Investment Performance Evaluation Re-Evaluated: Part Two

By: Steve_Selengut

The Working Capital Model (WCM) looks at investment performance differently, less emotionally, and without a whole lot of concern for short-term market value movements. Market value performance evaluation techniques are only used to analyze peak-to-peak market cycle movements over significant time periods.

Security market values are used for buy and sell decision-making. Working capital figures are used for asset allocation and diversification calculations. Portfolio working capital growth numbers are used to evaluate goal directed management decisions over shorter periods of time.

WCM tracking techniques help investors focus on long term growth producers like capital gains, dividends, and interest--- the things that can keep the working capital line (see Part One) moving ever upward. The base income and cumulative realized capital gains lines are the most important WCM growth engines.

Please refer to the chart in Chapter 7 of The Brainwashing of the American Investor: The Book that Wall Street does not want YOU to Read, or search Working Capital Model.

The Base Income Line tracks the total dividends and interest received each year. It will always move upward if you are managing your equity vs. fixed income asset allocation properly. Without adequate base income: 1) working capital will not grow normally during corrections and 2) there won't be enough cash flow to take advantage of new investment opportunities.

The earlier you start tracking your dependable base income, the sooner you will discover that your retirement comfort level has little to do with portfolio market value.

The Net Realized Capital Gains line reflects historical trading results, and is most important during the early years of portfolio building. It will directly reflect the security qualification criteria you use, and the profit-taking rules you employ. If you use investment grade value stocks and WCM buy/sell disciplines, you will rarely have a downturn in this important number.

Any profit is always better than any loss and, unless your selection criteria is really too conservative, there will always be something out there worth buying with the proceeds. Obviously, capital gains growth should accelerate in rising markets, and cost based asset allocation assures that such gains add directly to future base income growth.

Note that an unrealized gain or loss is as meaningless as the quarter-to-quarter movement of a market index. The WCM is a decision model, and good decisions should produce net realized income.

One other important detail: no matter how conservative your selection criteria, a security or two is bound to become a loser. Don't judge this by Wall Street popularity indicators, tealeaves, or analyst opinions. Let the fundamentals (profits, S & P rating, dividend action, etc.) send up the red flags. Market value just can't be trusted for a bite-the-bullet decision--- but it can help.

The Total Portfolio Market Value line will follow an erratic path, constantly staying below Working Capital. If you observe the chart after a market cycle or two, you will see that the Working Capital, Net Realized Capital Gains, and Base Income lines move steadily upward regardless of what the market value is doing!

You will also notice that the lows in market value begin to occur above earlier highs--- but this may take several cycles to develop. It's comforting to know that, although market value movements are not controllable, the WCM growth engines are. We can actively manage a portfolio to produce increasing base income levels, and we can conservatively select and monitor our equities to assure that all reasonable profits are brought to the bottom line.

The market value line should never be above the working capital line, except occasionally in 100% income portfolios. When it gets close, a greater movement upward in Net Realized Capital Gains should be expected. If it hasn't, you've become greedy--- let no profit go unrealized must become your success mantra!

Studies show rather clearly that the vast majority of unrealized gains are eventually brought to the Schedule D as realized losses--- and this includes potential profits on the boring securities housed in the income side of your portfolio.

One other use for market value: When that line is at or near an all time high, look around for a security that has fallen to a below investment grade S & P rating, and bite that bullet. Loss taking should be done slowly, and downgraded securities should be the first to go.

What's different about this approach, and why isn't it more high tech? There is no mention of an index, an average, or comparisons with anything except valid expectations based on securities and market cycles. It will get you where you want to be without the hype that encourages unproductive transactions, foolish speculations, and incurable dissatisfaction.

In the WCM, market value is used as an expectation clarifier and an action indicator for the portfolio manager. Most investors focus on market value and market indices out of habit. Market values, realistically, are neither bad nor good. You need to step outside the market value vs. something box, and focus on the opportunities for growth that security price changes provide.

All performance assessment lines need to be treated as learning tools instead of knuckle slappers, and they need to be looked at as inter-dependent pieces of the road map to goal achievement. But there is one more line to add to the chart.

The Net Invested Capital Line is the pulse of your investment plan and it should beat most rapidly in the early years of portfolio building. Steady deposits assure that opportunities are not missed and that base income attains the levels needed many years in the future. Most investors curtail their deposits in bad markets--- a major error in judgment.

The retirement phase of the investment plan should be based on a 70% or lower withdrawal of base income. In tax-deferred plans, the 70% level includes Uncle Sam's portion. Gotcha! With that discipline in place, the base income line will continue to grow at a rate in excess of most recent inflation levels.

By Steve Selengut
800-245-0494
http://www.sancoservices.com
http://www.investmentmanagemen tbooks.com
Professional Portfolio Management since 1979
Author of: "The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read", and "A Millionaire's Secret Investment Strategy"

Disclaimer : Anything presented here is simply the opinion of Steve Selengut and should not be construed as anything else. One of the fascinating things about investing is that there are so many differing approaches, theories, and strategies. We encourage you to do your homework.

© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.