2017: A Year In Review

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My Performance

My performance was, in the words of Benjamin Graham, unsatisfactory. I lagged the S&P 500 substantially.

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The S&P 500 was a mighty opponent this year. It was like the Kurgan in Highlander, or perhaps the T-1000 in Terminator 2. It kicked my butt. The market steadily increased with minimum volatility and drawdowns. It was quite possibly the most perfect stock market rally in history.

The road to my return was also far rockier than the S&P’s. As recently as August, I was down 4.8%. My portfolio recovered 12.5% from those levels in the last few months. The S&P, in contrast, increased every month this year in a smooth and unstoppable fashion.

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The S&P 500 was not to be trifled with this year.

Much of my underperformance is attributable to the underperformance of value investing as a strategy. This is to be expected. We’re in the late stage of a bull market. Value underperforms in the late stages of bull markets. In the late stages of a bull market, the stocks that shined the most during that bull market are going to be propelled forward by momentum while the laggards (i.e., beaten down value stocks) are going to be ignored or pushed down further.

Every AAII value stock screen underperformed the market this year. The lowest decile of EBIT/EV returned 8% this year, lagging the S&P 500 by 10%. The last time that EBIT/EV exhibited this level of underperformance was in 1999 when it lagged the index by 12%.

The parallel with 1999 could be an excellent thing. After 1999, from 2000-2003, value stocks went on to experience a substantial bull market while the indexes declined. The outperformance of value was significant during that time period:

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Will value investors be as lucky as they were during the 2000-2003 period? I hope so. A more likely scenario would be that value will go down in the next bear market with everything else, then recover nicely. There is no way to know for sure, which is why I will simply stick to the discipline at all times.

While there are psychological underpinnings to the current environment, it is also driven by the perverse nature of indexing. Index funds pile more money into the best-performing stocks of the index. As a stock goes up, the index fund buys more of it. As a stock goes down, the index fund sells it.

When investors look at the recent returns for index funds, they pour money into them. The index funds then go out and buy based on market cap, giving momentum to the companies with the highest recent market cap gains. When money is pouring into index funds, it fuels momentum in the top performing large-cap stocks. This happened in the late ‘90s, and it is happening again.

The best performers of a bull market are rewarded even more because of the money being pumped into index funds. Companies like Amazon, Apple, Google, Netflix, and Tesla expand their market caps. In the ‘90s bull market, it was Microsoft, Oracle, Intel, Cisco and General Electric. They did well throughout the bull market and then experienced a manic frenzy at the very end.

The critical thing to realize about these moments is that they’re not caused by any change in the fundamentals. They are caused solely by money pouring into index funds, which rewards large market capitalization stocks with price momentum and punishes underperforming stocks further.

I have no idea when the current environment will end. I just know that it will end eventually. This might be 1999. It might also be 1996, and this thing might just be getting started.

What I try to do is take a long-term perspective: I am invested in stocks purchased at attractive valuations with safe balance sheets. It is unpredictable what years will deliver the returns, but I am confident that over the long run I should be able to beat the market if I stick to this approach.

Value investing is pain. Value investors don’t earn their return when the strategy is working. They earn the return by enduring the pain when it isn’t working. The pain is how we make our return. If this were easy, everyone would do it, and these bargains would disappear. There isn’t a way to time it. We have to consistently maintain our discipline and buy with a margin of safety. We have to avoid fads. We have to stay away from what’s cool. We have to maintain the discipline. The concepts of value investing are simple. Sticking to those concepts through thick and thin is not. It’s simple, but it’s certainly not easy.

Mistakes & Goofs

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All of my underperformance isn’t attributable to the underperformance of value investing, though. I made specific mistakes and blunders this year which caused a good portion of my underperformance.

I made many mistakes in the last year. I think errors are fine, as long as you learn from them. Below are my biggest mistakes of the year. I learned the following lessons from all of them: (1) Do more homework, (2) Revisit the thesis when the company posts an operating loss, (3) Stay away from asset managers, (4) Don’t panic. Let Mr. Market do that.

Cato Corp (CATO)

CATO was a retail stock I purchased for an attractive valuation and dividend yield. I bought it for the same reason I bought my other retail stocks: I think sentiment against the industry is too negative. However, CATO was in a state of fundamental deterioration when I purchased it. The first time that the company posted an operating loss in January, I should have exited the position.

