Another quarter, more underperformance.
Value investing continues to underperform, and I continue to make mistakes. Regarding value’s underperformance, YTD to the 50 cheapest stocks in the S&P 500 has returned 3.62%. The 50 most expensive have delivered a 17.95% YTD return, outperforming the S&P 500.
I believe this will end, but I have no idea of when or how this will happen. The current cycle has looked like 1999 to me for nearly three years. I always suspect we’re close to that magical March 2000 moment, but it never seems to happen and expensive stocks continue to rip.
It looks like we’re late in the bull market to me, but no one really knows. There are no clocks on the walls, and everyone is flying blind, despite their assertive declarations to the contrary.
The only thing that I can do is continue to pursue my strategy: cheap stocks, good balance sheets, high probability of mean revision.
As for my mistakes, the biggest one appears to be abandoning my strategy a year ago for 20% of my portfolio and buying a bunch of international indexes that wound up vaporizing my money. The meltdown in Turkey caused me to wise up (or capitulate, depending on your perspective) and get back to the basics – buying individual value-oriented U.S. stocks.
This quarter, I sold all of my international indexes and bought specific U.S. stocks that I thought were undervalued. I was also paid out for my shares of the net-cash situation Pendrell. I reached a one year birthday on my position in Foot Locker and re-evaluated the position. The stock has been fantastic to me, and I’ve taken many of my gains off the table as it ran up over the last year. Evaluating the position on its birthday, it looked much more expensive than when I bought it a year ago, so I exited the position. I still think it’s a reliable company, but it is too rich for my tastes.
With the money from these sales and portfolio events, I purchased the below positions. Each position is linked to a blog post in which I outlined my reasons for buying it.
Of these buys, I am most excited about Micron, which strikes me as absurdly cheap. It is, in fact, the cheapest stock on an EV/EBIT basis in the entire S&P 500.
Overall, I still think Argan is the most compelling bargain in my portfolio, and the thesis continues to pan out.
Goodbye, Cruel World
I initially pursued my international strategy for two reasons: (1) In Q4 2017, about 60% of the cheap stocks I was screening were in the retail sector, and I didn’t want to have that level of concentration in one industry. (2) The US valuations look terrifying to me, so I thought an excellent way to diversify would be to buy cheaper foreign markets.
So what happened?
Many of the cheap retail stocks I didn’t buy went on to perform magnificently. Here are a few picks I didn’t invest in because I had 20% of my portfolio devoted to international indexes:
Williams & Sonoma (up 32% YTD)
Best Buy (up 16%)
DSW (up 31.26%)
I ignored my thesis about the retail sector (that the popular “Amazon eats the world” hypothesis was wrong, and retail valuations were unusually cheap) and pursued another strategy that wound up falling apart.
Experience the carnage:
Nearly every one of them declined, due to a combination of weakness in those markets and strength in the US dollar. I lost $1,090.30 overall on the experiment, which is 2% of my portfolio. Meanwhile, the stocks that I otherwise would have invested in did better.
I abandoned my strategy and underperformed as a result.
With all of this said, I still think that low CAPE ratio international indexing is a viable option that will outperform in the future. I also know it’s not for me. I need to understand my investments. I don’t know anything about the monetary policy or political situation of Turkey or Russia. I don’t know anything about foreign currency speculation. In short, I don’t know enough about the positions to stick with them when times get tough, as they are right now.
I also bought these indexes for all of the wrong reasons. Mainly, I am freaked out by the valuations of US stocks and thought this would be a way to diversify away from the risk of US overvaluation. The truth is, with the US comprising over 50% of the global market cap, when the US pukes, everything else is going to go down with it. There won’t be a place to hide, even among cheap international markets. And that’s what I’m terrified of — I’m not concerned about a gradual underperformance of the U.S. versus the world, I’m worried about the markets puking in a 2008 style event. Aside from hedging strategies, there isn’t much way to avoid this inevitable pain.
Should I just shut up and buy the damn screen?
I tweeted this back in April, and I think it’s true:
For my stock selection, I need to understand the companies to remain invested in them. I know if a sell-off is related to an actual problem (i.e., the woes of my sold Francesca position) or if it’s pure market noise (i.e., volatility in Argan). My understanding of the companies helps me stick with the strategy. Research helps me behaviorally.
Behavioral folly is also the reason I don’t go full quant even though I am very quantitative in my approach. I start with a screen of cheap stocks, research the output of the filter, and try to identify the opportunities which I think are best.
This approach has flaws due to the “broken leg” problem. One of the best examples of this is Joel Greenblatt’s brokerage service that was designed to help people implement the magic formula strategy. Greenblatt established a brokerage firm that would automatically invest in the magic formula for clients. Some clients automated the magic formula stock selection, while others chose from the list. The clients who picked their stocks from the magic formula list underperformed. Those who purchased the screen outperformed the market. Joel Greenblatt explains it here.
Why did this happen? In short, investors avoided the scariest looking stocks, which were the ones that provided the best returns. I don’t think this phenomenon only applies to amateur investors. I think it’s the main reason that many value investors underperform simple quantitative “cheap” strategies. You’ll often hear of exceptional value investors outperforming the stock market, but they often underperform the lowest deciles of cheap. They underperform simple metrics of cheap because, to avoid value traps, they often pass over the best opportunities in the market because of how terrifying they appear.
The evidence indeed suggests that I should go “full quant” and buy the damn screen. The reason I don’t do this is that I don’t feel that I would be able to stick with a “full quant” strategy. I want to understand what I invest in so I can stick with the plan through thick and thin.
The low CAPE strategy is a quant strategy as is merely buying cheap stocks. I recognize the compelling logic of a full quant approach, but I can’t fully embrace it because I want to understand the companies themselves. It might worsen my results over the long run, but at least I’ll be able to stick with it.
I set out on this blog to pick stocks within the low P/E, low debt/equity 1970s Graham framework. That’s what I’m going to stick to despite the temptations to abandon it. I am not knocking the low CAPE index approach, the magic formula, or the Acquirer’s multiple strategies. I just don’t think I’d be able to stick with a purely quantitative approach if it ever turned against me.
This is hilarious. “He just wanted to spend time with his family . . . and his robot. Like a normal guy.”
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