This article expands on advantages & benefits of function-centric investing / capital allocation, that was touched upon in the introduction article. I’ve added some examples to help illustrate the points. [Approximate Reading Time = 15 minutes].
In Part 1, I will discuss how function-centric investing gives the investor flexibility to adapt to changing conditions, plan for market downturns, and handle & avoid risk. I will also discuss how it doesn’t prematurely eliminate potential investment candidates or ideas.
Flexibility To Deal with Change:
The style allows for changes to be made in the investments that are being used in order to achieve & fulfill a specific function or purpose. When there is a significant change in the economic environment, regulations/policies, or other issues impacting a certain type of asset or industry, you are able to adapt and change your investments without changing your plan. You are not held to any set allocation percentages or categories and therefore could then look for a different type of asset and/or in a different industry/sector/market. Your aim is to satisfy the particular function or purpose in the overall plan, rather than to satisfy categorization requirements.
• Income Trust Tax: On 10/31/2006 the Canadian government announced what became the “Specified investment flow-through (SIFT) trust income and distribution tax”, on distributions from public income trusts (conversion deadline 1/1/2011), in order to level the playing field with corporations. The change caused many non-REIT income trusts to convert into corporations, and in the process resulted in significant reductions or eliminations of their distribution payments. After the conversion, many mid-sized and smaller trusts experienced financial difficulties as well. Income Trust investors whose style and plan revolved solely around investing in such Canadian entities, saw share prices plummet and their passive incomes along with it. While REITs saw their share prices recover, many non-REITs did not experience the same recovery. Income Trust investors had a very rough time adjusting and was forced to rethink their entire investment style/strategy & plan. They had to figure out what type of asset to invest in, which market/industries, and how to replace their lost income. With function-centric investing, if the purpose or role is income, you don’t need to box yourself into any single asset type (income trusts) or market (Canadian) as long as the investment satisfies the purpose (passive income). The sources of passive income can be from corporate bonds, interest bearing notes, dividends, REITs, physical real estate, royalties, etc. from the US, Canada, or other countries.
No unnecessary buying, selling, or holding:
Without the predefined asset allocations, you are therefore not pressured to buy, sell, or hold assets in any situation in order to maintain exposure to asset allocations or categorizations. You are not forced into buying or holding assets/categories where the conditions may be deteriorating, the risks are increasing, or the specific asset is becoming overvalued. Similarly, you wouldn’t be forced to sell or reduce holdings, where the conditions may be improving the potential for better returns, just because it no longer fits into the specified allocation. With function-centric investing you would allocate capital to priority functions/roles. You wouldn’t add or hold something that doesn’t contribute towards your goals at the current stage. You also wouldn’t eliminate something that is helping you reach your goals.
• Change in market cap: A stock’s market cap may have grown from small to mid, and would no longer fit in a small-cap investor’s allocation. Instead, you wouldn’t automatically think to sell an asset just because its market cap changed. You would be able to benefit from the longer term growth of companies, many successful ones of which continue to experience explosive growth after they grow beyond the small cap range. Under Armour’s [UA] market cap is now over $5B, but it’s been growing more aggressively than ever.
• Increasing risk & deteriorating investment conditions: If the risk of a hard landing & credit crisis in China was continually increasing, or business & accounting practices were becoming more questionable, a China-focused emerging market investment style may continue to hold Chinese-based equities or bonds just to maintain exposure. Instead, you would be able to divest such holdings and look to other markets.
• Long term potential in different sector: A particular technology holding diversifies into the solar industry. It might not be considered as part of the tech sector (energy sector) by technology investors. One day it spins off the division as a separate entity, which no longer fits with the allocation in technology. Instead of automatically divesting the asset, you would be able to assess its potential first. If it is a good long term investment, you can then decide to hold onto it. Taiwan Semiconductor [TSM], the worlds largest semiconductor manufacturing company, has a separate division for solar panel technology, and has intentions to spin it off into a separate entity & stock in the future.
Accommodates Planning For Market Downturns & Protection Against Associated Risks:
This advantage further expands on the previous benefit mentioned. Because flexibility & change is a large aspect of function-centric investing, it accommodates the inclusion of market downturn scenarios in your long term plan. A change in some or all assets into entirely different assets or transitional capital (usually cash) at some point, does not conflict with any aspect of this style. The causes of downturns usually present real business risks to associated assets, which may no longer enjoy the same widespread profitability that they may have once had. Negative conditions may remain for an undetermined period of time, making certain assets/sectors potentially unattractive indefinitely (such as US educational financing/lending post 2008). Sometimes, bear markets of a specific type or category can last a long time (the opposite is also true). You are protected against unnecessarily holding onto unfavorable assets, or assets in a particular industry/sector that may be directly impacted by the causes of a broad based economic & market downturn.
• Scenario planning: As part of the long term plan, there may be multiple scenarios where assets become overpriced and/or economic conditions deteriorate on a broad basis. When such conditions hit a certain level, the plan may then call for a specific portion of assets to be converted into and held as cash (fulfills transitional role). Cash would be held until the same assets (or other assets) become undervalued to a certain level. At that point, the plan may dictate that capital be redeployed into opportunistic investments that fulfill the functions of the next stage.
• Broad based decline & market index ETFs: As indices become overvalued, passive investment styles that allocate capital strictly to market index ETF assets would be susceptible to broad based stock market declines (as we’ve seen many times in the past). Instead, an investor can shift to an all cash position, or a position in entirely different assets.
Keeping Good Investment Candidates & Ideas:
This investment philosophy does not tie you to any particular asset type or category, which means that you don’t prematurely eliminate potentially good investment ideas before starting the candidate selection process. If a particular investment candidate doesn’t fulfill a particular function, you also don’t end up throwing it out completely, as it may potentially satisfy another role later on.
• Berkshire Hathaway: A stock holding like Warren Buffet’s Berkshire Hathaway [BRK.B] wouldn’t fit into a dividend or growth style portfolio, since it’s not considered a growth stock and it doesn’t issue a dividend. Instead of having it automatically screened out by default, you assess whether Berkshire’s characteristics might be a good fit with your long term plan, and might not miss out on the stellar returns & long term capital appreciation that it is capable of delivering!
• ETF Investments: Active investment styles that focus on equities & bonds may automatically eliminate consideration of ETF investments that are typically used by passive investment styles. Instead, you can take advantage of a wide variety of ETFs regardless of whether you held equities or bonds. ETFs such as the SPDR Gold Trust ETF [GLD] have performed well in the past few years and especially during the the period where equities & bonds were in decline.
I am long Taiwan Semiconductor [TSM], Berkshire Hathaway [BRK.B].
I no longer hold SPDR Gold Trust ETF [GLD].
I do not own any shares of Under Armour [UA].
I do not plan to buy or sell any of the above mentioned investments within the next 9 trading days.
Part 2: Function-centric investing allows for the inclusion of new asset types & categories. You can also be diversified into many areas, or concentrated in a narrow range of investments. It also ensures each investment decision made is not arbitrary, and has a purpose directly related to your plan.
Thanks & Happy Investing! — The Investment Blogger © 2012