Mistakes Have Been Made & Lessons Have Been Learned

I’ve been writing this blog for almost 4 years. I’ve learned a lot in that time. I have learned much more than I probably learned in the previous 20 years of following markets.

Writing about investing and talking to people about investing have helped me tremendously.

Some of the key things I’ve learned:

I Can’t Predict Macro

Anyone following this blog knows that I tried really hard to predict the macroeconomy.

This was important to me because I knew that value would outperform from the bottom of an economic cycle. I overestimated my ability to do this. The COVID meltdown and recovery (unemployment has gone down to 8%, which I couldn’t have imagined in April) makes me question my ability to predict this stuff.

What looked easy to predict looking back on history isn’t so easy in reality.

I spent three years waiting for the great crash to come that I thought was inevitable. When the yield curve inverted, I thought it was a fat pitch. CAPE at all time highs, a recession on the horizon – we’re going to have at least a 50% decline like 2000-03 or 1973-74.

The thing is, every cycle is different. I can study history, but the notion that I can predict things based on my study of history is a fool’s errand.

I should have ignored all that. I should have looked at high quality companies trading for dumb multiples in March and bought them. It doesn’t matter what the CAPE ratio is. What matters is what *I* own, not what’s in the index and how crazy it is. I should have listened to the advice of people like Peter Lynch and just ignored it.

And, instead of trying to predict the next recession and turnaround, I could have just bought and held sound value and waited. No one knows.

I Didn’t Think Like a Business Owner

I really bought in to the quant school of thinking. Nobody knows anything. You can’t predict the future of a business. (Ironically, I thought it was hard to predict the future of an individual business but thought I could predict the macroeconomy). Just buy quantitatively cheap stocks. Churn the portfolio. Sell a stock when it pops.

I no longer think this is the right approach. Business analysis is something that people can do. With a little common sense, I could have realized that my investments in tire companies and GameStop weren’t good investments. I should have realized that my theses around these positions were a stretch.

The quant school seems like a natural extension of the efficient market hypothesis. True value investing should be a rejection of this hypothesis. If Ben Graham and Warren Buffett taught us anything, it’s that thinking about an investment as an owner can yield good results.

It’s not worth buying a stock if you aren’t willing to buy the business in its entirety and hold onto it for 10 years if you have to. If the thesis is “a miracle will happen, the multiple will go up, and then I’ll sell it for a 50% pop,” then that’s probably not a long-term winning approach.

If you’re buying individual stocks, you have to have conviction in your holdings. You have to have enough conviction where you’ll hold when something goes wrong.

It’s probably a bad idea to buy into a business where you sweat before you read the latest K or Q. It’s not worth the aggravation and the lack of conviction will hurt results.

My Risk Tolerance Is Lower Than I Thought

I moved my entire 401(k) into the S&P 500 in March 2009. I told my family to do the same. I also told them to get out in 2006-07. This gave me the impression that I could accurately identify bottoms and tops in the stock market.

March 2020 turned out differently for me.

If I wanted to lie to myself, I could tell myself the comfortable lie that unpredictable events outside of my analysis changed things – but was it really unpredictable that the Fed wouldn’t let the global financial system unravel?

The uncomfortable truth, I think, is that I felt pain and I reacted to that pain. I made a behavioral error. It was probably because I have a lot more money than I did in 2009 and was looking at some rather scary losses. It was easy to say “stay the course” when I had a small sum in a 401(k) after working a couple years. It was a completely different experience after toiling a decade and saving a large amount of money and seeing a lot of it wiped out.

I was fortunate that I developed the Weird Portfolio prior to the crash. I built that portfolio so it could withstand an equity crash and I behaved correctly when it happened with that portfolio.

With this “enterprising” account that I track on the blog, I did not behave correctly. To try to fix this error, I’m going to try to own better companies. I don’t want to own companies where I need obsess over what the next gyration of the economy will be. I’m hoping that owning companies I have conviction in and are higher quality will help me behave better the next time this happens.

Pounding Predictions of Doom Into My Head Wasn’t Productive

Bearish predictions of doom generate clicks and ratings. I thought I was emotionally intelligent enough not to be swayed by them and rationally evaluate them.

