Thoughts on Quantitative Value

Strategy Shift

As I’ve documented on this blog, I’ve shifted my strategy from a widely diversified portfolio of quantitative bargains.

I’m running this portfolio with a different strategy: a concentrated portfolio of high quality businesses that are temporarily selling for cheap multiples.

This portfolio that I track on this blog is a “variable” portfolio, as Harry Browne put it. I wrote about variable portfolios on Medium here.

I also have my asset allocation strategy, which is where I’ve decided to put the rest of my savings. That’s the weird portfolio, which I’ve written about here.

That portfolio has a strong focus on small cap value, but also has built in protections for different economic environments.

Even though I’ve shifted from a quantitative approach in my variable portfolio, I’m still a believer in it.

Quant Value: Challenges With a DIY Approach

I am still very much a believer in quantitative value strategies and think they’ll come back even though they have underperformed the market for many years. I just think that the manner in which I was implementing it is not the best way to actually do this.

I think that the best way to implement a quantitative value strategy – for me, anyway – is to do it with an ETF. In my passive portfolio (which is where I have most of my net worth), I do that with VBR and VSS, to create a small value portfolio that’s globally diversified.

There are other excellent value ETF’s out there, many of which are more focused on the factor. Probably the best examples of this are Alpha Architect’s IVAL and QVAL, which quantitatively implement a deep value strategy.

One of the coolest value ETF’s out there is Tobias Carlisle’s ZIG ETF – which gives an investor a long/short value oriented hedge fund without the 2 & 20 fee and does it in an optimized tax structure.

When quant value comes back (and I strongly believe it will), my opinion is that the more focused ETF’s ought to experience a more significant outperformance – just like they’ve experienced more significant underperformance during value’s season of woe.

The Vanguard value ETF’s have less exposure to the factor and have underperformed less during value’s troubles. The Vanguard ETF’s are lower octane, which probably reduces long term returns but can help prevent behavioral errors during the bouts of underperformance.

An investor needs to decide how hardcore they want to go, which is a personal preference.

I think that ETF’s are the ideal way to implement a quant value strategy. A quant value approach works over the very long run even though it can underperform for years. It’s a lot easier to deal with that when done passively.

I think the best approach is to put it on autopilot and not look at it for a long time. Give the strategy a long time to work. Value works because it doesn’t always work. An investor can buy an ETF and not look at it for 20 years, which is probably the better approach to take with a quant value strategy.

Actually DIY’ing it – pick the stocks, buy and sell, deeply analyze the companies – can be very labor intensive. When value enters one of its funks as it has for the last 5 years – you can feel that all of those hours were spent fruitlessly. That’s an extremely frustrating process, which is what I’ve been dealing with.

That’s what I’ve discovered over the last 5 years or so. With an ETF, it’s a lot easier to deal with the seasonal underperformance of the strategy.


As a DIY investor, I think it makes more sense to implement a quantitative value strategy by passively owning ETF’s rather than try to DIY it. This is based on my own experience trying to implement a quant value strategy with a discretionary element, which I documented on this blog.

I found that actually analyzing all of the companies in a 30-stock deep value portfolio and trying to buy and sell at the right times is an exhausting process.

It’s also a recipe for behavioral errors. I made plenty of behavioral errors. These companies look like they have severe handicaps and it takes an extremely skilled business analyst to distinguish between those that have permanent impairment from those that are temporary. I think it’s best to do this in a diversified portfolio and not obsess too much over picking the winners.

For me, doing this in a discretionary way also led to foolish market timing. I tried hard to predict the crash and figure out the economic cycle and I completely failed at this.

These errors can be avoided by simply owning the ETF and letting it do its work over a long period of time. I don’t have to actually obsess over and follow closely all of the stocks in the portfolio. I can let the factor work. I can give the factor time to work.

