Merrill: 12 portfolio ideas for 2012

The following is excerpted from a report by the Chief Investment Officer Team for Merrill Lynch Wealth Management. The team is headed by Lisa Shallet, CIO of Merrill Lynch Global Wealth Management and head of investment management & guidance.

As we close out the best first quarter U.S. equities performance since 1998, our focus turns away from pure asset allocation rebalancing toward “risk”—where the “rising tide lifted all boats”—to a more narrow focus on stock, sector and geographic selection, where company-specific fundamentals and valuations come into play. With first quarter earnings season roughly 10 days away, estimate revisions continue to be negative and management guidance has been the second quietest of any month in the Bank of America Merrill Lynch (BofA ML) database that tracks such data back to 2000. Against this backdrop, we want to be active stock pickers focused on those that can meet and beat expectations. As such, we are focused on companies with pricing power, proprietary products and technology, and that have the potential to grow dividends and engage in other shareholder-friendly actions because of high cash balances and sustainable free cash flow margins. We believe the best opportunities for the intermediate term in this regard continue to be found in U.S. large caps and in emerging markets.

As we have often noted in recent weeks, the “risk-on” rally of the last five months from the October 2011 lows has been broad based—particularly favoring those asset classes and sectors that were most negatively affected in last year’s sell-off. The implication is that “quality” attributes have taken a backseat to pure cheapness and high beta. Furthermore, with earnings estimates for 2012 trending downward, we have now seen broad equity price/earnings (P/E) multiples expand to roughly 14 times. While that valuation level is not by any means extreme in a relative or historical sense, equities are no longer absolutely cheap and the direction of markets will increasingly be determined by the profits trajectory.

With a keen eye on capital preservation, we are focused on proactive risk management. Our approach has three prongs:

First, we encourage investors to diversify risk through a more global and multi-segmented approach to asset allocation. For equities, this means eliminating excessive home-country bias and including exposure to Emerging Markets. In fixed income, while we have continued to favor high-quality municipals, we think investors should consider exposure to a mix of corporate high-grade and high-yield bonds as well as non-U.S. sovereign and corporate debt. Broadening asset class exposure may also be appropriate for some investors who might consider including real assets, gold and low volatility/absolute return-oriented alternatives in their portfolios.

Second, we think that overall portfolio risk can be reduced by exploiting today’s scarcity themes of Growth, Quality and Yield. Where market volatility has caused portfolios to drift from long-term asset allocations, rebalancing opportunities exist to add to these themes. Large, multinational dividend growers, many of which gain market share in the secular growth story of the Emerging Market consumer, are opportunities.

Finally, we see opportunities to be more tactical as we actively manage risk. Higher volatility creates more risk but also more opportunities. Utilizing a flexible multi-asset manager for a portion of your equity sleeve can help raise the odds that absolute return goals are met.

12 portfolio action ideas for 2012

The guidance below, and how it is implemented, should be considered only in light of your individual investment plan—including your risk tolerance, horizon, objectives and liquidity needs. You should discuss these with your financial advisor.

1. Maximize yield and broaden exposure to high corporate free cash flows in your equity sleeve by adding dividend-paying and dividend-growing stocks as well as stocks with a history of strong buybacks. Barbell between pure defensives and cyclical exposure.

2. Increase Emerging Markets equity and fixed income exposure to at least 10% of your portfolio.

3. Diversify fixed income sleeve to include high yield, global sovereign and Emerging Market debt; reduce U.S. Treasuries; continue to use high-quality municipals.

4. Utilize flexible multi-asset class managers for some of your risk budget (fund this from your equity allocation).

5. Assess tax-efficiency portfolios in equities using ETFs rather than mutual funds where the case for active management is weak. Fixed income sleeves should optimize after-tax returns through the use of both municipals and taxables as opportunities are available along the curve.

6. Include exposure to commodities, such as oil and gold.

7. Consider adding private equity as a long-term play on low valuations and the growth of new technologies in healthcare, software/social networking and energy.

8. Manage downside risk by including non-directional hedged strategies (relative value, market neutral, global macro and select market-linked investments).

9. Reduce TIPS exposure for now; inflation at bay and fully valued.

10. Maximize real purchasing power and security of cash positions through diversification/optimization between FDIC-insured deposits, money market funds and ultra-short duration funds.

11. Manage the risk of a stronger U.S. dollar by hedging international exposures.

12. Rebalance more frequently to exploit volatility (at least quarterly or after substantial equity market moves).

Related Topics: Merrill Lynch, Risk Management