But, I think constantly pounding that stuff into my brain didn’t do me any good. A constant reading of bearish articles and listening to bearish podcasts didn’t help me.

The thing is – bearish predictions of doom always sound smarter than optimistic takes. The idea that the Fed is going to destroy the dollar, cause hyperinflation, and that we’re in a debt bubble that will cause Great Depression 2 seems compelling to me.

Is it, though?

If these smart guys can really predict Great Depression 2, why couldn’t they have also predicted the bubble that would precede Great Depression 2 and trade that? How many of them have been saying the same thing for 20 years?

Maybe we’ll have another Great Depression. I don’t know. I don’t think these guys do, either. I might as well own a company at a sound valuation that could survive the flood if it happened. For the defensive portfolio, I might as well own something balanced and that will minimize my losses in the worst case scenario. Worrying all the time about the second Great Depression and the thousand year flood seems like a fruitless & miserable effort. Maybe it will happen, but no one really knows.

It seems to me like it’s best to have a portfolio with elements that can survive any economic outcome, which is what the weird portfolio accomplishes.

For this portfolio that I track on the blog, I might as well own companies that I’m confident could survive an economic catastrophe. I don’t want a company in my portfolio that is completely dependent upon a change in the season or the continuation of spring. If I wouldn’t own the business for 10 years or think it could survive a Depression, then I probably shouldn’t own it at all.

If I invest for the rest of my life like the Great Depression and dollar devaluation is going to happen tomorrow, I’ll condemn myself to poor results.

Better to have a plan for the worst and hope for the best.

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.

On the hunt: Outstanding Companies at Deep Value Prices

I am revising the objectives of the portfolio that I track on this blog, as outlined in an earlier blog post. Traditionally, I would buy any company if it was at a deep enough discount to intrinsic value.

Owning mediocre and bad businesses made me endlessly worry about the macroeconomy. I am sick of that.

Going forward, I don’t want to own a business if I’m not confident it can survive a severe recession.

I also foolishly messed around with market timing. After my failures in this arena, I believe a strategy shift is necessary.

My goal is to buy wonderful companies at wonderful prices. This is an outline of the way I plan to manage this portfolio in the future.

Warren Buffett likes to say: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.“

I want it all: I want to buy wonderful companies at wonderful prices.

Wonderful Companies

What makes a company “wonderful”? I want a company that I could own with confidence in the event that the stock market were closed for 10 years. Thinking like this focuses the analysis and eliminates many of the stocks I used to buy for short term multiple appreciation.

  1. An economic moat. I want a company that can resist the pull of competition. Moats can come in many forms. A moat can be a fantastic brand, like Coca-Cola, which people will purchase over a store brand. Moats can come from sheer scale that prevents anyone from competing with price. Wal-Mart would be an example of this. A moat could be geographic. Waste disposal companies are an example of this – it’s hard to build a new landfill because no one wants one in their backyard. Moats could be regulatory. The cigarette industry is an example of this. It’s impossible to start a new cigarette company due to government regulation, insulating them for competition. Moats can come from network effects, where size grows organically. Facebook is an excellent example of this. I don’t want to invest in fads (or technologies) that can easily be upended by a competitor.
  2. Consistent & strong operating history. I want to own predictable businesses with consistently strong performance over a long period of time.
  3. Favorable long term prospects. I do not want to own a melting ice cube in a dying industry. While I believe these are perfectly valid investments for short term multiple appreciation, I am looking for investments that I can hold for the long term with confidence.
  4. Low debt with high financial quality. I look for companies that have a debt to equity ratio below 50%. For larger capitalization stocks, I will tolerate more leverage (around 100%). I also want to see a high degree of interest coverage, ensuring that the company can survive a serious deterioration in earnings and cash flow. As Peter Lynch put it: “Companies that have no debt can’t go bankrupt.” If a company is utilizing significant leverage, they may be able to produce great results in the short run, but one mistake can kill the firm. I believe that the best way to minimize the risk of the portfolio is to focus on the balance sheets of the companies in the portfolio. Additionally, my research shows that combining balance sheet quality with statistical measures of cheapness leads to long-term outperformance. This approach dulls results during booms, but outperforms over the long run because it contains drawdowns during recessions. Other key measures of financial quality that I look at are Altman Z-Scores (bankruptcy risk), Piotroski F-Scores (overall financial quality), and the Beneish M-Scores (earnings manipulation).

