After making its most recent selection, the Inflation-Protected Income Growth Portfolio still has 15% sitting in cash -- 20% if you include the money allocated for the stock that still might get away. That's a significant amount of its cash sitting on the sidelines, waiting to be invested.
With interest rates so low, that idle cash is earning almost nothing -- a potential danger for a portfolio focused on investing for a rising income stream. Yet holding cash may be a better alternative than throwing money at stocks that don't meet the portfolio's standards. With the market up sharply early this year, it's getting tougher to find companies that fit.
Which raises a key question -- what to do with the cash:
- Hold the cash and wait for the market to serve up more decent values?
- Soften the portfolio's diversification criteria and accept more companies similar to ones already held?
- Soften the portfolio's valuation criteria and accept lower expected rates of return?
The downside of a rising market
The company behind any given stock is worth the net present value of its expected future cash flows. That's a fancy way of saying that what a company does in the future determines what it's worth today. In most cases, those future prospects do not depend at all on where the stock is trading in the market.
If you hold that future constant, the lower a stock's price is today, the higher your expected future returns from buying the stock. The opposite holds true, as well; the higher a stock's price today, the lower your expected future returns. As a result, the fairly strong opening weeks of 2013 have lowered the expected future returns of owning many otherwise worthwhile stocks.
Take Emerson Electric . When the iPIG portfolio first launched last December, the company had a market capitalization of around $36.0 billion. A discounted cash flow analysis conducted at the same time pegged its intrinsic value around $39.3 billion. The company traded at a small discount to what looked like fair value.
This past Friday, however, Emerson Electric closed with a market price of $41.5 billion -- slightly ahead of that fair value estimate. Had the market price not risen so substantially -- nearly 15% -- in such a short amount of time to rise past that value estimate, it would be in consideration for potential purchase by the portfolio today. With over 50 years of a rising dividend and a healthy balance sheet, it would be a strong contender for a slot in the iPIG portfolio.
Is diversification helping or hurting?
Another criteria a stock has to pass in order to make it into the iPIG portfolio is that it has to fit from a diversification perspective. That rule has already been loosened once for the portfolio in an acknowledgement that the vast majority of the benefits of diversification can be met with relatively few stocks.
If the diversification criteria were to be loosened again, Intel would seem to be a decent fit, as well. As of Friday's close, that microprocessor titan is still trading below the $117.6 billion estimated for its fair value. With its healthy balance sheet and its near-decade-long streak of raising its dividend, it would seem to be a worthy candidate -- especially with its reasonable stock price tag.
The only problem is that the portfolio already includes Microsoft and Texas Instruments . Microsoft represents the other half of the "wintel" personal computing powerhouse, and Microsoft's and Intel's fortunes have for a long time been incredibly closely linked. Texas Instruments, like Intel, is a semiconductor titan, and the two are thus exposed to many of the same industry-shaking events.
Loosening the diversification rules to allow the iPIG portfolio to own Intel as well as Microsoft and Texas Instruments would likely put around 15% of the portfolio's cash to work in that high-tech industry. You might try to make the case that it's so unlikely that those titans would succumb to any trip-ups that the risk would be negligible, but that would ignore the harsh lessons from the recent financial meltdown.
Citigroup was once America's largest bank. It still is a behemoth, with nearly $2 trillion in assets. Yet it, along with many other major banks, was forced to slash its dividend to $0.01 a quarter as those financial issues unfolded. It even underwent a 1-for-10 reverse split to keep its stock out of penny-stock territory (and then cut that dividend again to maintain the abysmal $0.01-per-quarter level). That meltdown hit many other banks, too -- a nearly industrywide collapse.