Monday, April 24th, 2017

Values-driven investing

American Hero Investing

Goodness is the only investment that never fails.
-Henry David Thoreau

Definition

American Hero Investing is a strategy of targeting, for investment, those companies that best reflect Timeless American Values especially Integrity, Caring and Courage.

Discussion

In order to fully explain what American Hero Investing is, this article will first provide the corresponding relative definitions and their relationship with each other. Why American? What is an American Hero? What is investing? Furthermore, an attempt will be made to demonstrate how these concepts are actually implemented. Finally, it will show that investing can be beneficial to investors and improve the general welfare of society at the same time.

Definition of Terms

1. American

American is used because we are Americans. We operate in America. We plan to always be Americans. In other words we are proud to be Americans and trust the values that brought America into existence, propelled it into a position of world leadership and give it the foundation to continue that leadership. We do have a domestic focus; however there are some international companies and many of the domestic companies have significant international business. America has the resources to lead the world in the pursuit of life, liberty, and happiness.

2. Hero

For the purpose of this paper an American Hero is a publicly traded company that has earned that designation from American Values Investment, Inc. To earn that designation a company must be diligent by providing products or services that are life enhancing. It must also show humility by having associates that are proud of their employer. The company will also demonstrate integrity making it a desirable business partner. Finally, the company must have a caring nature making it a good neighbor and have the courage to be transparent. American Values Investments uses a proprietary research process consisting of a 500 point scoring system with over 300 different questions. A company must score well in all three categories to earn enough points for the American Hero designation. While a more in depth explanation of the research process is a worthwhile endeavor, it is not the purpose here.

3. Investing

A more in depth explanation to our investment philosophy is the purpose here. It will begin with a definition of investing and for clarification we will look at what is not investing. Investing is committing resources directly to an ongoing enterprise with the expectation of sharing proportionally future earnings and increases in enterprise value. Some examples are buying stock in publicly traded stocks including investment companies (mutual funds), being a proprietor, and owning rental property. For our purposes it will be primarily buying individual publicly traded stocks. Investing by definition is long term as opposed to short term speculation. Long term is more than three years. Investing is a WIN-WIN proposition. True or professional investing will add wealth not extract it. If an investor bought a stock twenty years ago and now needs to sell it or a portion to reallocate for their current situation, there is likely another investor that could buy that same stock with the intention of holding for a period of time until reallocation. The process can go on indefinitely. Over time investing has provided the highest probability for the greatest return. Over time is the key point. Investing is strategic.

A couple of other definitions can be helpful in further understanding what investing is. Saving is entering into a bilateral contract that numerates the principle and the price (interest) to be paid to the saver for the right to use that principle for a stated period of time. The holder of the principle will then invest the principle with the intent of earning more than the cost of using that principle. Saving vehicles include certificates of deposit, individual corporate bonds, and government securities. As you can see from this definition there is a close relationship with investing. The difference is the contractual relationship which provides a higher probability of return of principle in the event of difficult economic situations. In exchange for the higher probability of return of principle the saver gives up the higher probability of greater returns since the holder must earn more than its cost. Saving is for short and intermediate time frames.

Speculation is buying an item or entering into a contract with the belief or hope that it can be sold in the near future at a sizeable profit. Buying commodities such as gold with the belief it will go up in price is speculating. Commodities do not qualify as investing because their value is determined solely by supply and demand. There is no ongoing concern to generate earnings or increase its value. Commodities can play a strategic role by investing in materials companies or mining companies among others. Timing the market is speculating that the market or market segment is going to go up or down. A tactical approach is a form of market timing. Shorting a stock is speculating that the stock is headed for bad times. Hedging is speculating that short term anomalies will produce enough over performance to more than cover the costs of exploiting them (i. e. currency changes). Buying or selling bonds based on perceived interest rate changes is speculation. Leverage, the use of debt, is speculating that enough return can be realized soon enough to service the debt and provide a higher gain. Speculation is the most risky use of ones money. It provides the highest probability of the greatest short term gain and the highest probability for the greatest short term loss. Speculation does provide liquidity to the market with the trade off of higher volatility. Speculation is not for the faint of heart and should be left to the true specialist since it is a zero sum game.