Wonderful Prices

My goal is always to buy mispriced securities. I believe that the best place to find mispriced securities is among the cheapest deciles of the market. For that reason, I look for multiple metrics and valuation ratios which show that the stock is cheap relative to its history and its peers. I prefer stocks that have multiple measures of cheapness, as measured by valuation multiples. I don’t engage in complicated discounted cash flow analysis, because I think it’s simply a way to fool yourself into accepting your own biases about companies that you love with a false sense of precision. I’ve also noticed that while many value investors outperform, they often fail to outperform the most basic measures of statistical cheapness.

The key metric that I look at is Enterprise Value/Operating Income. This metric – the Acquirer’s Multiple – is best described by Tobias Carlisle in his book Deep Value. This outstanding ratio measures how attractive the company would be to a potential acquirer by comparing the actual earnings available to the owner at the top of the income statement and comparing it to the total size of the business, including debt.

There is also plenty of outside research showing that statistically cheap portfolios outperform. A good example is this excellent paper from Tweedy Brown, What Has Worked in Investing. My own research shows that cheap portfolios outperform for nearly every valuation metric.

The price is critical. If I pay a cheap enough price, I can still be wrong about the business and still make out alright. Additionally, if the problem causing the statistical cheapness is resolved, then I will obtain multiple appreciation on top of the performance of the business.

Portfolio Management

10-15 Stocks. The situations that I am looking for – outstanding companies at cheap multiples – do not come along very often. There are not many outstanding companies and it’s rare for them to become statistically cheap.

For this reason, I have to be a concentrated investor.

My research shows that, at a minimum, a 10-15 stock portfolio should minimize volatility. My goal is to be fully invested with at least 10 positions at a given time.

Sell rules.

I will sell positions for the below reasons.

a. The stock has reached an extreme valuation relative to its history.

b. A more compelling bargain is available.

c. The business has lost its competitive advantage.

d. To limit a stock that has grown to be too large a percentage of the overall portfolio.

Cash. I hold cash when I have trouble identifying stocks that meet all of my criteria.

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.

Strategy Shift

You might have noticed that lately I’ve been buying different kinds of stocks than I did in the past.

You might have also noticed that I’m buying bigger positions.

It’s a shift in strategy.

I summarized what I’m looking for in this blog post: Wonderful Companies at Wonderful Prices. I am trying to buy outstanding companies at deep value prices.

Previously, my focus was on obtaining multiple appreciation from beaten up companies. I didn’t want to hold them for the long-term. The goal was to have a widely diversified portfolio of 20-30 stocks. Buy depressed, beaten up situations (with sound balance sheets) – then sell them when they’re close to intrinsic value. You have to sell because they weren’t the kind of companies that were good businesses for the long haul. The goal was to flip them.

This is a great strategy. It’s a low P/E, low debt/equity strategy that returns about 15% a year in the backtest. I thought I could stick to it.

I couldn’t. The problem emerged in March when lock-downs were creating closures throughout the entire economy. This was the most unprecedented self-imposed economic catastrophe of my lifetime.

The issue is that the businesses I owned weren’t good businesses – they were mostly cyclical situations and I knew it. If the economy were unraveling, how were a bunch of no moat & cyclical businesses going to mean revert?

In terms of value investing, I’m perfectly comfortable with under-performing for a long time period.

What I’m not comfortable with are losses – and beaten up cyclicals are going to result in catastrophic losses during a Depression, which is what I thought was happening in March. You can look at the returns of small value during the Depression and you’ll see this to be true.

When the market recovered, it became clear to me that I had fallen into a trap that I thought would never happen to me: I grew pessimistic with the rest of the crowd. I panicked. I even bought a short ETF. Fortunately, it was a small position and I sold when the market went above the 200-day.

I did this is because the market – by every measure – is insanely overvalued. I still think that’s true and that the index is going to deliver flat to negative returns over the next 10-20 years.