Lesson learned: when a company you own posts a loss in operating income, revisit the thesis. Going forward, if a company shows such apparent signs of a deterioration in the fundamentals, I think I should admit that I was wrong in my analysis and get out.

I lost 51% on my position in CATO.

Manning & Napier (MN)

Manning & Napier is a small asset manager. I bought it because the valuation was low and I thought that sentiment against asset managers was too negative.

I learned two lessons from this stock: (1) I should do more homework and (2) I shouldn’t mess around with asset managers because they are difficult to value.

If I did more homework, I would have seen that their assets under management were in a state of decline even when things were rosy for other asset managers and that their strategies underperformed all of their respective benchmarks.

I lost 51.56% on Manning & Napier.

United Insurance Holdings (UIHC) & Federated National Holdings (FNHC)

These weren’t mistakes because I bought them, they were mistakes because of the circumstances that I sold them. I purchased both Florida-based insurance companies because they were cheap in the wake of Hurricane Matthew and were well run.

I reacted emotionally when Hurricane Irma was barrelling towards Florida and sold both in a panic. If I just stayed put, it would have worked out fine. While they plunged substantially more after I sold them, they later recovered quickly from the depths of the decline and are now higher than when I sold them.

Lesson learned: don’t panic. Also, don’t buy more than 1 insurance company in Florida!

I lost 3.8% on UIHC and 23.36% on FNHC.

IDT Corp (IDT)

IDT was purchased because of the low P/E and low financial debt. Like CATO, IDT gave me an obvious warning sign that I was about to lose money: it posted an operating loss in the spring. I should have paid closer attention to the deterioration in fundamentals and exited the position.

My sale of IDT was pure luck. I exited on December 1st to begin my rebalance and was lucky enough to get out at one of the more attractive prices this year after the spring meltdown. I managed to exit losing 21.44%. A few days later, the stock plunged another 32%.

Lesson learned (same as CATO): when a company that you own posts an operating loss then it’s time to revisit the thesis.

US Market Valuations

We’re currently at a CAPE ratio of 32.56. Japan was around a similar valuation in 1985 when the Plaza accords were signed. Returns a decade out were predictably low, but that didn’t stop the Japanese market from stampeding to a CAPE of 100 by the end of the ‘80s. The same thing could happen to the US market. There is no way of knowing.

I don’t pretend to know what will happen in the upcoming year, but I do look at macro indicators to identify what we can expect over the long term (10 years from now) in the United States. I hope to earn a premium over the market return, but the market return will act as the force of gravity on my own gains. For that reason, I pay close attention to it.

My favorite metric of market valuation is the average investor allocation to equities. With the most recent data, that figure currently stands at 42.82%. Plugging this into my formula (Expected 10-year rate of return = (-.8 * Average Equity Allocation)+37.5), I get an expected 10-year return of 3.24%.

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3.24% isn’t particularly exciting, but it’s not the end of the world either. It is a premium to the current 10-year yield, which is currently at 2.41%. The road to those returns is unknowable, but if history is any guide, it will not be 3.24% in a straight and orderly line. Within the next 10 years, there are going to be both screaming bull markets and savage bear markets. Through it all, a 3-4% return is the likely outcome.

Market returns are going to be low over the next decade, but not negative. Investors are likely to be disappointed in their future profits. With that said, it’s also not a Mad Max end of Western civilization scenario.

Recession Risk

As for the US economy, the current risk of a recession is low. If the market turns in 2018, I don’t think it will be driven by a recession or a problem brewing from within the economy. It may be caused by valuations just coming back to normal. In 2000, high flying stocks didn’t come back down to Earth because of a recession. People just realized that the prices were nuts. It just happened. Oddly, the decline in stocks likely caused the recession of 2001. Most of the time, this happens the other way around. Macro trouble brings stocks back down to Earth.

I think recession risk is low because the Federal Reserve is still accommodative and the balance sheets of households and businesses are still in good shape. Of course, wild things could happen like a war against North Korea or oil spiking to an insane level due to a revolution in Saudi Arabia. With that said, a recession is unlikely to occur naturally.

