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 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.
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.