available time for most people. But the question you must ask yourself is…what will you do with all that time?

Most individuals need something that is bigger than themselves in order to feel valued and energized.

Jack Guttentag, a retired Wharton Professor once stated “The least successful [people in retirement] are those who hated what they did to earn a living, and looked forward to a retirement where they could begin to do what they enjoyed. The most successful are those who loved what they did during their most productive years, and continued their involvement with the same or closely related activities, possibly at a reduced scale, as they became older.”

Selecting Your Special Interest

Those who find a second career often identify a cause worthy of occupying their time.

These people also typically use their experience and knowledge in a different way and often feel challenged by what they may be working to accomplish.

According to a study by Merrill Lynch, people are happier, healthier, and possess a higher self-esteem and stronger sense of purpose when they volunteer in retirement. However, this sense of purpose doesn’t have to come from a second career or through volunteering. It can also be found in the form of a hobby or an activity that you throw yourself into and simply just enjoy.

Still wondering what to do? Perhaps it is time to think about looking into a phased retirement where you can work less by going part-time, all while withdrawing retirement benefits.

Realizing Your Retirement Goals

One of the hardest aspects of retirement is that many people build up their personal idea about what it will look like. Once they have reached retirement, however; they come to realize it is very different from their vision and are typically left with a feeling of overall discontentment.

The grandiose idea of retirement many of us have envisioned is long gone. In its place is the philosophy of Restylement — doing something you love that has both purpose and intention.

Shaping Success One Contribution at a Time

Peter Cappelli, Professor of Management at Wharton stated “A lot of people get both their identity and social interactions from work, so the idea of stopping [a career] means they’re going to lose both.”

Many individuals are concerned about their financial well-being in retirement. But true happiness is more likely to be found in the people who take time to maintain their social engagements and those who have created and sustained an identity for themselves.

While having an unlimited amount of free time sounds enticing, it’s important to remember the most successful people in retirement are those who enjoy the time they have and use their talents and passions to make a contribution.

FLOW: Volume 7 — One Month In; A Smaller Barrel

Flow Graphic - 1185 x 450

In our most recent series written by Jamie Cornehlsen, Denver CFA and founder of Capstone, FLOW examines how we seek out investments and make selections based on current market trends and future forecasts. Part seven of our series unveils the significance of obtaining a sustainable cash flow in high-yield stocks.

It has been one month since I opened my FLOW account; investing $150,000 in high yielding stocks.

When I selected my 20 investments, I did not choose based on how each had performed in the previous month or year. The investment value was presented in each company’s ability to produce cash flow.

I had to remind myself that this was the goal after the value of the portfolio declined to $140,137 within the first week; a cool $10,000 loss, or about 7% in five days of trading.

But this investment was developed to increase cash flow through acquiring businesses that could produce. Rather than focus on price, the value of the underlying business is what we will instead choose to concentrate on.

Besides the downturn in the account, we also received our first dividend check. With the TD Ameritrade account I created, I requested that dividends be paid out each month. On February 2, $432.67 was deposited into my savings account. This represents an annual return of 3%. I expected this percent to increase once our investments reached the ex-dividend date, which is the date stock must be owned by in order to have a right to the dividend.

After a full month of investing, I predicted the annualized yield to reach 11%.

Sustaining a Steady Cash Flow

Fortunately, the portfolio is beginning to produce satisfactory results. By the end of January, the account value had reached $157,489. Although I expect the principal value to fluctuate, the cash flow should preserve the investment.

Here’s my FLOW investment summary:

  • 20 investment positions
  • 10 investment categories
  • Categories: convertible/preferred, covered calls, emerging markets, foreign governments, go anywhere (manager discretion), high-yield (junk bonds), REIT, mortgage debt, infrastructure, individual stocks (of the stock category, there are 6 individual stocks)

Since the last time of purchase made in the end of January, we have seen a spike in prices. Consequently, conditions for investing are not as favorable. However, for a cash flow yield, there are still opportunities with these 20 investments.

So, where does this leave us? In a slightly less favorable place, but a place that is still providing consistent cash flows.

The next step is to begin the weeding process. This is probably the most important practice of all, as it is where we evaluate the holdings to see if they are continuing to provide a consistent cash flow. If an investment shows a declining ability to produce a flow, we will then sell and replace with investments that we feel can generate the desired results.

In summary, I’m planning to keep my account open for the long haul, and expect to continue reaping the gains of the cash flow while I ride out the volatility of the stock market. I will be reporting back with updates as changes are made to the portfolio.

Past performance is not indicative of future results. This article is intended for informational purposes only and is not intended as investment advice. Individual investor experiences and results will vary.