Sure, the rest of the market was overvalued (and still is), but I should have ignored that and pounced on the value where I could find it. I don’t own the market. I own the stocks in my portfolio.

I could react to this realization in two ways.

I could spend the rest of my life as a perma-bear complaining and worrying about macro. Or, I could recognize that macro is unpredictable and I should stick to what I can wrap my brain around.

The purpose of this brokerage account that I track on this blog was to try to go after the wild goal of outperforming the market. To give it my best shot.

I thought the best way to do this was Ben Graham’s classic low P/E, low debt/equity strategy in a 20-30 stock portfolio. Buy a compressed P/E, sell for a 50% pop, then move on to the next target. Repeat. Make sure I own 20-30 positions. Stick with it.

It turns out that when the turds hit the fan, though, that I couldn’t stick with it. What good is an investment strategy if you can’t stick with it?

In many ways, I’m happy I didn’t stick with it. Being 50% cash before the crash was a good thing. My max drawdown this year was only about 20%. Meanwhile, deep value had a nearly 50% drawdown. If I stuck to the stocks I owned and didn’t sell – by my calculations I would have had an even worse drawdown than the deep value universe. Nearly 60%.

Instead, year to date, I’m outperforming all of the value ETF’s because I contained that drawdown.

Selling was a good decision for most of the stocks that I’ve owned through the history of this blog. I wrote a post about how selling all of them was a good decision.

I still think that a 20-30 stock low P/E, low debt/equity stocks and churning it is a good strategy. I still think it will return 15% a year for someone who can stick with it over 20 years.

What emerged in March, though, was that I’m not the investor who can stick with it. Owning these kind of businesses during a severe economic shock is terrifying.

As I sat in cash while the market ripped higher – it became clear that I panicked at the worst possible moment.

This realization caused me to really do some soul searching and check my priors. It quickly became apparent that I was wrong about the macro picture.

It’s partly a product of my own mind. I’m a pessimist at heart and think most people are full of it – this leads me to be naturally drawn to predictions of doom.

It turns out that my instincts about the macro-economy were completely wrong. Perhaps I should have read my old post on the matter, The Dark Art of Recession Prediction, where I wrote “Macro is fun, but it’s probably a waste of time.”

If only I listened to my own advice.

After realizing all of this, I considered moving this account to my asset allocation strategy, the Weird Portfolio.

That’s where I have most of money. I never panicked with that money. From January 1 – March 31, it was only down about 14%. Long term treasuries and gold did their job. I stuck with it and the portfolio recovered, with year to date gains.

With that strategy, an investor will frequently under-perform. That’s not something I really give a damn about. I can watch QQQ investors make bank and I don’t care.

What I do give a damn about is losses. That’s something the weird portfolio excels at containing. The Weird Portfolio delivers a satisfactory – but not outstanding – rate of return and contains losses with low volatility.

Of course, that’s not the point of the money I set aside to track on this blog. To put in Ben Graham’s terms, the weird portfolio is for the defensive investor. I’m defensive with most of my money. This account is for the enterprising investor.

The point of this money was to play the game. To try to outperform, as maddening as that can be.

The truth is that I had little conviction in my positions. How can you have conviction in bad businesses with no moat when we’re facing a severe economic downturn?

This led me to a simple conclusion: if I’m going to buy stocks, I need to own businesses that I have long-term confidence in. I need to own businesses where I won’t obsess over the yield curve, unemployment rates, or the CAPE ratio. I don’t want to own a steel company or a bar in Florida and constantly worry about the impact of the macro-economy on those stocks. I want to own better businesses that I’m not going to panic sell when the economy looks like it is headed to the woodshed.

I don’t want to hold mediocre or bad businesses in the hopes of multiple appreciation. While this is a perfectly valid strategy, I think my behavior shows that I don’t have the intestinal fortitude for it.

Of course, the trouble is, there aren’t many high quality companies that sell for a margin of safety. They are rare birds. I certainly can’t fill up a portfolio with 20-30 of these situations, even though I know that’s the optimal portfolio size.

The situations that I want to buy (and can have enough confidence to hold when the economy goes to hell) are rare gems: wonderful companies at wonderful prices.

