Why EvenBlue-ChipInvestmentPortfoliosMust BeProperlyDiversified

November 2018Client LetterHere is something I’vebeen reviewing with clientsthat is helping with theirunsettledness over the pastthree months. Most of youhave a balanced portfolio,which includes a mix ofcash, bonds, preciousmetals, and stocks. When

you hear and read aboutthe market’s decline andthe uncertain per ioda h e a d , i t i s w i s e t oremember these nastyheadlines are not affectingyour entire portfolio. Mostof you have approximately50% invested in equitiesand the other 50% investedin securities which tend tohold their value or declineless compared to stocks.

As for the stocks in yourportfolio, we look to investin blue chip, industry-dominating, financiallystable companies. Sure,the share price of thesecompanies wi l l haveperiods of decline. But wee x p e c t m o s t o f t h ecompanies we own tow e a t h e r m a r k e tcorrections and continue togenerate sales, market

their products or servicesand pay you a dividendeach year.

None of us likes to see ourportfolio lose value, buttha t i s the na ture o finvesting. Markets go bothways over time. But themore time passes, theg r e a t e r t h e o d d s o fsuccess—especially whenowning a group of solidbusinesses.

The following diagramshows that, over a one-yeartime horizon, investorsshould expect to losemoney in stocks about 25%of the time, or once everyfour years. Extend the timehorizon to five years andthe risk of loss falls to1 1 % . F o r l o n g - t e r minvestors, the news getseven better. Over the 132fifteen-year periods since

1871, U.S. stocks havenever lost money. Thatincludes during the GreatDepression and the morerecent financial crisis.Successful investing haslots to do with quality andtime. If we are invested inquality businesses andhave time on our side, thechances of winning arepretty good.

Quality and time may notwork for you when yourtime frame is short, youa r e n o t p r o p e r l ydiversified, or you areover-concentrated in al i m i t e d n u m b e r o f

securities. On occasion,even the bluest of blue-chip companies runs intotrouble.

Blue-ChipStocks That Raninto TroubleThe Dow Jones index isconsidered a blue-chipbenchmark. In theory, onecould buy stocks from theDow and never need tosell. But the index changesbecause companies do notalways last. At year-end1999, the once-venerableGeneral Electric, HewlettPackard, General Motors,Eastman Kodak, Citigroup,a n d o l d A T & T w e r emembers of the Dow.For decades, GeneralElectric was consideredthe best-managed companyi n t h e w o r l d . G E ’ s

management trainingprogram was second tonone, with many formerexecutives going on to leadlarge publicly tradedc o m p a n i e s . I n 1 9 9 8Business Week ran a coverstory on how well GE wasmanaged, calling JackWelch “America’s #1Manager.” Today, GeneralElectric is no longer amember of the Dow andappears to be struggling tosurvive.

Hewlett Packard was apioneer in the technologyi n d u s t r y a n d o n c econsidered one of the mostinnovative companies inA m e r i c a . I t t o o w a sdumped from the Dow. HPhas been sliced and dicedand is now a shadow of itsformer self.

General Motors has long

been America’s biggest carcompany, but that didn’tprevent GM from filing forbankruptcy following the2008/2009 financial crisis.

Ditto for Eastman Kodak.Eastman was a former Dowmember and the dominantp r o v i d e r o f f i l m i nAmerica, but the firmfai led to adapt to thedigital world and wentbankrupt.

Citigroup, once the biggestbanking enterprise inAmerica, almost failedduring the financial crisis,and AT&T, a longtimemember of the Dow, wasswal lowed up by SBCCommunications, one ofthe Baby Bells. SBC ofcourse took AT&T’s name.

A t y e a r - e n d 1 9 9 9 , aport fo l io invested in

General Electric, GeneralMotors, Citigroup, HewlettPackard, the old-AT&T,and Eastman Kodak wouldh a v e l i k e l y b e e nconsidered a blue-chipportfolio. Admittedly, apoorly diversified portfoliowith only six names, butblue-chip nonetheless.

How did this hypotheticalblue-chip portfolio performover the subsequent 19years? The following charttracks the performance ofan equal investment ineach of the above-namedsix stocks since year-end1999. This portfolio wouldhave lost about two-thirdsof its value over a 19-yearperiod.

I am of course cherry-picking a portfolio of blue-chip losers to illustrate apoint, but even the blue-chip stocks that havesurvived and performedwell can suffer from poorstock-market performance.Microsoft’s stock comes tomind in this category.

MicrosoftMicrosoft is on the vergeof becoming the world’smost valuable company,but at t imes i ts stockperformance was notgreat. If you retired at thebeginning of this centuryand owned a significantholding in Microsoft, you

may have regretted yourdecision. Yes, things haveworked out as of today;but, for the first 15 yearsof this century, the shareswere underwater.

Today, we own Microsofts tock in some c l i en tportfolios. In addition to animpressive dividend-growth record, Microsoft’sposition in the technologyindustry appears to be wellentrenched. The Windowsoperating system andOffice productivity suitesti l l have the leadingmarket share amongconsumers and businesses.Microsoft is also a strongnumber two in the publiccloud, where growth hasbeen robust. Unlike sometechnology businesses thathave few barriers to entryand almost no competitive

advantage, we believeMicrosoft possesses both.

Pacific Gas &ElectricInvestors who believediversification doesn’t haveto be one of their primaryconcerns because theyinvest in regulated utilitiesand other “widow andorphan” stocks shouldthink again. The recentshare price collapse ofPacific Gas & Electric isinstructive. PG&E is alarge California-based gasand e lec t r i c u t i l i t y .Because of potentiallybankrupting l iabi l i tyrelated to fires this yeara n d l a s t , P G & E h a seliminated its dividend,and its share price is downover 60% from Septemberof 2017.

