My streak of underperformance continues. I have no idea when it will end. All I know is: you can’t time this stuff. You just have to stick to it. Over time, markets reward disciplined rules-based value-oriented approaches. I think Cliff Assness put it best when he said in a recent interview that you should “find something you believe in and stick to it like grim death”. I believe in this stuff. It’s logical, time-tested, battle-tested. I’m not going to abandon it because of underperformance.
Value tends to do best coming out of a recession. If I had to guess, I won’t really see any outperformance until we see another recession and the recovery from it. That’s going to take anywhere from 5 to 10 years. Of course, that’s not how things worked out in 2000. The outperformance of value actually started before the recession. There simply isn’t any way to know or time it. I just have to stick to it.
This is my key advantage as a small investor. A professional enduring my underperformance would be in serious trouble with their investors. In an effort to keep their job, they would start to buy more popular positions. They would start to hug the indexes. They wouldn’t be able to ride something like this out and be cool with it. This is why most professionals underperform.
What’s my edge? I don’t have an informational edge. The only edge that I have is behavioral, which is something most professional investors can’t afford to have. I can handle the stench and dive into the dumpster. I can ride out the underperformance. If I can’t, then I might as well put this IRA into an index fund.
In short, I have to stick to it like grim death.
After staying put for the first quarter, I did much more trading this quarter. You can read a list of all of the trades here. I’m trying to stick to some concrete, easily identified sell rules. Those rules are:
- I can sell on an operational slip. For me, that is an operational loss. When I’m buying a stock on the basis of EV/EBIT, what is the position worth if EBIT begins to fall apart?
- I can sell if I held the stock for at least a year.
- I can sell as part of an annual rebalancing or a price increase of more than 50%.
For the operational slip rule, this was a result of the lessons I learned from my positions in IDT, Manning & Napier, and Cato Corp in 2017. All gave me early warning signs of a problem in the form of a decline in operating income and I ignored it.
Selling is one of the hardest elements of deep value investing. You can go with a very simplistic system such as Greenblatt’s magic formula, in which he recommended holding a stock for a year and then selling it unless it was still undervalued. Graham recommended selling after a 50% gain or after holding for two years.
My method is a combination of the two along with an element of downside protection by getting out of positions in businesses that post operating losses.
A deep value portfolio is going to be a high turnover portfolio. I am not buying stocks of companies with deep moats and high returns on invested capital. These are companies with problems that are causing an undervaluation. My goal is to buy when sentiment is poor and sell when sentiment has improved. I also sell when the fundamentals deteriorate. This is a major reason that the account I decided to track on this blog was the IRA, so I wouldn’t have to worry about tax considerations.
My sell rules aren’t perfect. My sale of Francesca’s, for instance, is looking like a mistake. Even though it will result in mistakes, I think sticking to it will help to cut off the bleeding in the worst positions. I will probably add to the rules over time as my experience grows.
Many investors hate rules. I love them. Rules keep me honest. Rules keep me out of trouble. There are thousands of investment ideas. It’s important to have strict guidelines or it will be easier to do dumb stuff. Guidelines and rules keep me honest. They keep me from straying from a tried and true path.
After selling for various reasons (price pops, operational slips, etc.), I bought a number of positions in the past quarter. They are all listed below. I also included links to my brief write-ups on each position, explaining why I found the idea attractive.
They check all of my boxes: (1) statistically cheap, (2) clean balance sheet, (3) poor sentiment, (4) potential for improvement.
I’m fully invested, which makes me nervous when U.S. stocks are as expensive as they are. I’m trying as hard as possible to ignore macro stuff and stick to buying undervalued stocks.
Now I’ll proceed to look at it anyway.
For US stocks, the average investor allocation to equities stood at 42.82% at the end of Q1 based on the latest data. That’s a slight improvement from 43.63% at the end of Q4 2017. This suggests a 3.2% rate of return from US stocks over the next 10 years. This is the same as than the 10-year treasury yield (3.2%) but much less than the current yield on AAA corporate bonds (4%).
Bottom line, the market is expensive. That should be news to no one. That doesn’t mean it’s going to crash. That doesn’t mean we’re going into another Depression. It means they’re expensive and returns are going to be fairly low over the next ten years. The road to those returns is unknowable.