To further prevent behavioral errors, I own my small value ETF’s in a portfolio with safeguards for different economic environments. That’s why I own things like gold and long term bonds to protect against economic catastrophes because I have a pessimistic bent and always worry about this sort of thing. Long term bonds protect against deflation and recessions. Gold protects against extreme inflation, currency collapse, and a global Depression.

I’ve found that these defensive elements were essential for me. They kept me from making behavioral errors in March. In the depths of the crisis, I was only down about 14% in the weird portfolio and I didn’t sell like I did with this variable portfolio. I was able to stick to it. It’s nice to have that asset allocation doing its thing, with the confidence of knowing that it has all kinds of built in protections for different economic environments.

Another consideration is taxes. The account I track in this blog is money I’ve saved up over the years in an IRA and has deferred taxes, so this wasn’t a major consideration.

For a taxable account, though, a high turnover quant value portfolio is going to generate a lot of taxes because there is a lot of trading. That’s the beauty of an ETF. The taxes only need to be paid when the ETF itself is sold. The trading within the ETF – the selling of stocks when the multiples pop, buying new stocks at compressed multiples, doing it over and over again – doesn’t create taxable events due to the ETF structure.

You might still want to pursue a deep value strategy and DIY it, which is fine if that’s your bag. I just found it to be extremely difficult to implement on my own and concluded that it’s easier to simply have an ETF do the work for me.

You Do You

You might feel that you want to implement a DIY, quantitatively oriented, deep value strategy. That’s totally fine.

With that said, I found it extraordinarily difficult to do on my own. I made a number of behavioral errors in implementation. When the turds hit the fan, I found my portfolio terrifying to own.

My conclusion is that implementing a value factor strategy through an ETF – and letting someone else (or a computer) do the work – is the ideal approach. You can just enjoy the sausage and not concern yourself too much with how it is made.

Another great thing about ETF’s is that you can spend your time doing something more important than following companies and the market.

These were the lessons I learned. You might have a different conclusion, which is totally fine. Investing is a personal process and you have to figure out what works for you.


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.

Why Quality is Essential for a Concentrated Portfolio

As I refine my approach, a critical area I need to focus on is the size of my portfolio.

I’ve decided to aim for at least 12 extremely high quality positions.

Below is a breakdown of how I’ve evolved towards this approach.

My Old Approach: Trading, Not Investing

In the past, I bought and sold many stocks in this account. I owned a lot of stocks (usually 25-30 positions), and I traded them quickly, rarely owning a position for more than a year.

I developed a number of techniques to contain losses – such as selling after a quarterly loss (a kind of stop-loss based on fundamentals). I also sold stocks as soon as I got the multiple appreciation that I was after.

This was a higher octane version of Ben Graham’s advice to sell after 2 years or a 50% gain, whichever comes first.

I was getting pretty good at it. In the last four years, I’ve outperformed my stock screens and I’ve outperformed the small value universe.

The thing is: most of my out-performance was due to good trading, not good stock selection. I discussed this in this post.

The techniques I developed are essential when dealing with terrible businesses. The goal is to get in when they are beaten up, get your multiple appreciation, and move on. If one of them starts falling apart, it’s essential to get out before the face ripping drawdown.

A good example of this is a stock like IDT – one of the first stocks that I purchased for this account. Since I bought it, it’s down 60%. I got out of it with only a 20% loss. Another example is Big Five Sporting Goods. I managed to eek out a 8% gain from that company. Later, Big Five had a roughly 90% drawdown from my purchase price.

Other stocks I owned show why it’s essential to get out of bad businesses and stop losses – I’ve also owned positions like GameStop and Francesca’s. I got out of Francesca’s with an 18% loss – it then went on to have a 96% drawdown from my purchase price. I got out of GameStop down 50% at $11.45. It later collapsed further to $2.57.

I also owned airlines despite the terrible economics of the industry. Fortunately, I got out of stocks like Alaska and Hawaiian with 10% and 26% drawdowns. They later had 60% and 80% max drawdowns from my purchase price.