I want wonderful companies at distressed prices. As Buffett once put it, I want Phil Fisher companies at Ben Graham prices. Moreover, I want them to be able to resist a recession. I want them to have solid balance sheets with enough cash to survive a recession. I don’t want businesses that are easily crushed by the inevitable recession. I want them to have a moat that resists competition. I want to have it all – high quality at a deep value price. Stocks like this don’t come along very often – but they are available.

This naturally leads me to more concentration because there aren’t many of these situations. My research shows that the first dozen positions does most of the work in eliminating volatility, so that’s what I’m going to aim for.

It’s not optimal for maximizing Sharpe ratios. That portfolio is around 25 stocks.

Of course, I can’t find 25 wonderful companies at wonderful prices that I’m comfortable holding during an economic catastrophe. I’m going to have to be more concentrated now that I’m being more discerning.

The stocks I’ve bought recently which fit this mold are:

Biogen

Charles Schwab

Enterprise Product Partners

Biogen is a good example of what I’m looking for. It’s absurd that a company like that (a 23% ROIC over the last 10 years that has grown revenue at a 12% clip) trades at 7x EV/EBIT.

Enterprise is another example. There is no reason that a quasi monopoly should trade for 5x cash flow with an 11% dividend yield. That’s the kind of situation I want.

Charles Schwab is a firm with secular growth propsects. It should inherit more AUM as investors move away from high fee advisors and products. It’s hard to imagine how it won’t continue to grow AUM over the next 10 years. It has grown book value at a 12% rate for the last decade with a 12% ROE. At 1.8x book, it’s a steal. It traditionally traded for 4x book.

These are the kind of situations that I want. For all of these companies, I’m confident that they will deliver a return without any multiple appreciation. Schwab’s book value will continue to grow. Enterprise will continue to serve as an energy toll road and continue to churn out growing dividends and resist competition. Biogen will continue to main a strong research pipeline and create more high margin drugs. With multiple appreciation – the return will be outstanding.

I made each of these positions approximately 8% of my portfolio – with the goal of finding at least a dozen of these positions when fully invested.

I believe they are wonderful companies at wonderful prices. I don’t need multiple appreciation for them to do well over the next 10 years. I’m confident that the business will deliver strong long term results. I think I’ll get multiple appreciation on top the actual business results, but I won’t need it for my return.

I also realize that I can’t find a dozen of these situations right away. When I started this blog, I filled this account up with 20 stocks. Obviously, I can’t do that with this approach because there aren’t that many of these stocks.

I’m still going to have to hold a lot of cash and sit around and wait for a wonderful company to sell for a wonderful price. That’s fine by me. If I know I hold a great, non-cyclical, business and own it for a price that I think is outstanding – I can hold onto that position with confidence and not sell.

I’m not going to force myself to be fully invested and buy businesses that I don’t have confidence in just to fill up a portfolio.

The best strategy isn’t the one with the best Sharpe ratio or the highest CAGR. It’s the one that you can stick with. I think this is an approach I’ll be able to stick with.

We’ll see.

So, if you’ve noticed a change, you’re right. I’m running a more concentrated portfolio with a bold goal: wonderful businesses at wonderful prices. Let’s hope it works out.

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.

Enterprise Product Partners (EPD)

Key Statistics

EV/EBIT = 11.27x

Dividend Yield = 11.12%

Earnings Yield = 12.5%

Price/Revenue = 1.23x

Debt/Equity = 117%

The Company

Enterprise Products Partners operates pipelines throughout North America. Their pipeline infrastructure moves natural gas, natural gas liquids, and crude oil. They are the biggest midstream operator in the US, with $29 billion in revenue. The next biggest operator is Kinder Morgan, with $12 billion in revenue.

The heart of their pipeline network is in Texas, where they connect suppliers (like drillers in Texas & shippers in the Gulf) to end-users via their vast pipeline network, which stretches throughout the United States. They also operate storage facilities and processing plants. Currently, they own approximately 50,000 miles of pipelines.