FLOW: Volume 6 – Tracking the Portfolio’s Progression

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In our most recent series written by Jamie Cornehlsen, Denver CFA and founder of Capstone, FLOW examines how we seek out investments and make selections based on current market trends and future forecasts. Part six completes our series by taking a closer look at the specific investment opportunities that were chosen to enhance the performance of the FLOW portfolio.

When I chose the 20 investments for this portfolio, I did not choose based on how they had performed over the last month or year. Although the yield each investment presented was likely due to poor performance recently, the overall investment value was presented in each company’s ability to produce cash flow.

Despite reminding myself of this logic, the value of the portfolio declined to $140,137 within the first week of the initial investment being made — a cool $10,000 loss, or about 7% in five days of trading.

But this investment was selected for the cash flow opportunities and the faith that the chosen businesses could produce such returns. So rather than focusing solely on price, the value of the underlying business is what we will continue to concentrate on.

Identifying Success through Dividend Production

As a result, this means removing the S&P 500 as a benchmark for success. The success is created off of dividend income generated from a portfolio. Outperforming the S&P 500 doesn’t generate revenue; it’s the production of dividend income that leads to an increase in profits.

As the portfolio continues, buy and sell decisions will not be dictated by the performance of the S&P 500, or the 20 individual investments. In the future, we will either look into upgrading to higher quality investments with greater income-generating capabilities, or sell the investment if the company’s ability to generate cash flow no longer supports its ability to pay the dividend or if the price is much greater than the value.

As we progress, I will provide updates on the cash flow and will keep readers informed of the decisions I make, whether it’s upgrading to investments with higher cash flow or seeking other income-generating opportunities.

FLOW: Volume 5 – Understanding Price Movement

Flow Graphic - 1185 x 450

In our most recent series written by Jamie Cornehlsen, Denver CFA and founder of Capstone, FLOW examines how we seek out investments and make selections based on current market trends and future forecasts. Part five of our series dives deeper into portfolio development and helps readers understand what creates value in today’s changing market.

The downturn the stock market experienced in the final weeks of 2015 and the first few weeks of 2016 set up a prime time to invest.

I went into the new year thinking that I would take on five investments at a time. If the market fell, I would buy the next lot.

As chance would have it, the first lot was purchased on January 12th. The following lots were purchased on January 15th, January 19th and January 20th.

The portfolio was invested more quickly than expected, but the declining prices in the market provided a favorable opportunity, with a jump in current yield occurring right off the bat.

Removing the Panic from Portfolio Development

The declining prices have led many investors to fret over their portfolios, with the anxiety and fear being that they will lose all their money. But if the investment was made with the belief that the company will not only continue to generate cash flow, but overall growth in the future, then the anxiety is more emotional and less analytical.

I have observed that poor investment decisions are often dictated by price movement. However, price movement is very different than a company’s ability to continue generating earnings and to grow those earnings over time. There are times when a decline in price reflects verifiable concerns, but price movements alone can be very misleading. A rising stock price may put an investor at ease, creating a false sense of security.

Investors make mistakes when they let emotion creep in and impact behavior and investment decisions. When plowed over by the hype from greed or the hysteria from fear, investors seldom make rational decisions. This type of behavior only creates optimal opportunities for those not falling prey to emotions.

Value is what you get; Price is what you pay

I seldom hear of investors providing the price they are willing to pay in order to generate a stream of cash flow. In our FLOW portfolio, we were willing to pay $150,000 for a stream of cash flow of $17,580 annually, or 11.72% of the portfolio.

I don’t know if this is what will eventually come of it or if the portfolio will be significantly lower, but I wanted to make sure the price of $150,000 for 20 different investments could create a value worth at least $15,000 a year (in this case $17,580).

Value is different than price because value represents cash flow to us. Since we are value-conscious investors, we are intently keen on paying attention to potential cash flows that are expected to be received. Unfortunately, few investors spend the time necessary to focus on this critical element. Instead, many financial brokers’ attention is placed on stock price and its up or down pattern of movement.

If you pay too much, you receive very little value. No matter the amount of cash flow a company generates, the overall impact felt is the price that was paid to buy that investment. When purchasing an investment, you can often determine the value by how much cash flow is being received now, as well as in the future.

As I mentioned before in FLOW: Volume 1, Warren Buffett’s investment philosophy is all about value in purchasing a stream of cash flow for as little as possible. His quote, “Price is what you pay. Value is what you get” clearly summarizes this.

With the $150,000 invested in cash flow generation, my thinking now turns to the possibility of buying the whole company as the investment process begins.

FLOW: Volume 4 – Building a Strong, Sustainable Portfolio

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In our most recent series written by Jamie Cornehlsen, Denver CFA and founder of Capstone, FLOW examines how we seek out investments and make selections based on current market trends and future forecasts. Part four of our series uncovers the various reasons why investors select particular investments when creating a portfolio, as well as the importance of each component.

