Build My Portfolio: Steering a Silicon Valley Power Couple Away From Tech

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By Barry Randall :

This piece is part of a new, ongoing series here on the ETFs & Portfolio Strategy page at Seeking Alpha. The concept is for a money manager or RIA to field a hypothetical portfolio construction question from an SA user about how to best construct a portfolio that will help them meet their financial goals and then proceed to build an effective portfolio that will take their risk/reward profile into account. All participants in this series are real-world professional investors who are available to help individuals, companies, and financial professionals construct intelligent portfolios. To submit a question for a future edition of Build My Portfolio, email Rebecca at rbarnett@seekingalpha.com.

This edition of Build My Portfolio features Barry Randall, CIO of St. Paul, Minnesota-based Crabtree Asset Management . Barry founded Crabtree in 2008 following a 15-year Wall Street career as an equity analyst and portfolio manager specializing in growth stocks. In 2007, Barry earned a Wall Street Journal Category King award for his co-management of the MTB Small Cap Growth Fund [ARPAX].

Barry,

I am a 41 year old Head Programmer at a top U.S. tech company who makes roughly $250k a year after taxes. After funding my 401(k) and other expenses, I have roughly $90k left over. My college loans have been fully paid off at this point and my wife and I own our house in full (no mortgage).

In terms of life situation, my wife and I are expecting twins in November. These will be our first kids. My wife is planning on leaving her job at a top accounting firm once the twins are born and will likely seek work again once the kids start kindergarten so we will be living off just my income for the time being. The good news is that between my wife and I, we have very well-funded 401(k)s through our respective jobs, totaling nearly $500k in short-term CDs that are about to mature. We are concerned that if we don't start really 'growing' this money, we will come up short when it comes time to send our kids to college, grad school, etc. We also would like to make sure we have enough for retirement.

As we recognize that we have a solid 18 years or so to accomplish this first goal and significantly longer to accomplish the second goal, we are willing to take reasonable chances with our investments and have no desire to remain overly-conservative. We recognize the risks that come with investing in stocks but feel the chances for much greater rewards are well worth those risks.

Please help us build our portfolio.

Morgan and Beth
Mountain View, California

Dear Morgan and Beth,

Before I get to the financial stuff, let me first congratulate you on the forthcoming birth of your twins and extend my best wishes to you both. And congratulations too on your foresight to not only have accumulated quite a nest egg in your 401(k)s, but also to have paid off your mortgage too.

I have read your question carefully and I believe I have a solid plan to help you achieve the growth you're looking for. Fair warning: my solution may seem somewhat counter-intuitive. But once I have explained it, I believe you'll be confident in achieving your goals. First, however, let me introduce you to my firm.

At Crabtree Asset Management, our specialty is growth and technology. We offer clients a proprietary technology-focused SMA product, the Crabtree Fund. However, we also provide overall portfolio strategy and investment planning that extends across a client's entire financial situation.

At Crabtree, we utilize not only our nearly 20 years of investment experience, but also the timeless tools of diversification, dollar-cost averaging, portfolio re-balancing and generally keeping expenses low. Many Investment Advisors like to tout "double-secret probation"-style investment strategies that seem to magically apply to every scenario. At Crabtree, we use our "house" product only where it's appropriate, but otherwise rely on the proven strategy of low cost funds, typically Vanguard funds or ETFs.

How proven is the low-cost fund advantage? Consider that about a year ago, Morningstar analyzed its own fund performance data and came to a startling conclusion ( free login required to view this article ). To quote Morningstar's own Russ Kinnel,

"If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds."

What's more, Morningstar admitted that its own star ratings were not especially effective as predictors of future performance. Again quoting Kinnel, "How often did it pay to heed expense ratios? Every time. How often did it pay to heed the star rating? Most of the time."

In cases where we recommend individual equities, we utilize our internal research to locate companies that can consistently generate cash while maintaining or growing market share. Companies can always trade one for the other (i.e., dropping prices and profit margins to gain market share) but our experience is that doing both simultaneously creates alpha. I have been running and testing a quantitative model for over 11 years that searches for and finds companies with these alpha generating characteristics.

At Crabtree, we adhere generally to the four box method: 25% of your net worth each in equities, fixed income, real estate and cash, with annual re-balancing if any of the four moves 5% from its target.

So with that in mind, let's review your current situation, and what changes, if any, might position you better for the next 18 years and beyond.