There are risks to investing. The main risk is losing money. Risk can be managed by using a proven strategy of balancing investments and savings while minimizing speculation. In other words determining the proper asset allocation is the best way to manage risk. Asset allocation is best determined through a comprehensive risk profile that considers the investors comfort, capacity, and calendar (time frame) for risk. Many may need a good financial plan to answer these questions and monitor them because they will change over time. The amount to be invested is then based on that particular asset allocation for the investor’s current situation. The amount invested should not be based on what the market just did or might do in the short term.

Portfolio Characteristics

To this point American Hero Investing has been defined at a high level. Hopefully, the three components in the name have been adequately explained. Further explanation should be beneficial in understanding the total concept. 

1. American Heroes Only

First and foremost American Hero Investing only invests in American Hero Companies. We follow prudent, time tested, and well structured investment principles. The process ranks all the American Hero Companies using a proprietary scoring system of selected financial fundamentals. We operate as a committee and use multiple third party disinterested resources for analysis. We want invesotrs to be proud of the stocks we select for investment.

2. Sustainable total return

One of the key principles in developing a portfolio is taking a long term stance. Long term was previously discussed as being a distinguishing characteristic of investing. Long term means investing in a stock until a better alternative at a better value is available or when it is time to adjust the asset allocation. Long term does not mean simply buy and hold which will be discussed more in relation to rebalancing later. The market is more efficient in pricing securities over the long term, because it lessens the impact of speculation. 

3. Diversification

Another key principle is that of market diversification. Diversification is the way smooth returns over the long term and captures more of the upside trend. The American Hero Model will always contain some exposure to the at least  60% of the market sectors defined by Standard and Poors’ GSIC®.  The maximum allocated to any one sector will be 25% or the corresponding S&P weight which ever is larger. In the larger sectors the model will generally have representation from multiple industries. Sector weighting is influenced by the quantity and quality of stocks available, current market weights, and to a lesser degree by market conditions.

4. Concentration

American Hero Investing uses a model concentrated on consistent winners. Following the success of investment legends like Benjamin Graham, Philip Fisher, and Warren Buffet, we have found using a smaller number of high quality stocks has provided market competitive returns. A limited number of stocks can be better understood and more closely monitored. Each stock will have at least a 3% concentration, thus the highest number of stocks used will be thirty three. The policy of not buying into any one position at more than 5% means there will always be at least twenty stocks in the model. Concentration is a strategy for building wealth and diversification is a strategy for protecting wealth. Therefore, a good balance of the two makes for a sound overall investment strategy. 

5. Similar Weight

The American Hero model is a similar weighted portfolio. By being weighted between 3-5% each stock has the opportunity to contribute to performance in a meaningful way. It also allows for a blending of growth and value stocks. It is another protection from over concentration of a few stocks and allows for diversification over different market capitalizations.  Historically, the model has often been equal weighted. 

6. Multi-Cap Blend

The universe of American Hero Companies (100+/-) covers a balanced and broad spectrum of the overall market. As a result the portfolio is a multi-cap blend. The intention was not to build a core portfolio but it was determined by the make-up of the companies in the universe. 

Active Management

1. Values Research

The research that determines which companies earn the designation of American Hero is a critical part of American Hero Investng. Understanding the research process gives a much better perspective to the investing process. The purpose of this article is to emphasize the depth of the process and that it is on going. The process uses over three hundred different questions in a five hundred point scoring system. Each company is reviewed annually. Even companies that just miss are reviewed periodically. More information is available at the American Values Investments, Inc. web site americanvalues.com.