In building a portfolio, I always ask: what is the purpose of this particular portfolio? It seems like a simple concept to be purposeful with what to invest, but often times this imperative thought escapes the process.

This question may seem like common knowledge to some, but it is of vital importance for an investor to ask.

What Are You Investing For?

Investing comes with many trade-offs. Generally speaking, higher yields often imply lower capital appreciation, and vice versa. 10% yields are eight percentage points above the S&P 500. Companies that are on a fast growth trajectory tend to retain the cash they have for further growth.

Investors do not have the same goals, needs or investment objectives. Some investors want outright appreciation in order to beat the stock market. Others are concerned with protecting the downside. And then there are the investors that want the highest income possible. Consequently, I believe investors should ask what purpose is this investment for?

For the FLOW portfolio, the investment objective is maximum cash flow with the current yield. For high-yield, investors should expect a lower rate of capital appreciation in order to achieve their goal. If you are looking for maximum capital appreciation or total return, you will not find it in a high-yielding portfolio such as this one.

Portfolio Characteristics

  • 20 Investment Positions
  • 10 Investment Categories
  • Categories: Convertible/Preferred, Covered Calls, Emerging Markets, Foreign Governments, Go Anywhere (manager discretion), High-Yield (junk bonds), REIT, Mortgage Debt, Infrastructure, and Individual stocks.

The main objective of the FLOW portfolio relies on the investment’s ability to create cash flow, which will either produce a capital appreciation over time, or will distribute a cash flow directly to the investor.

Consequently, the volatility in the value of this portfolio should not matter. It is only important that the investments continue to sustain the 10% or more cash flow distribution.

Future total returns will also be functionally related to the level of valuation that a company can be purchased at. Lower valuations can lead to higher future returns generated by price-to-earnings ratio (P/E) expansion as a result of a reversion to the mean. Consequently, if valuations are low enough, which could also be the source of an above-average current yield, this can result in high or above-average future returns that can be accomplished even through investing in lower growth entities.

Is Climbing the “Wall of Worry” Still an Option?

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By Ted Schwartz, CFP®

From March of 2009 until 2015, the stock market climbed a “wall of worry”, rising dramatically throughout the six-year period. In the wake of the strongest financial crisis since the Great Depression, we experienced great unknowns as we embarked on unprecedented government policies to stimulate the economy. This process was a slow recovery, as banks were reluctant to grant loans, and we were forced to face many other issues that caused a great level of economic uncertainty. Throughout it all, the market shrugged off the concerns, slowly ascending with little volatility as it marched towards ever loftier valuations of assets.

Since the middle of 2015, we have been in a downward spiral of decreasing markets and increasing volatility. Falling energy prices have gone from a positive for consumers to a negative for the economy. Slowing growth in China, ending government stimulation, and a general sense of unease have all steered the market downwards. It appears that we no longer have the ability to climb the wall of worry that remains in front of us.

Investing for the Long Haul

We are not sure what will turn markets and cause them to rebound from the doldrums. We are certain; however, that the fundamentals of investing have not changed and will not change. Stripped of emotions, you are investing now in order to receive a future income stream from your money. Reassuringly, the income stream you can expect from your investments is certainly higher now than it was at the beginning of 2015. With about half of all stocks having fallen 20% or more from their highs, both the dividends and valuations look pretty attractive for the long haul. That is the key for us. While stock prices are driven by emotions in the short-term, they are guided by earnings, dividends, and growth in the long run.

At Capstone, we think now is a great time to lock in cash flow to your portfolio. If you can add investments with attractive interest and dividends (especially dividends that are likely to grow over time), you can use that cash flow to help survive the current market turbulence and set yourself up well for the future. While markets are volatile and emotional over the course of shorter time periods, dividends and interest are surprisingly stable throughout market cycles.

If you can concentrate more on the cash flow (and pay less attention to the short-term market mayhem), we believe you will be richly rewarded in the long haul. As the famous investor Sir John Templeton pointed out, you want to buy investments at the “point of maximum pessimism”, which is where we seem to be now. It’s possible for things to get worse (there is no certainty of market emotions being reigned in before the damage escalates) but….we are somewhere in the area of making good long-term investments. It is a good time for contrarian investors to climb the wall of worry.

FLOW: Volume 3 – Taking the Financial Plunge into High Dividend Funds

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In our most recent series written by Jamie Cornehlsen, Denver CFA and founder of Capstone, FLOW examines how we seek out investments and make selections based on current market trends and future forecasts. Part three of our series evaluates how increasing risk and investing in high dividend funds can generate an increase in cash flow over time.

Below is my experience in finding an investment whereby I acted as the owner of a business and followed Warren Buffett’s true sense of investing.

As the stock market continued its downward spiral, I went off in pursuit of finding a reasonable investment. I thought about investing in a liquor store. I thought about a venture in the real estate industry.

