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Why Strict Investing Standards Rule

Monday - 5/13/2013, 4:05pm  ET

The real-money Inflation-Protected Income Growth portfolio just finished another solid week. The value of its holdings increased nearly $200 since the prior week's update, finishing above $34,200. That's not bad for a portfolio that started just over five months ago with $30,000.

It's also not a sustainable rate of return. Thanks in large part to a rapidly rising market, many of the stocks in the iPIG portfolio have risen far faster than the economic successes of the companies they represent. Indeed, several of the companies in the portfolio have seen their stocks rise so much that, if they weren't already iPIG members, they wouldn't make the cut today.

And that's a good thing
The iPIG portfolio maintains strict investing standards built on the principles of dividends, valuation, and diversification as inspired by Benjamin Graham, the man who taught investing to Warren Buffett. It's because of those standards that somewhere in the neighborhood of 10% of the portfolio's original investment capital remains in cash. It's also because of those standards that it's OK to hold on to many of the companies that are in the portfolio but wouldn't make it as new picks today.

After all, no company is perfect in its ability to tell the future. Competition, regulatory changes, acts of nature, and plain old-fashioned inability to deliver all conspire to trip up any business' projections. What makes a company resilient, though, isn't its ability to perfectly forecast, but rather its ability to adapt to and recover from those unforeseen situations.

Because the iPIG portfolio has such strict standards on the buy side, it has more flexibility on the sell side. This enables a fundamentally solid company to work through some temporary rough patches while still potentially providing decent returns for its shareholders.

Take Mine Safety Appliances , for instance. The safety equipment provider missed expectations in its most recent quarter. But its very solid balance sheet helps protect it from the cyclicality in its industry, and its overall strength enabled it to increase its dividend last week, in spite of that short-term weakness. That solid balance sheet was one of the key factors that led to its selection for the iPIG portfolio and the reason the portfolio still has room for the company even though it slipped.

Similarly, United Parcel Service took a significant charge associated with its pension shortly after making the cut as an iPIG pick. That charge knocked the company's debt-to-equity ratio above the iPIG portfolio's buy criteria and sent the business' dividend payout ratio above 100% of earnings. That was a painful charge for the company, but one that could have absolutely sunk a less well prepared business. So rather than dump the company, the iPIG portfolio is watching to see how well it recovers.

Likewise, when toy maker Hasbro flubbed the critically important fourth quarter of 2012 -- the quarter including Christmas -- it too remained in the iPIG portfolio. The stock looked dirt cheap when originally picked, as if the market were expecting a flop. When the company did miss, the iPIG portfolio's position still turned out OK, thanks to that low valuation that made it initially a reasonable buy.

And in what was probably the fastest transition from strength to struggle for the portfolio, supplemental insurance giant Aflac reported weak earnings just after being picked. Still, the company's solid balance sheet, reasonable valuation, and very strong dividend history made it a solid business to own, in spite of those short-term worries.

Success despite those struggles
A large part of the incredible returns that the iPIG portfolio has seen since inception came from the market's rapid ascent in that window. Still, given the less-than-perfect execution among many of the companies in the portfolio, a decent part of it had to have come from the strict investment selection criteria, as well.

After all, when a company is priced for perfection and has a balance sheet dependent on that perfection for it to survive, any stumble can be financially fatal to its shareholders. Yet when a company is priced for an imperfect reality and has a solid enough balance sheet to survive the inevitable rough patches, its investors can continue to see rewards, even when things aren't going swimmingly. That's especially true when a portion of those rewards come from dividends supported by cold, hard cash.

iPIG portfolio snapshot as of May 10, 2013

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