Natural gas and natural gas liquids are core aspects of their operations. Natural gas is critical to US energy needs, supplying 38% of US electricity generation. Natural gas is also essential for heating. The United States boasts the largest supply of natural gas in the world. We are the Saudi Arabia of natural gas.

Natural gas liquids – liquids separated from natural gas as it is processed – are also crucial to the US economy. Natural gas liquids include propane, ethane, and butane. These are critical to our agriculture needs. Additionally, natural gas liquids are inputs in everything from tires to diapers.

Enterprise is like a hub at the center of the energy needs of the United States.

In recent months, traders destroyed the stock and the rest of the energy sector after the COVID energy shock. I think this company’s stock was crushed via guilt by association.

A return to its 52-week high would be an 80% gain from the current price.

My Take

Despite ESG investors’ wishes, hydrocarbons are here to stay for the foreseeable future and are essential to life as we know it.

Without hydrocarbons, life would not be possible as we know it. I think that ESG investors are creating opportunities (via forced selling) for those who are willing to take the plunge into hydrocarbons. ESG investors are behaving like we’ve invented matter/antimatter reactors harnessed by dilithium crystals when no such innovation has actually taken place.

My views caused me to take a hard look at companies in the hydrocarbon sector. I looked at a lot of duds. Highly cyclical (and leveraged) frackers burning cash and going bust at the slightest energy blow up. Even large and respected companies had significant amounts of leverage and dicey track records. I looked at many companies with high dividend yields and wasn’t sure if they could sustain it if the economy rolled over.

Enterprise was different. Enterprise strikes me as the best available opportunity in the energy sector. It’s a fantastic company with substantial advantages and the stock was sold off via guilt by association. In my opinion, it’s a wonderful company at a wonderful price.

The recent decline in energy consumption is temporary. Ten years from now, with modest growth, we will need more natural gas and oil and it doesn’t matter if your ESG fund manager wants it or not.

Enterprise has a formidable moat. No one else is going to spend the money to compete with their vast nationwide network of pipelines. Even if a competitor wanted to match their network, they would need to overcome regulatory hurdles. Every pipeline has to be approved by the government, and no one wants a pipeline in their back yard. Pipelines also benefit from network effects – the more you own, the more valuable your network is. I imagine regulatory approval will grow even more difficult in the future, especially now that “hydrocarbon” is a dirty word. This further insulates them from competitors.

As the biggest midstream pipeline operator in the US, it is also the best managed. This is best demonstrated by a comparison of profit margins. The moat gives it pricing power compared to the next biggest competitors.

Enterprise also establishes contracts with shippers when building a new pipeline, which can be for 15 years or more. They don’t build a new pipeline if the business isn’t already lined up and the existing pipelines have practically guaranteed streams of business.

The fact that no one can duplicate their network and they have long-term contracts with their clients creates a rock solid stream of business. Most importantly, it’s a rock solid stream of business that is resistant to competition.

The company is essentially an energy toll road, and as long as we continue to use natural gas, natural gas liquids, and oil – that toll road will continue to pay dividends.

Speaking of dividends, I was amazed when I looked at Enterprise’s dividend yield. It is currently 11%. I was more amazed when I realized it was sustainable and the company wasn’t employing significant leverage.

Usually, a very high dividend yield is a sign that something is wrong. It’s a sign of massive leverage, a dividend that will be cut, or a melting ice cube of a company. Enterprise is not a melting ice cube. This is a sustainable dividend yield that can continue even if cash flows decline significantly.

The durability of the dividend is best demonstrated by the track record. Enterprise has been able to increase the dividend each year for the last twenty years.

As for other metrics, the P/E is 8, and it trades at 5x cash flow.

Pre-COVID, Enterprise traded for a premium valuation due to its enviable position, strong management team, moat, returns on equity, and cash flow gushing assets. ROE has averaged 16% for the last 10 years. For most of the last ten years, it has usually sold in the 15-25x range, which seems right for a company of this quality. Currently, on an EV/EBIT basis, it trades at 11x.

Enterprise is also in healthy financial condition, with a debt/equity ratio of 117%. This is more than I typically go for (I prefer less than 50% for small caps, and less than 100% for large caps), but it’s conservative compared to the rest of the energy sector. The cash flows that Enterprise generates – even in recessionary years – are more than enough to sustain the company and the dividend.

