Submitted by Steve Selengut
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The Working Capital Model - Part 3
I know of no other Investment Manager anywhere (other than those who have contacted me and obtained my consent), private or public, that uses the "Working Capital Model" to direct individual investor portfolios --- certainly none of the major operators, who are dependent for their survival upon the whim of large "others".
The following is a slightly edited excerpt from Chapter Four of: "The Brainwashing of the American Investor":
"Now I realize that this approach is totally different than anything you’ve ever dealt with before, but in one fell swoop it surely eliminates all of those nagging ifs, ands, and buts, that make standard "bottom line" "market value" analysis totally useless (to the investor).
I created the "Working Capital" method of performance evaluation many years ago (1975), when it became evident that a trading strategy was quite a bit different from most styles of management. It shows you where you are and allows for meaningful comparisons with where you’ve been. As a "kicker" it allows for an instant and accurate appraisal of asset allocation.
Working Capital is defined as the actual Cost Basis of the securities in the portfolio; not their current market value. This concept is consistent with the retail store approach towards equity investing which was discussed earlier. Income of any kind, including realized capital gains, and deposits increase your working capital while withdrawals and realized capital losses alone decrease it.Current market value is not a factor.
Since you will constantly monitor the age of the securities in the portfolio the tendency to hang on too long to nonproductive assets is also avoided. The total "Working Capital" will always be more than the Market Value of the portfolio, unless the bulk of the portfolio is invested in fixed income securities. (AND then only if interest rates have moved down since the time the Fixed Income securities were purchased.) This is both expected and accepted because it is easy to understand without having to sift through a dozen research reports that try to explain an array of "unknowables" about the economy and the company’s Management Team.
However, the closer the "broad" market gets to truly high ground, the narrower the difference between working capital and market valuations. Is this clear? Working Capital doesn’t change as a function of market value. It grows through the addition of cash from deposits, dividends, interest, and realized gains. It decreases when losses are realized and when cash is withdrawn from the portfolio. The day-to-day changes in market value that you used to worship so fervently can now be thrown out into the street with the other garbage!
Maybe this hypothetical conversation will help. So how do you respond to that "How are you doing in this market" question? "Pretty well so far. Trading has been really good because of this wonderful market volatility. I’ve taken lots of quick, short-term profits that I’ve put back into new fixed income and equity positions. Most of my older holdings have come back well enough to escape gracefully. Base Income hasn’t been growing as quickly as I’d like lately because of lower interest rates, but I’ve actually been able to sell some fixed income stuff profitably as well.
I expect to increase working capital by at least 10% this year, just like last year. Overall it’s been another great year!" Be prepared for a blank stare (in 2000 and 2001), an open mouth and a "what are you talking about? "
Don’t forget to smile while your friend makes one more attempt: "Oh, I see, when did you get out of the market? You sure were lucky!" "Actually, it doesn’t ever make any sense to be out of the market. My equity allocation has always been around 70% and it will stay there until I’m a bit closer to retirement. I consider myself an investor, not a speculator."
We are replacing our profitable investments (merchandise we have sold at our store) with new ones that have potential for future profit (inventory on the shelves). Thus our current portfolio value will not "catch up" until new buying opportunities dry up. If you have nothing to buy, "smart cash" builds up (compounding at money market rates) while profit taking continues.
In recent years (1998 through March 2000), there were always many more stocks going down than going up, so finding new investments was not a problem. Over the past 18 months or so (through July 2001), the environment has turned around completely.
Remember "The Investor’s Creed" "My intention is to be fully invested in accordance with my planned equity/fixed income asset allocation. On the other hand, every security I own is for sale, and every security I own generates some form of cash flow that cannot be reinvested immediately. I am happy when my cash position is nearly 0% because all of my money is then working as hard as it possibly can to meet my objectives. But, I am ecstatic when my cash position approaches 100% because that means I’ve sold everything at a profit, and that I am in a position to take advantage of any new investment opportunities (that fit my guidelines) as soon as I become aware of them."
Click for Details --> WCM Part 1 <--