FAF

First American Financial (FAF) is near its 52-week high (and the price the last time I sold it). It’s significantly above the single-digit P/E in December and is now up to a P/E of 13.74. I sold 46 shares @ $56.68 for a gain of 30%.

First American Financial is a great company and I will definitely be interested again if the price gets absurd again.

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.

Is diversification for idiots?

bunny

Concentration is cool

Value investors are prone to make outsized bets on single stocks or have extremely concentrated portfolios.

Mark Cuban has a more blunt view of diversification:

“Diversification is for idiots.”

Warren Buffett, the master himself, made many concentrated bets throughout his investing career. The most famous example is American Express during his partnership days. After the salad oil scandal in the 1960s, American Express stock plunged. Most investors thought the salad oil scandal would put American Express out of business and the stock fell.

Buffett realized that American Express would survive and knew it was a fantastic franchise. He moved an astonishing 40% of the partnership’s assets into American Express, sending the partnership’s returns from great to extraordinary. Buffett would repeatedly make concentrated bets throughout his career when he had conviction. He took on significant, concentrated positions in companies like GEICO and Coca Cola.

Buffett had this to say about diversification:

“Diversification is protection against ignorance. It makes little sense if you know what you are doing.”

Munger has this to say:

“The whole idea of diversification when you’re looking for excellence is totally ridiculous. It doesn’t work. It gives you an impossible task.”

Because value investing has come to mean whatever Warren Buffett and Charlie Munger say it is supposed to mean, most value investors take their advice to heart and make big, courageous, outsize bets on their “best” ideas.

The Other Side of Concentration

Concentration is cool until it is not. Legends like Bill Ackman built up early, stunning returns by concentrating on their absolute best ideas. This worked well until Ackman’s best ideas were Valeant and shorting Herbalife.

Concentration worked out well for Joel Greenblatt, whose early hedge fund used extremely concentrated portfolios of spin offs and special situations to deliver stunning returns.

Ben Graham recommended holding 30 stocks and believed this would provide adequate diversification. The eggheads in academia actually agree with him on this point, and most the research shows that an ideal portfolio is around 20-30 stocks.

Other successful value investors who are more in the Graham state of mind also have diversified portfolios. Walter Schloss owned over 100 stocks. Seth Klarman currently has 35 holdings. Irving Kahn also stuck to Graham’s advice and owned 20-30 positions at any given time.

The Evidence

For me, I’m more interested in the evidence of what works so I conducted backtests on a value portfolio in an effort to identify the ideal number of holdings. I backtested the returns and characteristics on a simple EV/EBIT portfolio. I began with the insane portfolio of buying the single cheapest stock in the S&P 1500. I then added the next cheapest, creating portfolios ranging from 1 stock to 30 to determine the ideal size.

This is pulled from an S&P 1500 universe, the backtests are conducted since 2005, and the portfolios are rebalanced annually.

Returns

The return characteristics of different portfolio sizes are all over the place, but they all beat the market over the long run. Strangely, they start out high, bottom out around a dozen stocks, and then start to improve.

portfoliosize

Volatility

I don’t think volatility is risk. I believe risk is the probability of losing money permanently. However, I also believe that volatility accurately measures how big a container of Tums that you should have at your desk.

I also don’t think a Sharpe ratio is the accurate representation of how decent a portfolio is.

With that said, here are the results:

standarddeviation

sharpe

In terms of volatility, most of the benefits come from the first dozen positions. However, in the context of EV/EBIT, the Sharpe ratio tends to max out around 25 positions.

Maximum Drawdown

My view of risk is less about volatility and more preventing blowups that will permanently impair my capital.

The bigger the blowup, the harder it will be to recover from it. In mathematical terms, large drawdowns are increasingly more difficult to recover from.

drawdowns

The deeper the drawdown, the bigger that the bounceback needs to be. Once the drawdown exceeds 50%, it becomes nearly impossible to recover from. Drawdowns of the 80% magnitude are almost certainly fatal to investment results. Common sense tells us that concentration will lead to years where returns are remarkable and that this will likely be balanced out by deep and painful drawdowns later on. The evidence backs this up.

maxdrawdowns

Concentrated portfolios are prone to some genuinely epic drawdowns. For the insane 1-stock portfolio, the maximum drawdown was 90%. Over the long run, the 1-stock cheap portfolio delivers a return similar to all of the others, but you will likely jump out of a window or develop a drug problem before you can actually enjoy those returns.

It appears that the first 15 positions can at least get the portfolio down to the market’s maximum drawdown.

Summary

  • Most EV/EBIT portfolio sizes beat the market, from the ultra-concentrated to 30 or more stocks.
  • In terms of reducing volatility, the first dozen stocks provide most of the benefits of diversification.
  • It takes at least 15 stocks to reduce the odds of a portfolio blowup that will exceed the maximum drawdown of the S&P 500.
  • Sharpe ratios tend to be maximized in a value portfolio around 25 positions.
  • Diversification is not for idiots.
  • Ben Graham was right (as usual), and the ideal portfolio size is somewhere around 20-30 positions.