The Federal Reserve is both the cause and cure of nearly every U.S. recession, whether we like it or not. As they tighten monetary policy, they restrict cash flows for households and businesses. Ultimately, this causes households and businesses to limit spending, causing a recession. The Fed then loosens monetary policy until businesses and households begin borrowing and spending again. Cycle repeats.

A useful metric of the current household cash flow situation is household debt service payments as a percentage of disposable income.  Currently, this remains at a very low level of 9.91%. This implies that households are not going to restrict cash flows as a result of Fed tightening. Fed tightening isn’t having much of an impact (yet) because rates are low and most households cleaned up their balance sheets after the financial crisis. The same is true of the debt/equity ratio for the S&P 500. Firms haven’t gotten crazy with leverage in the current cycle after getting burned so badly last time.

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Households aren’t stretched

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Corporate leverage also looks healthy

The yield curve is another excellent indicator of the current state of monetary policy. The best metric to measure this is the difference between the 10 and 2-year treasury yield. It’s still positive, implying that the Fed still has more room to tighten rates without triggering a recession. In other words, monetary policy is still accommodative.

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The yield curve has not yet inverted. Monetary policy is still accommodative.

With households and company cash flows in good shape (because of low leverage) and an accommodative monetary policy, the risk of a recession is very low.

My US macro view: (1) Returns are going to be low over the next 10 years because stocks are expensive, but equities will still return a premium over bonds. However, a 3.24% rate of return is significantly below the expectations of most investors.  (2) The risk of a recession is low because the current round of Fed tightening isn’t restrictive enough to cause businesses and firms to restrict their spending.

The 2018 Portfolio

For analysis of each company stock that I own, you can read my analysis here. A breakdown of my portfolio is below.

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I currently own (1) a small piece of a net-net (Pendrell), (2) a spin-off at an attractive enterprise multiple (MSGN), (3) multiple companies in assorted industries with low valuations and safe balance sheets, (4) multiple retail stocks with low P/E’s and debt/equity ratios and (5) two very cheap airlines (Alaska & Hawaiian Air).

I also set aside 20% of my portfolio to put into country indexes with low Shiller P/E’s. I did this because it allowed for some international diversification in a manner consistent with a value framework and it reduces my exposure to retail. If I were to fill my portfolio with all the cheap stocks in the United States right now, my portfolio would be 60-80% in retail stocks. I decided to cap this at 30%. Currently, 28% of my portfolio is invested in the retail sector.

If these retail stocks are cut in half, I will lose 14% of my portfolio. That is a loss that I can deal with. If I were 60-80% in the retail sector, then a 50% drawdown in retail would take my portfolio down by 30-40%. That is a more difficult event to recover from.

In a value-oriented portfolio, you have to go where the bargains are. For the last couple of years that has been the retail sector and everyone knows why: Amazon. I think the retail sector is undervalued and that the current narrative is overblown. In 2018, we’ll see how that works out.

My concentration in the retail sector is not merely for the bargains, but also my belief that a recession is unlikely in the upcoming year. The economy is strong even though our markets are expensive and poised for disappointing gains in the future. If the yield curve were inverted and consumers looked stretched, I would have a different outlook.

My outlook for the US economy is also why I am comfortable investing in Kelly Services, a staffing company with low valuation metrics that will benefit from the tight labor market.

The full portfolio breakdown is below:

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Of course, all of this is speculation. That is why the margin of safety is the paramount concern when I make a purchase. Even if I’m wrong, I at least purchased at an attractive valuation. I buy stocks that post multiple low valuation metrics: low P/E’s, low enterprise multiples, low price/sales. I also like stocks with little debt as measured by debt/equity and debt/EBITDA. This is very similar to the strategy outlined by Benjamin Graham in the 1970s. Even if I’m wrong about the US economy, I am systematically buying cheap stocks with clean balance sheets, which should perform well over the long run.

Investing vs. Speculation

Bull markets dull the senses. Years of high returns with few drawdowns make people forget what the pain of losing money is like. They become more confident. They become more greedy.

As value investors, one of our key responsibilities is to not get swept up in the mania. We have to keep our wits about us. One of the key things to keep in mind is the difference between investing and speculation.