Diversification aCornerstonePrincipal atRichard C.Young & Co.,Ltd.At Richard C. Young & Co.,Ltd., diversification is acornerstone principle ofour strategy. We seek toown a group of namesdiversified geographicallyand across industries. Wewill inevitably hold a stockl i k e P G & E a t a ninopportune time or beinvested in a blue-chip firmthat fails to adapt to theever-changing economiclandscape. That is thenature of investing. Butb e c a u s e w e c r a f tdiversified portfolios, ther isk of such an event

having a devastating andlasting impact on yourportfolio is remote, in ourview.

Unlike many of the market-cap-weighted index ETFsfavored today, we favorwhat is essentially anequally weighted allocationstrategy to common stocks.We believe a capitalization-we ighted a l locat ions t ra tegy c rea te s anoverconcentration in thebiggest firms. An ETF thattracks the S&P 500, byexample, may own 500names, but the top 10account for an outsizeshare of the portfolio.

We own both Exxon Mobiland WEC Energy (a utility)in some client portfolios.Both stocks receive thesame allocation in ourclients’ portfolios, but if we

pursued a market-cap-weighted approach, wewould own about 14 timesmore Exxon than WECEnergy.

How Is theEconomyDoing?Third-quarter GDP growthcame in at an impressive3.5%, but some indicatorsnow point to a potentials lowing in economicmomentum. The slowing isnot ye t broad -basedenough to become overlyconcerning, but i t i smeaningful enough tomake us perk up and payattention.

The interest rate-sensitivesectors appear to be themost impacted. Auto saleshave plateaued over the

last year or two, and nowthe housing sector islooking top-heavy.

My chart below on newand existing home salesshows signs of a slowdownin housing. The nearly one-percentage-point rise inmortgage rates since thestart of the year has likelydampened demand. Withconsumers still in goodshape, the question forinvestors is whether theslowdown in home sales isa temporary reaction to the“sticker shock” of higherinterest rates or somethingmore lasting.

In the coming months, wewill look to the ConferenceBoard’s Index of LeadingIndicators to assess theprospects for the economy.Last month the leadersregistered their lowestmonthly rate of increasesince May of this year.

The slowing in selectsectors of the economyappears to have caught theattention of the FederalReserve. Some members ofthe policy-setting FOMCcommittee have started tocall for a pause in interestr a t e i n c r e a s e s . W econtinue to anticipate onemore interest rate hike in2018, but the number ofhikes in 2019 is now lesscertain.

Have a good month. Asalways, please call us at(888) 456-5444 if your

financial situation haschanged or if you havequestions about yourinvestment portfolio.

Warm regards,

Matthew A. YoungPres ident and Ch ie fExecutive Officer

P.S. Last year at this timeyou would have beenforgiven for thinkingBitcoin was taking over thefinancial universe. Today,th ings have changeddramatically. Prices forBitcoin are down 79% inless than a year. Therem a y b e v a l u e i n t h einnovative technologiesthat drive Bitcoin; but, as acurrency, Bitcoin remainsspeculat ive and best

avoided by retired ands o o n - t o - b e - r e t i r e dinvestors.

P.P .S . T h e C h i n aHousehold Finance Surveyrun by Gan Li at Chengdu’sSouthwestern University ofFinance and Economicsrecently found that onef i f th—that ’s 20%—ofChinese homes do not haveoccupants. Instead, thesehomes a re owned asinvestments in what couldbe one of the world’s mostdistorted markets ever.

Keeping in mind Chineseshares are already downover 20% (in yuan terms)in 2018, the country hashad rocky trade relationswith the U.S. That and thedisturbing real estatestatistics above makes itappear China has someproblems. In 2012 my dad

explained his bearishoutlook on China:

I have long adviseda g a i n s t d i r e c tinvestment in China.A m o n g t h e m a n yreasons I am bearisho n C h i n a i s t h ec o u n t r y ’ s v a s t l ydistorted economy.China is a commandstyle economy run byan unelected politicalparty—the CommunistParty of China (CPC).The CPC’s policieshave resul ted in agrand misallocation ofcapital. A mercantilistc u r r e n c y p o l i c y ,perverse incentives forprovincial governmentofficials, and crudemonetary policy toolshave helped inflate afixed asset and real

estate bubble that putsthe U.S. real estatebubble to shame.

In our view, unti l andunless there is meaningfulreform in China, directinvestment in the countryshould be avoided.

P.P.P.S. According to theWSJ, some 15,000 financialadvisors at Merrill havec o m p l a i n e d t omanagement about a paystructure that encouragescustomers to take on moredebt. This is possiblebecause brokerages likeMerrill are held to the low-bar “suitability” standardof client service. Boutiquefee -on ly inves tmentcounsel firms like RichardC. Young & Co., Ltd. areheld to the higher fiduciarystandard. Fiduciaries mustput clients first, and we

always do.R e a d t h i s f r o m L i s aBeilfuss in the WSJ abouthow Merrill advisers arepressured to push theirclients to take on debt tomaximize company profits:

Adding to tens ionwithin the Merri l lranks: Some brokerssay they feel pressuret o p u s h B a n k o fAmerica products, suchas checking accounts,to wealthy investorclients. Merrill is thebrokerage arm of Bankof America.

Advisers can make uplost compensation byacquiring new clientsand doing more forexisting clients. Thecatch, some brokerssay, is that growingportfolios by pushing

clients to take on debtcan be easier thanfinding new assets.

Loans that are backedby a client’s investmentp o r t f o l i o a r e aparticular favorite ofbrokerage firms, saidJ e f f r e y H a r t e , abrokerage analyst atSandler O’Nei l l +Partners. “It’s takingmoney that’s alreadythere and making moremoney on it, versus themuch harder job ofgoing out and growingassets,” he added.