Both opportunities likely would have delivered optimal returns, but I opted for something different. Instead, I discovered that the recent market decline had opened up the chance to dive in and explore some interesting investments that I had not seen in over four years.

With $150,000 set aside, I was eager…not to invest based on speculation, but rather, for the underlying ability of the business to generate cash flow.

Adopting a Higher Level of Risk for a Greater Return

In my search for investments that would grant financial independence, I decided to skip the liquor store investment and pass on the real estate venture. I knew I was more interested in learning opportunities with higher potential reward in exchange for more effort and risk. As a result, I settled on companies with high yielding dividends, master limited partnerships (MLPs), real estate investment trust (REITS), and closed-end funds (CEF), all of which I knew would provide me with a 10% return.

Ever since I heard Buffett and Munger discuss owning an investment as a business, I have thought about applying this philosophy to my financial choices. In Chapter 8 of The Intelligent Investor, author Benjamin Graham discusses the idea of buying a company with a partner. There may be some days when the partner comes running into your office saying the business is worth half as much as the day before and he wants to sell to you. The very next day, this same partner comes running in saying the business is now worth twice as much and he wants to buy out your share.

In reality, the business does not swing in value by that much. As I indicated in Flow #2, returns are based on three key factors: the cash flow that is generated and paid to you, the amount by which you can increase this payment each year, and finally, the price you are able to sell it for.

Selecting Investments That Work for You

In his book, Graham advocates that people should not partner with this type of person as they are proven to be fickle. Instead, he believes individuals should invest on their own and focus primarily on what the business can provide in cash and how it can increase that amount each year.

For me, detecting an investment that provided the beneficial outcomes I sought came in the form of high dividend yielding companies, master limited partnerships (MLPs), real estate investment trust (REITS), and closed-end funds (CEF). From here, I created a list of 170 investments to further evaluate. My goal was to narrow this down to 20 in order to limit the individual risk of each going out of business. Narrowing down my choices also allowed me to watch my basket closely and follow the progress of each investment.

Now that I knew what my investment would be, it was time to develop the portfolio…

FLOW: Volume 2 – Exploring the Real Estate Investment World

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In our most recent series written by Jamie Cornehlsen, Denver CFA and founder of Capstone, FLOW examines how we seek out investments and make selections based on current market trends and future forecasts. Part two of our series takes a look at the positives and negatives of real estate investing.

After deciding against purchasing the liquor store, my next move was onto real estate. I have several friends that thrive in the area of real estate investing and have learned that hiring a management team can provide relief from having to do the maintenance and the management yourself, so I began the search.

I focused primarily on residential properties as well as multi-family units.

I had determined that I wanted to get at least a 10% return with this investment. Looking at the real estate industry, I figured I could get a minimum of a 7% return and in some cases, as great as 17%.

Recognizing the Three Components of Return

All investments have three components of return: earnings or cash generated each year, growth of earnings, and (hopefully) increase in valuation. Earnings are the cash flow that is generated and paid to you. The growth of earnings is the increase in those expected earnings over a period of time. Last, the increase in valuation is the upturn in price per unit from the time you buy to the time you sell.

In terms of stocks, earnings are dividends that are paid to you. If a particular stock is paying a 10% dividend yield, you as the investor can expect 10% from dividends. The increase in earnings is the rise of dividends each year paid out to you. If the stock was purchased for $10 and the dividend was originally $1 per share, but increased to $1.30 over the course of five years, then the increase in earnings was 30% total, or 6% per year.

Last, you might have purchased the stock for 10 times a dollar of earnings and sold for 15 times a dollar of earnings. This represents a 50% increase in the valuation over five years, or 10% per year. As a result, you would have a total annual return of 26% per year: 10% for dividends, 6% from growth in earnings, and 10% for appreciation.

Wouldn’t a return like that be nice to get now a days? Unfortunately, the stock market has only averaged about 4.5% a year for the past 15 years.

Looking into the real estate market, I found homes that I could rent and expect to receive a 7% return from the rental income. I estimated I could increase the rent by 2% per year, and expect to see a 1% increase in the valuation.

I looked at buying a home for $150,000 and charging an annual rent of $10,750 or 7%. I could expect the rental income to increase from $10,750 in the first year to $13,450 at the end of a five-year period; roughly a 1% increase per year. At the end of five years, I could anticipate selling the property for $165,000, which in total would earn me a return of 10%. This would be good!

The Reality of Real Estate Investing

However, weighing into this grand plan would be the cost of annual maintenance, the expense of personally managing the home or hiring a property manager, and the toll of having a potentially unruly renter.

In the end, I decided that although I might be able to earn a great return on a real estate investment, I would still have to put up with the risk and hassle of managing the rental to some extent, in which the costs may outweigh the benefits of such a return.

My next FLOW post specifies how and what I decided to invest in.