2. Rebalancing

On going management is a combination of regular ranking of the individual stocks as discussed below and regular rebalancing. The periodic rankings are the way to identifying better alternatives at a reasonable price. The ranking process is typically done monthly. Rebalancing is a disciplined approach to selling high and buying low. It will also shift allocation from over performing sectors to under performing sectors capturing any returns from mean reversion. Mean reversion is the theory that over time returns will be average, so periods of higher returns will be followed by lower returns keeping the average fairly consistent. Rebalancing is done annually in attempt to gain from the momentum of periods of higher returns and mean reversion. 

3. Stock Selection / monitoring

Individual stock selection is the primary function of the active management. The selection process begins by sorting the American Hero Companies by sector. They are then ranked within the sectors by investment merit. The rankings are composed of twelve different fundamental metrics. The rankings are redone regularly, usually monthly. Each sector will have the number of individual stocks relative to its weighting. A watch list for potential buys and sells is maintained and updated each time the stocks are ranked.  Third party independent research is used to aid in the determination of fair value, and review of previous rankings.

As stated before the market tends to be more efficient over the long term, therefore the rankings include some metrics tracking long term total return. Total return over ten, five and three years are included. Management effectiveness is an indicator of diligence. Factors reviewed relative to management effectiveness include return on equity, gross margin, income growth, and dividend yield. How well a company manages debt, its economic or competitive advantage, and its governance tell much about its commitment to its stakeholders. The rankings are done using a proprietary process and are maintained on a spreadsheet for on going review.

The American Heroes selected for inclusion in the portfolio are those that best enhance human well being in economically efficient ways.

Conclusion

American Hero Investing uses the discipline of time tested investment basics. The process manages risk with diversification and by avoiding speculation. American Hero Investing is a concerted effort to be driven by faith and grace rather than fear and greed. Perhaps the greatest benefit is the alignment of investments with many of the same values America was founded creating more wealth for investors, companies, and society at large.

Investment Process

The American Hero Investing Process is the steps we take to create American Hero Portfolios.  We have an Investment Committee that oversees the process.  We incorporate independent research from firms that do not offer investment products.  These steps are as follows:

Step One: we begin by only considering companies in the American Hero Universe around 100 companies.

Step Two: we sort each company by sector to facilitate risk management through diversification.

Step Three: we regularly perform fundamental analysis based on a proprietary set of over 15 fundamental metrics including PE ratios, performance, debt/equity and more.

Step Four: we closely monitor each stock by repeating the fundamental analysis and tracking portfolio performance on a regular basis.

Step Five: we adjust the holdings at least annually through rebalancing and as needed based on values and fundamental analysis.

Fundamental Analysis

For our managed portfolio, the American Hero Equity, we use fundamental analysis to rank each American Hero Company stock for investment merit. Our goal is to determine which of our American Hero Company stocks have the best opportunity for sustainable total return with the least possible risk.

Every American Hero Company stock is scored in each of 15 fundamental metrics such as, P/E ratio, debt/equity, etc. Points are then tallied for each stock and then ranked in order of score within their sector. We use the 11 sectors as determined by the S&P 500. Stocks scoring near the top of their sector are giving more consideration for inclusion in the American Hero Equity portfolio.

Below are the 15 metrics used in five different categories:

Strategic advantage
1. Economic moat
2. Quality points (profitability grade, growth grade, financial health, credit rating…)
3. Price earnings ratio

Long term total return
4. 3 year total return
5. 5 year total return
6. 10 year total return

Management effectiveness
7. Return on stockholders’ equity
8. Net income growth
9. Cash flow

Corporate governance
10. Dividend yield
11. Dividend growth
12. Debt to equity

Corporate culture
13. Volatility (standard deviation)
14. American Hero score rank
15. American Hero Stars

Two American Hero Portfolios

Two American Hero Portfolios have been developed using the discipline of time-tested investment basics. The process manages risk with diversification and by avoiding speculation. American Hero Investing is a concerted effort to be driven by faith and grace rather than fear and greed. Performance of each portfolio, although not audited, is computed and maintained by a third party. Updated figures are posted to our website quarterly. Included here are portfolio descriptions and comparisons.