At current prices, this is an opportunity to buy an 11% dividend yield that is sustainable and likely to grow in the future. The dividend is currently only 52% of EBITDA.

The main risk to Enterprise is a deterioration in the economy, which will reduce the demand of end users. Even if that were to occur, I doubt Enterprise would post actual losses. Even during the Great Recession, Enterprise continued to generate positive operating income with moderate losses in EPS. It continued to stay profitable during the energy bust of 2015-16. In Q2 2020 (the COVID quarter), they still posted earnings per share of $.47, suggesting that they will be able to handle further economic challenges.

In my opinion, this is a unique opportunity to buy a wonderful company at a wonderful price with limited downside risk, the potential for substantial multiple appreciation, and a fat sustainable dividend yield.

Of course, that doesn’t mean that there won’t be more short term pain. It’s possible that we’ll face further troubles in the economy. It’s possible that investors will continue to irrationally sell hydrocarbon stocks (while they sit in a home heated by natural gas, fly around in planes that guzzle fuel, use electricity generated by natural gas, eat food that was made possible by natural gas liquids, and have packages delivered to them via gasoline-powered trucks). There are a lot of short term potential troubles, but I think that this is a safe company to own for the long haul with favorable prospects. Even if pain occurs in the short run, an investor will continue to collect that nice dividend.

Random

Phil at at his best.

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.

VLGEA

I sold 85 shares of VLGEA at $25.11. I bought it because I thought it would benefit from COVID-driven grocery store sales, which have already materialized and it’s not a company I want to hold long-term now that the world is snapping back to normal. I made a modest 5.7% on the position.

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.

The Charles Schwab Corporation (SCHW)

Key Statistics

Price/Book = 1.82x

Return on Equity = 14%

Earnings Yield = 6.67%

Debt/Equity = 38%

Summary

Charles Schwab has long been a financial industry powerhouse. With the merger with TD Ameritrade, it is going to become the dominant player in this market.

Schwab’s origins are as a discount brokerage. They offered cheap commissions for DIY investors. Perception around the stock is that this is what Schwab’s business still is. The truth is that brokerage commissions were a trivial component of Schwab’s business, which is why they were so quick to cut it to zero in an effort to clobber their competitors. They continue to make money on trading activity, via order flow. The financial media gets incensed about this, but I don’t think anyone really cares.

They cut commissions to zero to clobber their competition, which is rapidly disappearing. By merging with TD Ameritrade, the only serious challenger to their business is Vanguard. The sheer scale gives them the ability to cut costs and offer services at a lower fee. In my mind, this is a moat. They’re like Wal-Mart in 1990 taking on small mom and pop retailers, Clover, and Bradlee’s.

The stock is cheap for a simple reason: interest rates are low and investors think that will last forever. When clients leave cash in a brokerage account, Schwab offers the client little interest, and then they invest that cash in short duration fixed income products. With interest rates low, that income is reduced. There are also jitters about the merger with TD, but I think that the merger is only going to strengthen their competitive position.

My Take

I don’t think that the trend of investors cutting expensive mutual funds and expensive financial advisors is going to stop. There is a lot of money wrapped up in high fee financial services. As younger investors inherit that money, they’re going to invest it themselves and I think much of it is going to continue migrating to Schwab and Vanguard.

I don’t see how this trend stops. It’s hard to imagine how much of this money won’t migrate to Schwab one way or another.

There are challengers to Schwab, but I don’t see how they succeed.

There is Betterment, which offers robo-portfolios, but they’re a small player of an industry where scale matters more than anything. Additionally, an automated portfolio of asset classes tailored to age & risk tolerance isn’t an amazing innovation and it is easy to duplicate. In fact, Schwab already has automated investing portfolios of their own.

There is also E-Trade, but E-Trade is losing this war, which is why they sold to Morgan Stanley.

There is also Robinhood, but I think Robinhood’s emerging reputation as the home of Millennial and Gen-Z gun-slinging daytraders is not going to help them attract future capital, particularly after this insane market inevitably rolls over. It’s a reputation that they need to shed and I’m not sure if they will succeed.