I also got out of many positions after they popped near highs and made gains by trading. An example of this is Pro Petro. I sold that for a 45% gain at $19 – it later fell to $1.36. I sold Amtech for a 48% gain at $6.60 – it later fell down to $3.55. I made 35% on PLPC, getting out at $68. It later fell to $36.

All of the stocks I bought were optically cheap when I bought them, but obviously bad businesses with poor underlying economics. These were not safe positions to own for the long-term. That’s why a trading strategy was essential to contain losses and lock in fleeting gains. I had to sell when it popped and get out when the fundamentals began to unravel.

And for all of those good trades that I made – I have very little to show for all of that frantic effort over the last four years.

Another thing I did a lot of – trying to predict the economic cycle – is also essential when dealing with terrible businesses.

Terrible businesses are actually the best place to be at the bottom of an economic cycle. A portfolio like that can deliver 200% returns in an environment like 2009.

Terrible businesses are the worst place to be when the economy falls apart. The cheapest decile of price/free cash flow had a nearly 70% drawdown in 2008. This is a major reason I sold so many positions in March 2020. I thought we were only in the early innings of a 2008 or 1973-74 economic collapse.

That’s why I was so obsessed with figuring out the economic cycle.

Knowing our current position in the market cycle was going to be a major factor in my returns. My plan was to anticipate the great crash, then have a pile of cash to buy quality net-net’s when they became available in large numbers. Well, I’ve spent four years waiting around for the great crash. It might have already happened and I might have missed it.

The problem is: how can I know it’s March 2009 and not August 2008? I thought I could tell the difference, but the extent to which I got March 2020 wrong makes me question this.

All of these trading techniques and macro forecasting tools are something I want to move away from.

I don’t want to trade stocks any more. It’s frantic, exhausting, and stressful. I want to own businesses. 

Moreover, I want to own businesses with good long-term economics. I want to hold them in a concentrated portfolio. I don’t want to be a trader any longer, frantically moving in and out of positions.

Why 20-30 Stocks?

I tried to own 20-30 stocks because that’s what the research says you are supposed to do. That’s what Ben Graham and the academics suggest.

Because I like to test things on my own rather than take other people’s word for it, I did my own research on this topic, which I discussed here. The gist of it is that Sharpe ratios get maximized around 25 positions in a low EV/EBIT portfolio, matching the advice of Ben Graham and the academics.

The issue with owning 30 stocks is that it was extremely difficult to keep track of all of those positions and all of the events that were occurring with them.

I’m a hobbyist investor who does this part time as a labor of love. I have a full time job and I manage this account in the early morning hours, at night, and on the weekends. Reading K’s and Q’s at 3 AM was not a lot of fun (particularly when they contained such awful results), but it was essential to keep up with what was going on in my portfolio.

These days, I want to look for good businesses with good economics and buy them when they trade with a margin of safety. These are rare situations. Because they’re rare, I need to veer more towards concentration.

A New Approach: A Dozen High Quality, Deep Value, Positions

Of course: how much concentration is too much?

This is a matter of personal preference. For me, I’m going to rely on my own research and the advice of some great investors.

I’ve decided that 12 positions are ideal for me.

In my post from 2019 about portfolio sizes, I found that 12 positions is where a bulk of the benefit comes from in reducing volatility and containing drawdowns. Starting from 1 position, each stock that is added to a portfolio adds exponentially declining diversification benefits. Sharpe ratios get maximized around 25 positions, but a bulk of the benefits of diversification – in terms of containing drawdowns and lowering volatility – is found in the first dozen positions.

Beyond the quantitative research, I think that a dozen positions will be more manageable from a homework perspective. I ought to be able to keep up with a dozen positions and follow what is happening with those companies.

Fortunately, there are also two superinvestors who seem to agree with me: Peter Lynch and Joel Greenblatt.