Random

“Killing Eve” is a great show.

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.

CD’s & Cash

bank

After the run-up in the market, there are no longer a lot of bargains.

I also think a recession is coming in the next couple of years, so I don’t want to take on unnecessary risk and would like to gradually unwind. I want to have plenty of cash to take advantage of the next downturn.

Additionally, looking at some of the mistakes in my portfolio, I noticed that they all happened when I bought subpar stocks just to stay 100% fully invested. Looking back on it, I would have been better off if I only purchased the bargains I felt were compelling, as I did with the stocks purchased in December 2018. I would have been better off if I held more cash and only bought when I had more conviction.

Thinking about all of this, I turned to the writings of Seth Klarman for advice. I think he nailed it with these quotes about this topic:

“Our willingness to hold cash at times when great opportunities are scarce allows us to take advantage of opportunity amidst the turmoil that could handcuff a competitor who is always fully invested.”

“It wouldn’t be overstating the case to say that investors face a crisis of low returns: less than they want or expect, and less than many of them need. Investors must choose between two alternatives. One is to hold stocks and bonds at the historically high prices that prevail in today’s markets, locking in what would traditionally have been sub-par returns. If prices never drop, causing returns to revert to more normal levels, this will have been the right decision. However, if prices decline, raising prospective returns on securities, investors will experience potentially substantial mark to market losses, thereby faring considerably worse than if they had been more patient.”

So, I moved $1,992.16 into short-term CD’s that mature in December with a 2%+ yield to maturity. The mid-December maturity coincides with my standard portfolio rebalance. Hopefully, at that point, more bargains will be available.

I considered moving towards a long-term bond ETF, but that is an outright speculative bet that a recession will happen. I think a recession is a likely outcome in the next 1-2 years, but I do not think I should make an outright speculative bet on that outcome.

For now, I will stick to the traditional value investing strategy. When I can’t find a new bargain, I will hold cash and cash instruments like CD’s and short term bonds. I will resist the impulse to stay fully invested at all times.

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.

Hooker Furniture (HOFT)

couch

Key Statistics

Enterprise Value = $358.61 million

Operating Income = $49.48 million

EV/Operating Income = 7.24x

Price/Revenue = .53x

Earnings Yield = 10%

Debt/Equity = 15%

The Company

Hooker Furniture is a Virginia-based furniture company that has been in business since 1924. They own multiple brands. Their line of Hooker branded furniture includes items for home entertainment, home office, accent, dining, and bedroom. They also own an upholstery segment and acquired the Home Meridian brand in 2016.

Hooker primarilly sells their furniture to other retailers without the burden of a massive physical brick and mortar footprint. They sell their furniture primarily to independent furniture stores, department stores, warehouse clubs, and e-commerce retailers. Their furniture is featured prominently on Wayfair, for instance.

The stock has been punished since last fall due mainly due to macro moves in the broader market that aren’t showing up in the actual operating results of the company.

My Take

Hooker Furniture is a business with a bright long term future. I really like the fact that they don’t have a big physical brick and mortar footprint. This keeps them versatile as brick-and-mortar stores face pressure due to mounting threats from e-commerce. As furniture demand dries up in the stores, they should be able to quickly replace that demand with more sales to online businesses.

Hooker Furniture also has a solid long term track record. They never suffered a loss during the Great Recession, and have grown steadily through every year of the expansion. Their acquisition of Home Meridian is a smart move and was completed while maintaining a conservative balance sheet. The company earned $2.42/share last year, which compares to a $.80/share 5 years ago.

The risk is that this is a cyclical business. The yield curve just inverted and we are likely to have a recession in the next two years if past history is any guide. Despite this risk, when I saw this company show up in a few of my stock screens, I couldn’t resist it when I did more research. At current multiples, it’s too compelling of a bargain to pass up. It’s indeed an excellent company at a bargain price.

From a relative valuation standpoint, Hooker’s current P/E of 10.40 compares to a 5-year average of 17. The current P/E is also significantly below the P/E of competitors in the industry, such as Flexsteel, which trades at a P/E of 24. Another competitor would be Basset Furniture, which currently trades at a P/E of 19. An increase in P/E to the 5-year average would be a 63% increase from current levels. A P/E of 15 seems right for a steadily growing, well run, conservatively financed, and versatile company like Hooker furniture.  HOFT also trades at 53% of sales, which compares to an industry average of 72%. On an enterprise multiple basis, Hooker’s current 7.24x multiple compares to a 5-year average of 10.67. An increase to this level would be a 47% increase from current levels.

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.