Graham defined the difference as follows: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

In other words, an investment is something for which you can calculate a margin of safety. Your margin of safety might be wrong. There are undoubtedly many ways to determine if you have a margin of safety. There are value investors who focus on assets. There are some who look at earnings based ratios. There are others who perform discounted cash flow analysis. Some take a relative valuation standpoint. Others try to purchase growth at a reasonable price.

“Value investing” is a big tent and there isn’t one right approach or one true faith, but the important concept is: value investors are trying to figure out what something is worth and they are trying to pay less for it. They might be wrong in their analysis, but at least there is logic to it.

Speculation, in contrast, is when you can’t calculate a margin of safety and buy it anyway. Speculation is looking at a chart. Speculation is looking at recent price action and getting excited about it. Speculation is listening to a hot stock tip and buying it without doing any homework on your own. Speculation is buying something for which you can’t calculate a margin of safety and don’t understand.

With that said, you can’t be a speculator and a value investor at the same time. A value investor is a person for whom the margin of safety is the paramount concern in investing. Value investing isn’t a series of techniques and statistical abstractions: it is a way of thinking about the world.

The 21st-century term for speculation is FOMO. Fear of missing out. For a value investor, that’s the emotion that we need to continually keep in check and resist. Resisting FOMO may keep us out of “multi-baggers,” “compounders.” Investing is methodical and boring. Speculation is exciting. It may make us describe our returns in percentages and not “x.” It will also keep us from suffering permanent losses of capital. You can’t compound from zero.

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A reminder from Highlander: avoid permanent losses of capital.

One of the peculiar things about value investing is that the secret has been out since Benjamin Graham wrote “Security Analysis” in 1934. You would think that value investing would have been arbitraged away by now. You would think that it would be in the dustbin of history. The reason that hasn’t happened is because value investing goes against human nature. Most people are speculators. They are enticed by price action, they feel FOMO. People are never going to change, and that’s why Benjamin Graham’s lessons are timeless.

Only a select few are immune to this impulse. They’re the kind of people who look at a mania and think “this is BS.” They’re the kind of people who get excited when they buy a $50 pair of shoes for $25. They’re people who don’t look at value investing as some kind of statistical trick or academic exercise: it’s in their blood. It’s a way of thinking about the world. It’s a way of thinking that runs contrary to much of human nature. That’s why it continues to endure.

Before you make a purchase, think about it through this lens. Am I buying something for which I can calculate a margin of safety? Do I have a margin of safety? If the answer to both questions is “no” then you’re speculating, not investing.

There are certainly wealthy speculators, but they’re the exception. Speculation doesn’t work out too well for most of us. Speculation is buying something based on a chart, based on hype, based on a story. Success in investing requires us to avoid these impulses entirely.

Value investing isn’t low P/E, low price/sales, the magic formula, net current asset value, or low EV/EBIT. Value investing is a way of looking at the world rationally and not allowing ourselves to be swept up in the emotional impulse to speculate. This is an important thing to keep in mind in these frothy, speculative times.

The Blog

The year wasn’t entirely filled with folly. Concerning achievements, I’m most proud that I finally took the plunge and started this blog.

I’ve struggled with the itch to pursue active value investing for most of my adult life and lacked either the money or the courage to do so. The blog has been a real-time chronicle of my journey as a value investor. It also helps me stay accountable.

This year, I think my biggest achievement was finally pulling the trigger and doing this after thinking about it for so long.

Looking back at my posts, I am happy I did this. It is nice to look back and see my views in real time. It’s fun to share what I’m reading and thinking with others.

The blog is useful. It’s comfortable with the benefit of hindsight to look back and try to frame what I thought in the past. Putting down my thoughts on a blog makes it impossible to do that. It makes me more accountable for my decisions. I can look back and see why I did something and what my thought process was at the time. Hopefully, I can stick to it. I think it will help me become a better investor. I encourage others to do the same thing. Even if you don’t do it publicly, keep a journal and keep track of your decisions. Revisiting those decisions and your process will help improve your skills as an investor in the future.

I appreciate all of the feedback and am somewhat surprised that I actually have readers! Hopefully, you can all learn from my mistakes and goofs. Keep reading: you can learn about the markets on my dime!

To all of you, have a very happy, healthy and prosperous New Year!

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

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