Peter Lynch had this to say:

“Owning stocks is like having children – don’t get involved with more than you can handle. The part-time stockpicker probably has time to follow 8-12 companies, and to buy and sell shares as conditions warrant. There don’t have to be more than 5 companies in a portfolio at one time.”

This is what Greenblatt had to say on the topic:

“Statistics say that owning just two stocks eliminates 46 percent of the non-market risk of owning just one stock. This type of risk is supposedly reduced by 72 percent with a four stock portfolio, by 81 percent with 8 stocks, 93 percent with 16 stocks, 96 percent with 32 stocks, and 99 percent with 500 stocks. Without quibbling over the accuracy of these particular statistics, two things should be remembered:

1) After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small, and

2) Overall market risk will not be eliminated merely by adding more stocks to your portfolio.”

Combining the advice of Greenblatt, Lynch, and my own research: I’m going to aim to have at least a dozen positions.

It’s also essential because the situations I’m looking for – wonderful businesses at wonderful prices (think Apple in 2016 at a P/E of 10 or defense stocks at single digit P/E’s in 2011) – are rare. A business that is worthy of being held, not traded. Moreover, I want to obtain this business at a compelling price. There aren’t 30 of them in the market at a given time.


If I only own 12 positions, then they ought to be incredibly high quality positions.

I think that owning 12 positions like Charles Schwab and General Dynamics is a different proposition than owning 12 no moat bad businesses in secular decline just because they are optically cheap at half of tangible book or a single digit P/E.

From a risk perspective, I think that owning 12 positions like Schwab and GD is less risky than owning 30 bad businesses just because they are below tangible book.

As I considered a higher quality portfolio, I recently re-read Tobias Carlisle’s book, Concentrated Investing, which analyzed the track record of investors who ran concentrated portfolios.

My favorite investor from the book is Lou Simpson, who managed GEICO’s stock portfolio.

His track record was astounding and he was very concentrated.

Of course, he didn’t concentrate in high risk situations. He concentrated in companies like Nike.

Carlisle explains in the book:

“In 1982, GEICO had about $280 million of common stock in 33 companies. Simpson cut it to 20, then to 15, and then, over time, to between 8 and 15 names. At the end of 1995, just before Berkshire’s acquisition of GEICO ended separate disclosures of the insurer’s portfolio, Simpson had $1.1 billion invested in just 10 stocks.”

Simpson’s approach – a concentrated portfolio in extremely high quality companies – worked very well. Simpson delivered a 20% CAGR from 1980-2004.

Carlisle also breaks down Simpson’s investment philosophy, which makes a lot of sense to me:

1) Think independently.

2) Invest in high return businesses run for the shareholders.

3) Pay only a reasonable price, even for an excellent business.

All of this resonates me. Simpson’s strategy is similar to the one I want to follow: own wonderful businesses at wonderful prices.

This is a sharp contrast to what I have been doing over the last four years.

Owning a lot of positions gave me comfort because one of the positions couldn’t make or break the portfolio.

However, it also reduced the quality of my portfolio. I’d often think of positions in these terms: “It’s only 3% of my portfolio and I can afford to lose 3%.”

I’d rather not think in those terms any longer. If there is a high probability that the business can completely unravel and it can collapse, then I probably shouldn’t own it at all. I’d rather own a more concentrated, but much higher quality, portfolio going forward.

Position Sizing

As I’ve discovered in the last four years, stock selection and portfolio management is a deeply personal endeavor. Investing in individual stocks isn’t simply a one-size-fits-all mechanical approach. Every individual stock investor needs to find an approach that works for them. No one is the same. Everyone has different risk tolerances and beliefs.

There are some investors who would be comfortable only owning 5 stocks. They have high conviction positions. Some of them will even put 40% of their portfolio in a single stock. I would definitely trim a position before that happened. I think extreme concentration is fine if that works for them, but I’m a bit of a wuss and probably wouldn’t be able to handle that level of volatility.

