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.
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.
- 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.
- Consistent & strong operating history. I want to own predictable businesses with consistently strong performance over a long period of time.
- 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.
- 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).
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.
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.
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.