First, if you own a home in Silicon Valley outright, then that amount of equity ($750,000?) more than fills the Real Estate box. In fact, according to your letter, it seems to represent perhaps 60% of your net worth. So our solution will involve addressing your exposure to the other three asset classes.

Second, since your 401(k) assets are in a cash equivalent (CDs in your case), we'll move two-thirds of those assets into both fixed income and equity vehicles to give you both diversification and some of the growth you desire.

Third, because your professional life is 100% tied to the technology field, your investment strategy should point you mostly away from that sector. It would be easy for us to say, "you want growth, you're obviously comfortable with technology, we're tech specialists at Crabtree, let's do tech, tech and more tech."

But that simply wouldn't be prudent in your particular case. If there were an economic downturn, or your firm was taken over by another, you could easily find yourself unemployed. But this might be occurring (recall 2002 and the bursting of the dot-com bubble) at exactly a time when you might need to draw on your net worth to support your family. So diversification extends beyond your investments, to include your career.

The fourth unique aspect of your situation is that 18 years from now (when your twins will head off to college) is conveniently the year in which you turn 59 - the earliest age you'll be able to withdraw funds from your 401(k) without penalty. You can use these funds (less applicable taxes at that time) for yourself or your kids' education - whatever you'd like.

So let's get to your specific plan:

1) Hold on to your house and take good care of it

2) As the CDs in your 401(k) mature, begin rolling that money over into low cost equity and bond funds.

For equities we'll consider: Vanguard Growth Equity Fund (ticker: VGEQX; yield: 0.66%; expense ratio: 0.51%), Vanguard International Growth Fund (ticker: VWIGX; yield: 1.53%; expense ratio: 0.49%) and Vanguard Selected Value Fund (ticker: VASVX; yield: 1.51%; expense ratio: 0.47%).

As noted earlier, these funds, like all Vanguard products, have low expenses. In addition, each has relatively low turnover (<50% annually) and each of the three pays a modest yield that is greater than the expense ratio. We would recommend putting 25% of the equity allocation in each of the two equity funds, and 50% in the value fund. The international product is growth- rather than value-focused because the "value" in such a fund is based on balance sheet figures, which we feel are less trustworthy than income statement items, when considering non-U.S. financial statements.

For fixed income, consider: Vanguard Long-Term Bond Index Fund (ticker: VBLTX; yield: 4.65%; expense ratio: 0.22%), Barclays Capital Long Term Corporate Bond ETF (ticker: [[LWC]]; yield 5.51%) or the Barclays TIPS (inflation-protected) Bond ETF (ticker: [[TIP]]; yield 3.92%).

Again, our choice of funds is consistent with research showing that low expenses is actually a predictor of outperformance, and a sub-portfolio comprising one-third weightings of these highly liquid fixed-income products offers a blended yield of 4.69%.

3) Outside of your 401(k), start maximizing contributions to your and your wife's IRAs with the aforementioned funds. You have 24 years of contributions (at $5k/year for you and your wife). Although your current contributions won't be tax deductible because of your high income level, any capital gains and dividend income will accumulate tax free.

4) If you want to invest in individual stocks in your 'equity box', I'd recommend [[IBM]], 3M ( MMM ), Verizon ( VZ ) and Caterpillar ( CAT ) among large-caps, and NIC Inc. ( EGOV ), Red Hat ( RHT ), Cerner (CERN) and Ensco (ESV) among small- and mid-caps. These eight companies are either currently or have recently been among those that our aforementioned quantitative screen has found, when looking for companies generating cash and maintaining or gaining market share.

5) Once a year, tally up how much you have in each of the four boxes, and how any individual stocks are doing and adjust your balances and your contributions going forward. Fortunately, most of your investible assets are in tax-shielded accounts, so there's no need in the near term to engage in tax avoidance strategies for now.

Your primary goals were to grow your money for your kids' college education, and make sure your own financial needs were met thereafter. Now consider that an average year at an Ivy League school is currently about $55,000, all expenses included. So with $500,000 already socked away, your twins could attend a top university for four years starting next year and you'd still have money left over. So our plan for you focuses as much on preserving the assets you have, as it does on growing those (and future assets) to support you in your retirement.

Disclosure: Long [[IBM]] and [[EGOV]], which are in the Crabtree Fund model portfolio, and in which Barry Randall is an investor.

See also Battle Of The Brands Match-Up 1: Pepsi Vs. Coca-Cola on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: CAT , EGOV , MMM , RHT , VZ

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