There are other investors who think 12 stocks is crazy and too small of a portfolio. That’s fine. You do you. There isn’t a one size fits all approach to investing. Everyone needs to find an approach that matches their own preferences and risk tolerances. Hopefully you’ve learned some lessons on my dime following this blog.


Ratt – Nobody Rides for Free. If you don’t like Point Break, what the hell? 🙂

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.

General Dynamics (GD)

Key Stats

Price/Earnings = 12.6

Price/Sales = 1.1

EV/EBIT = 12.6

Debt/Equity = 119%

Return on Equity = 27.5%


General Dynamics is a 121 year old defense contractor and private jet manufacturer. They have manufactured US military staples such as the M1 Abrams tank. They are also the original designer of the iconic F-16 fighter jet.

The US government is their biggest customer and most of their business is locked-in via long term contracts.

Not only do they have ongoing contracts to build new hardware for the United States government, but they are also responsible for the ongoing maintenance of the US arsenal. That’s about as steady a stream of business as you can get in this world.

The US government is their main customer, but it’s not their only customer. 66% of revenue is derived from the US government, 9% from foreign governments (they produce the British army’s AJAX armored fighting vehicle, for instance), and 25% is from their commercial aviation business (Gulfstream jets).

The commercial aviation segment (Gulfstream aerospace – which they purchased in the late ‘90s) is the cyclical part of the business, but it is only 25% of revenue. The cyclicality of that industry isn’t something that can sink the rest of the company. If this was the sole focus of General Dynamics, this would be a terrible business to own due to its cyclicality. With that said, when times are good, it’s a fine business to own with decent profit margins (operating margins were 17.6% in 2018 and 15.6% in 2019). Another nice aspect to this business is that the contracts to build the aircraft are often locked in, so the revenue doesn’t disappear overnight during a recession.

The defense segment is split up into Combat Systems, Information Tech, Mission Systems, and Marine Systems.

Combat Systems ($7 billion in revenue) mainly consists of land-based vehicles, such as tanks. They also produce arms, such as machine guns and grenade launchers. A key vehicle produced by this division is the Stryker armored personnel carrier.

Information tech ($8.4 billion) is primarily IT work for the United States government. They provide cyber security for the Pentagon and are migrating DoD applications to the cloud. They also provide services for the US government beyond defense, such as their $2 billion contract to manage the US state department’s supply chain.

Mission Systems ($4.9 billion) are navigations and communications equipment.

The marine unit ($9.1 billion) is a critical source of growth for the company. GD is the US government’s lead contractor in the production of the Columbia class submarine, the latest generation of nuclear subs. They also manufacture destroyers, support ships, along with many other vessels. They also provide ongoing maintenance and parts for the fleet.

Valuation & Financial Quality

General Dynamics generates high returns on capital and strong margins. This is because its biggest customer is the United States government and defense contractors are essentially an oligopoly.

Returns on capital are excellent. Return on invested capital was 18.8% last year. They have maintained high returns on capital consistently for a long period of time. Returns on invested capital have averaged 17.6% for the last 20 years. To put this in perspective: Facebook has a return on invested capital of 17.7% and Google has a return on invested capital of 18.7%. Of course, GD is never going to grow as fast as Facebook or Google, but I think the comparison gives perspective into how profitable their business is.

With the exception of the decline in 2011, operating profits experienced explosive growth during the 2000’s when the Iraq and Afghanistan wars began. They have remained elevated and grown slightly even as those wars have slowed.

Even though growth in operating profits has slowed a bit, earnings per share and free cash flow per share have continued to march higher thanks to share buybacks (share count is down roughly 25% over the last decade). They also return capital to shareholders via dividends. The stock currently has a 3% dividend yield, and dividends have steadily increased throughout its history (General Dynamics is a “dividend aristocrat”). The company has a good track record of returning capital to shareholders.