1. American Hero Equity

This portfolio is a concentrated portfolio of 20 to 33 stocks from the American Hero Universe. These stocks are selected based on our proprietary fundamental analysis which uses over 15 different metrics. The stocks are similar or equal weighted allowing for all to participate in returns and prevents over concentration. At least 60% sectors of the S&P 500 are represented with no one sector over 25% or its respective S&P weight which ever is larger. Turnover is normally less than 50%. The stocks are rebalanced annually. The inception date of the American Hero Equity Portfolio is 4/30/2004.

2. American Hero Index

This portfolio is an equal weighted group of all* the American Hero Companies. It is rebalanced annually and new heroes are added quarterly. A company losing Hero status is immediately removed from the portfolio and new Heroes are added promptly. The inception date of the American Hero Index is 12/31/2009.

*The one exception is when the number of American Hero Companies gets beyond 120. If that occurs then only the top 120 scoring companies (the values score) are included. Our primary custodian, Folio, only allows a maximum of 120 positions per portfolio.

Portfolio Comparison

Below is a quick comparison table of some of the key components of each portfolio.

  ​American Hero Equity American Hero Index
Strategy Active: Sustainable total return Passive: Values Index
Style Multi-cap blend Multi-cap blend
Diversification Similar to S&P 500 Similar to S&P 500
Beta usually less than 1.0 close to S&P 500
Standard deviation usually less than S&P 500 close to S&P 500
Concentration each stock 3-5%  equal weight 
Turnover Low (3-4 stocks average per year)  
Buy Investment merit Achieve Hero status
Sell Make room for buy as needed Loss of Hero status ASAP
Rebalance Annual  Annual 

Portfolio statistics from Morningstar

Investment Performance

As of 0/31/2017 Year to Date 1 yr 3 yrs (annual) 5 yrs (annual) 10 yrs (annual)
American Hero Equity +3.50 +12.68 +8.23 +9.90 +7.32
American Hero Index +3.72 +17.19 +7.50 +10.83 see note 11 below
Wilshire 5000 Equal Weight +4.16 +24.17 +5.38 +12.24 +7.37
S&P 500 Total Return +6.07 +17.17 +10.37 +13.30 +7.51
Dow Jones Industrial +5.19 +19.91 +10.61 +12.15 +8.25

Disclosures

1. Our primary goal is not investment performance but to help investors build a brighter America. We limit ourselves to investing only in American Hero Company stocks which make up a very small segment of the market. There are many other stocks which have better prospective investment merit but are not considered for our portfolios.

2. Figures are shown as percentages (%).

3. An allowance of .6% per annum (60 basis points) for fees and/or expenses has been deducted from both models which reflects an estimate of fees charged by American Values Investments. Most financial advisors will charge additional fees. No fees were deducted from the benchmark return figures.

4. The primary benchmark is the Wilshire 5000 Index Equal Weight which contains over 6,500 stocks that trade in the U.S. including issues on the New York Stock Exchange (NYSE), NASDAQ Stock Market, and the American Stock Exchange (AMEX). It is often referred to as the 'Total Market Index' because it covers a wide variety of publicly traded companies. Performance assumes all dividends are reinvested; you cannot invest directly in the index. We use an "equal weighted" index as a benchmark because once each year we adjust all of our holdings so that each individual stock position represents an equal dollar amount (or close to an equal dollar amount) of the portfolio.

5. We believe the Wilshire 5000 Equal Weight index is a reasonable benchmark on which to evaluate the financial effectiveness of our individual equity selections. The S&P 500 Total Return Index is shown to give an idea of how an "equal weighted" strategy might compare to some of the more traditional "cap weighted" indexes.

6. The above figures were computed by a third party, Bridge Portfolio. They reflect the performance of our models which is not necessarily the composite performance of all accounts invested in these models.

7. One, three and five year figures are annual percentage returns. The "since inception" returns are simple, cumulative returns.