I think Robinhood’s strategy is to lock in younger investors in now. Then, those investors will continue to accumulate assets as they save and inherit money – and they’ll keep it in Robinhood.

I don’t think it will work this way. My guess is that Millennial and Gen Z investors will see Robinhood as the wild person they dated when they were 23, but not the person that they’re going to marry.

The year is 2025. You’re 30 years old. Let’s say that you inherit $100,000 from a dead relative. Are you going to put it in Robinhood – where your 25 year old friend lost a bunch of money daytrading in 2020 and made a bunch of TikTok videos about it? No. You’re going to figure out a “serious” way to invest it. This isn’t $500 on an app that you’re fooling around with. This is $100,000. This is serious money. Your desire to invest “seriously” will probably lead you to Schwab or Vanguard.

If you don’t want to DIY it, then you’ll turn to Schwab or Vanguard for advice, which is a lot cheaper than hiring a traditional financial advisor. In fact, Schwab offers a flat consultation fee of $300 to set up your portfolio, and then they can roll it into one of their automated solutions for $30/month. This is where much of the Boomer & Silent money currently getting charged 1-2% of AUM in an ocean of high fee mutual funds is going to migrate to.

Here is another scenario. Let’s say you worked for a company for 10 years, you get a new job, and have a nice amount stashed in a 401-k. Let’s ask the same question: where are you going to roll over that 401-k into? Chances are it will go to two places: Schwab or Vanguard.

Are you going to entrust this money with a financial advisor at a bank? Boomers might have done this in 1989, but Millennials hate banks. They’ve had an adversarial relationship with banks for most of their adult lives. Banks are the institutions that charged them 30% on their credit cards and a $35 fee when they accidentally went over in a checking account because the Netflix renewal hit before payday. They hate banks and don’t trust them.

The irony is that Schwab is structurally a bank (they take deposits and earn interest on it), but that’s not how they are perceived, and they’re not an institution that most people have had a negative experience with. They’re not engaged in the risky behavior that many banks routinely find themselves making headlines for (trading scandals, risky loans, stupid nonsense with derivatives, clashes with regulators, breakdowns in risk & controls, aggressive practices). They’re not a bank that set up a fake account or that charged you a crazy rate on a credit card. As a result, Schwab is more reputationally sound than most banks.

The main worry with Schwab is over interest rates – which is the concern hanging over the entire financial sector. I see this as a temporary problem. Investors seem to think that interest rates will be low forever. They think this because of what the Fed tells them. In my opinion, the Fed’s word is worth very little. If inflation emerges as a problem, the Fed will be forced to raise interest rates. It’s hard for modern investors to fathom this because most living investors have invested during a 40 year period of declining rates.

Interest rates are obviously something out of Schwab’s control. Schwab should simply focus on increasing the size of the assets that it manages, which is something that will continue to happen naturally due to its size and reputation.

Over time, interest rates are going to do their own thing. Schwab should focus on what it can control: increasing the assets that it manages and scaling up the business. This lowers prices and eliminates competitors. This is exactly what management is doing.

Schwab is incredibly cheap relative to its history due to the interest rate worries and jitters over the merger.

For the last decade, it usually trades in a range of 2-4x book value. It currently trades at 1.8x book. Meanwhile, I think the book value will continue to grow. In terms of multiple appreciation, I could see this easily returning to 4x book value if interest rates increase even a little bit.

Meanwhile, over time, I think that secular trends will make that book value continue to grow regardless of what happens to rates.

Schwab has earned 10-17% on equity for the last decade (a decade of low interest rates), and I don’t see how that doesn’t continue in the future. If interest rates remain low, it will earn the low end of that ROE, while the equity will continue to grow organically.

This means that even without multiple appreciation, Schwab should offer a satisfactory rate of return over the next 5-10 years via increasing book value and strong ROE. With multiple appreciation, it will offer a fantastic rate of return.

I also look at the size, reputation, rock solid balance sheet, and strong management as factors that will prevent a permanent loss of capital and make this a safe long-term holding.

Random

I’ve been listening to a lot of Prince lately. 1984’s Purple Rain has to be one of the best albums of all time.

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.