FREQUENTLY ASKED QUESTIONS
Below you will see a list of questions we have been asked
When you refer to selecting growth stocks using the Clean Surplus ROE (Return on Equity), what do you mean by a high ROE?
When I did my Doctoral research, I selected stocks that had higher ROEs than the S&P 500 stocks on average which was about 14.5% at the time. For actual portfolios, I select stocks that have a Clean Surplus ROE (from our computer program) of at least 20%.
What do you look for in the ROE when selecting stocks?
I look for at least a 20% ROE and an ROE for next year that is projected to be as high or higher than the 3 year average ROE.
What do you mean by a consistent ROE?
I like to see an ROE that has been relatively consistent over each year in the past. This means the earnings are growing at a consistent rate. When I see a stock I would like to look into, I click on the stock name (on the computer program) which brings up a full table of numbers to the right of the screen. I then look at the ROE column to make sure that the ROE stayed relative consistent over the years or is rising over the years. The important point is to look at years when we had recessions such as 2001, 2002 and 2003 as well as 2008 and 2009. I don’t want to see the ROE decline during those years. If there is a decline, that means we are looking at a cyclical stock which we don’t want to see in our portfolios.
Why don’t you like cyclical stocks?
Cyclical stocks do great during the good times. However, they usually go down further than the average stock during recessions. In 2008 and first quarter of 2009, the market dropped almost 40%. Many cyclical stocks declined more than 40%. That’s a tough thing to ride through and usually causes an investor to get out of the market and the point of maximum pain which seems to always be near the market bottom.
What do you mean “hedging” your growth portfolio?
Hedging means any form of portfolio protection (insurance) and/or lowering of portfolio volatility. We like to use a system of buying put options on either the S&P 500 index or the S&P 100 index. We purchase put options approximately 10% below the present value of the market. We also buy them in stages.
Example: If the market (S&P 500) is at 1,700, we take 90% of that value which in this case is 1530. If the portfolio is worth $1,700,000, we will need approximately 11 put options at a level of $153,000. (0.90 times $1,700 = $153,000). Each option at this level is worth $153,000. (100 times the index of 1,530). 11 put options times the 1,530 gives us insurance on $168,000,000 (11 times 1,530 times 100).
We also stagger these options out. If this is say January, then we will buy 3 put options expiring in February, 3 put options expiring in February, 3 put options expiring in March and the rest expiring in April. Then when the February options expire, we will purchase some May put options.
Why do we do this? On October 19, 1987, which is now called Black Monday, the market dropped a bit over 22%. The October options expired on that previous Friday. If you didn’t have your insurance in place for the “future” you were caught without insurance. As Buffett says, “You can find out who has been swimming without a bathing suit when the tide goes out.”
One more point. You wouldn’t drive your car without insurance so why would you NOT insure your hard earned money you have invested in the stock market? I know, good question.