8. The figures are not audited and do not represent performance of individual accounts.

9. The American Hero Equity Model is a concentrated (20-30 stocks) selected exclusively from the American Hero Universe, equal weighted representing at least 7 of 10 sectors as defined by Standard & Poor's. The stocks can range from small to large and from value to growth as defined by Morningstar. Any sector represented is at least 50% of the S&P 500 weighting and no more than 200%. No stock represents more than 5% of the model at initial purchase. The model is rebalanced annually. The stocks are selected based on a proprietary investment merit analysis based on 10 -15 fundamental matrices.

10. The American Hero Index Model consists of the total American Hero Company Universe of 100-125 public companies. To be included in the American Hero Universe a company must score a minimum 400 out of 500 on a proprietary analysis of the company's corporate culture. The analysis focuses on the three key values of Integrity, Caring, and Courage.

11. As 0f yet, there is not a 10 year history for the American Hero Index Portfolio. But, the simple accumulative performance from the inception date of 12/31/2009 is 136.13%.  Corresponding bench mark returns were Wilshire 5000 Equal Weight 124.28%, S&P 500 Total Return 146.98% and the Dow Jones Industrials 141.24%.

12. Past performance is no assurance of future results. Investing in equity markets involves risk; you could lose a significant portion or all of your original investment. All recommendations are based on our experience and may or may not have been profitable in the past, now or in the future. These performance figures may not reflect the impact that material economic and market factors might have had on our decision making if we had actually managed clients' accounts.

Risk Management

All investments in all asset classes are subject to risks including the risk of losing value. Risk can be managed but cannot be eliminated. Overall risk is managed by spreading the risk over more than one asset class also known as asset allocation. Risk can be further managed within each asset class of which equity investments is one. American Values Investments manages equity risk by:

1. Investing in American Hero Companies only. We believe that companies that hold themselves to a high level of ethical standards are likely to perform well relative to the market, especially during challenging times.

2. Analyzing fundamentals to determine investment merit. We believe that companies that consistently exhibit good fundamentals tend to also perform well relative to the market and manage difficult situations well. Our in house analysis uses over twelve different metrics. Companies that maintain strong fundamentals are less likely to be replaced, thus the turnover is low which means fewer trading costs.

3. Reviewing third party analysis for checks and balances. We use reports from Standard and Poore’s, Morningstar, and Argus; none of which sell investment products. This process assists with minimizing emotional biases.

4. Diversifying across several sectors of the market. We intend to have at least 60% sectors represented in the managed portfolio. Those sectors represented will have a maximum of 25% or their respective allocation in the S&P 500 which ever is higher.

5. Watching macroeconomic indicators. We want our sector weightings to be determined by fundamentals rather than momentum.

6. Concentrating on twenty to thirty three individual stocks. Modern Portfolio Theory state that adequate diversification can be achieved with ten to twelve stocks. Having thirty stocks or less guards against over concentration and makes regular monitoring manageable. Limiting the number of positions usually translates into lower trading costs.

7. Monitoring stocks on a regular basis. The investment merit is reviewed on a monthly basis. Alerts for news and company announcements are set for all current holdings. Quarterly earnings presentations are observed for all current holdings.

8. 3-5% weighting. Each stock will have a maximum of five percent concentration thus limiting the negative impact on overall performance. 3-5% weighting also protects against emotional biases.

9. Rebalancing regularly. Rebalancing not only prevents over concentration it enforces a ‘buy low sell high’ discipline. Our goal is to rebalance annually with the rebalance date being at least three hundred sixty six days after the previous rebalance, thus keeping tax consequences lower.

Riskalyze

The underlying risk of our portfolios is estimated by a third party provider, Riskalyze. Scores are only estimates using their proprietary formulas. There is, also, no assurance the portfolios will perform according to the ranges shown in the full reports.

Here are the performance-based* scores as of February 2, 2017 and a link to the actual reports..

Click here for more information on Riskalyze

* There are two ways of calculating risk using Riskalyze, by individual holdings or prior performance. Since our holdings have changed over the years and will probably continue to do so, we have chosen to analyze the risk based on prior performance.

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