Expensive markets don’t crash just because they’re expensive. Usually, there is an event that triggers the sell-off. Usually, the event is a recession. I think about rich valuations in the sense of “the bigger they are, the harder they fall”. To fall, you still need something to push you.
The most common cause of a recession is the Fed tightening too much, which is why the yield curve is a useful indicator. The 2 year vs 10-year yield curve still hasn’t inverted, implying that a recession is not imminent. We’re likely entering a very juicy stage of the business cycle (think 1969, 1989, 1999, 2006).
There also hasn’t been an uptick in unemployment, another indicator that a recession is about to begin. Unemployment continues to drop. With a tight labor market, some employers are experiencing inflationary pressures (Eric Cinnamond mentioned others on “the investor’s podcast”). This suggests to me that the Fed won’t stop tightening and at some point, they’re going to push the yield curve into an inversion and trigger a recession.
Nonetheless, the fact that I don’t expect a recession in the next year makes me comfortable with the fact that I’m fully invested and have positions in some deeply cyclical industries. The market could easily crash 20%, but I don’t think we’re going to see a really nasty recession that would trigger a 50% drawdown in the next year.
1. I saw “Solo” and didn’t understand the criticism of it. It was fun and it checked off on all the fan boxes: we saw how Han met Chewie, how Han obtained the Millennium Falcon, etc. We even saw the Kessel Run! It was certainly better than “The Last Jedi”. My suggestion is to not listen to the haters and see it.
2. I hope Gamestop gets bought out. This has been one of my long-suffering positions and there are signs on the horizon that the situation is improving.
3. Argan is the position I am most excited about. It certainly seems like a “no-brainer” at this valuation and considering the quality of the company. Still, I’m trying to keep an equally weighted 20 stock portfolio and I am not taking a position that is too concentrated. We’ll see if I come to regret that.
5. My day job has been pretty hectic this quarter but it seems to all be working out. I work in operations for a bank. I was promoted last December to a section manager role and faced an internal audit and headcount exodus right after getting the job. I was able to hire new people who are working out well and I received news this week that I passed our internal audit, which was a relief. I hope the rest of the year is a smoother ride now that those hurdles are gone.
6. My personal highlight of the last quarter was taking a week off of work, going to the beach, and spending my time reading “Margin of Safety” by Seth Klarman. Good times.
7. I also caught a couple of really good under-the-radar movies. Thoroughbreds was a really twisted tale that you should check out. It was unlike anything I’ve ever seen before (American Psycho for rich entitled high schoolers?) Just don’t expect to feel good about human nature when it’s all over. I also really dug Lady Bird, a funny movie about a high school senior in 2002 plotting to get out of Sacramento and go to college. That was actually a feel-good movie. I recommend it!
8. Deutsche Bank really worries me. The bank looks like it is in a slow-motion collapse. It’s one of the biggest banks in the world and I don’t know how the global economy would handle it if the bank fell apart.
9. I’ve really been enjoying the Focused Compounding podcast with Geoff Gannon and Andrew Kuhn. They avoid a lot of the trendy topics that are geared towards big investors that seem to dominate the podcast landscape these days (sorry guys, I don’t care about venture capital or angel investing because I’ll never be able to do it and I think most of them are lucky gamblers anyway). They focus on individual stocks and situations that small investors can take advantage of. This one and “The Investor’s Podcast” are my go-to’s. I look forward to listening to them whenever they pop up in my feed.
10. Politics is nauseating and it is getting worse. When I was in my 20s, I loved politics. I was a news and political junkie. That hasn’t been the case for most of the last decade. It’s becoming increasingly impossible for people to empathize with the opinions of others. This is very apparent on Twitter and I follow people on both sides of the aisle. Everyone thinks the other side isn’t just wrong, they’re evil and need to be destroyed. All of this anger and vitriol isn’t good for people’s state of mind. Both sides have a mob mentality. I don’t know how we’re going to snap out of it. To paraphrase Charlie Munger, ideology is turning our brains into mush.
11. Last, but not least, Captain Kirk’s finest hour.
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.