General Dynamics operates with a high degree of financial quality. Debt/equity is reasonable, at 119%. The Z-Score is 2.74, showing low bankruptcy risk. The M Score is 2.5, showing no signs of earnings manipulation.

The valuation for General Dynamics is extremely cheap for a company of this quality. Currently, it trades at a 12x P/E, 12x EV/EBIT, and a price/sales multiple of 1.1.

This valuation isn’t as cheap as it was during the debt showdowns of 2011 when the P/E fell to the single digits (back when people thought the US government found spending religion – lol). It’s nowhere near as cheap as it was during the generational buying opportunity after the fall of the Berlin Wall.

Even though it’s not as cheap as it was back then, I think the stock can still deliver totally satisfactory returns from current valuations. I think that the valuation got a bit silly after Trump was elected, and has since come back down to Earth, as seen on a raw price/sales basis.

From a pure price action standpoint, sentiment is currently poor against General Dynamics. It is in a nearly 40% drawdown from its early 2018 peak.

The Moat

Defense contractors have a pretty obvious moat, which is why they all enjoy high returns on invested capital that aren’t competed away.

This isn’t an industry where they have to worry about new competitors emerging to challenge their pricing power. A startup in San Francisco called Subr isn’t going to start up tomorrow and start burning cash for 10 years provided by VC gamblers to make nuclear submarines and ruin GD’s business.

Plus, weapons manufacturing is not an industry that would attract modern ESG-minded disruption capital. That is more drawn to things like vegan hot dogs, solar powered lawn mowers, subscription services telling people how to do a push up, and putting random stuff on a blockchain.

If the US government wants high grade military equipment, then it needs to deal with the defense contractor oligopoly. Even if a big company was willing to throw $100 billion into competing in this industry, they would have a tough time. If they wanted to play in this game, they wouldn’t have the deep knowledge and defense-specific engineering skills to enter it. They would also need to build the manufacturing capability from scratch. They also would need relationships in the US government, which run deep for a company like GD.

Defense contractors like General Dynamics also enjoy extremely long term, lucrative contracts.

A good example of this is the Columbia class submarine. General Dynamics is currently locked in for production of the Columbia submarine through 2042. The Columbia nuclear subs will replace the aging fleet of Ohio class nuclear subs, which started production in the 1970’s. The government is going to spend roughly $110 billion to produce these subs, and General Dynamics has the contract. The Columbia class will start construction in 2021, and General Dynamics will be making them for 20 years. How many other businesses in the world have that kind of visibility into future revenues?

Companies like General Dynamics are also needed for ongoing maintenance and parts. Considering they have manufactured so much of the US military arsenal, that ought to produce a steady stream of business, too.

Growth Prospects

Eisenhower talked about the growing military/industrial complex back in 1960, and he was not wrong. The defense industry has been a growth sector for decades, even during the tranquil period of the 1990’s after the fall of the Soviet Union. Defense stocks tanked after the Berlin Wall fell, but the dramatic cut in defense spending that the market was worried about never really materialized. That was a generational buying opportunity which Warren Buffett bought into.

With that said, I think defense spending is likely to increase in the next 20 years beyond normal levels.

I believe that General Dynamics has a strong source of growth in a growing Naval race with the Chinese.

After the end of the Cold War with the Soviets, the United States had almost total naval dominance of the planet. The US has mostly left this naval dominance of the world on auto-pilot since the USSR collapsed.

Meanwhile, China seems determined to challenge the United States as the world’s sole superpower.

This is most evident in their efforts to build up their Naval power. They have been ramping up the size of their Navy. China currently has a 335-ship Navy (the US has 293 ships), 55% bigger than the size of their Navy in 2005. Nor is their Navy small potatoes: it includes 2 aircraft carriers and 12 nuclear attack submarines.

While the Chinese have more ships, the US leads in tonnage and global reach. That said, I don’t think there is any question that China is making a strong push to replace the United States as the world’s superpower. The US needs to deal with that and will deal with that.

The path to superpower status is the oceans.

The Russians are also expanding their navy. Putin has committed to building 51 warships and 24 submarines, including eight vessels carrying nuclear weapons.

For the first time since the 1980’s, the United States has serious Naval threats to contend with.

I don’t think the United States is going to sit idly by and allow this trend to go on forever. My guess is that the US will eventually wake up and start ramping up its Navy.

A key aspect of the US military build up will be building more ships. There are only two Naval shipbuilders in the United States right now: General Dynamics and Huntington Ingalls Industries. Both of these companies should benefit when the US begins ramping up its Navy, but I think that General Dynamics is the higher quality of the two companies. General Dynamics is more diversified beyond shipbuilding, so it should continue to do well even if my thesis about a Naval ramp up is wrong.

In a more general sense, the world is not becoming a more peaceful place. I have no idea what conflicts will emerge in the coming decades, but it seems like wishful thinking to think there won’t be any in the future. Whatever happens, it’s hard to imagine that there won’t be wars in the future and that General Dynamics won’t benefit from those wars.


I don’t believe that there is a significant risk to owning a 121 year old company whose main customer is the United States government, but let’s dive into some potential risk factors.

The main risk to General Dynamics is if the United States government curtails spending. (Please, try not to laugh.)

This happened after the budget showdown of 2011 and lasted for approximately 5 minutes and the US government returned to spending-as-normal relatively quickly once the D’s and R’s stopped posturing.

Call me skeptical, but I think that the risk of the US government finding spending religion is about the same as Charlie Sheen joining a monastery.

The defense budget could be targeted if a very left wing President won an election. The kind of person who spent a lot of time in college reading Noam Chomsky and Howard Zinn, for instance. I see this as unlikely. Joe Biden isn’t exactly Ralph Nader.

It was feared that Bill Clinton and Barack Obama would cut the defense budget, but it never happened. If Joe Biden and Kamala Harris were to win (which looks likely), I don’t think that they would cut the Pentagon, either.

It also seems like the political left is more concerned over domestic issues (like taxes, UBI, etc.) than they are about foreign affairs.

Personally, I think that there is a reason that all Doves-on-the-campaign-trail become Hawks-in-office. Once the new President sits down and sees the intelligence briefings, they quickly realize that the world is a nasty, violent, and dangerous place (probably more dangerous than the American people are led to believe) and change their tune.

The fact that the defense budget was hardly cut in the 1990’s – after the US’s main global adversary was vanquished and during the tenure of a Democratic administration – is proof that defense spending is here to stay. I think US military spending is going to grow even stronger now that China and Russia are ramping up their military and the United States will not allow itself to fall behind.

The other risk is that the United States faces some type of debt crisis where the US can no longer run massive deficits or enjoy its reserve currency status to print cash and spend recklessly. If that were to happen, the global economy will likely be a horror show, and I’d rather be invested in a company like General Dynamics instead of a company dependent upon the vagaries of the economic cycle.

The business jet segment is the part of the company that I like the least and contains the most risk, because it is cyclical, but it should perform well during economic booms and won’t eat the rest of the company during busts.


Overall, General Dynamics checks all of the key items on my checklist: (1) statistically cheap, (2) positive long-term growth prospects, (3) strong returns on capital, (4) a moat insulating it from competition and protecting those strong returns on capital, (5) financially healthy with low leverage, (6) a strong long term operating track record, (7) a track record of returning capital to shareholders via dividends and buybacks, (8) Not highly cyclical, and (9) I wouldn’t be freaked out if I wasn’t allowed to sell it for 10 years.


Rest in peace, Eddie Van Halen. I loved your music and it inspired me to make many bad life decisions.

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.

Margin of Safety Still Matters

Defining a Wonderful Company

In previous posts, I described the kind of situations that I’m looking for: wonderful companies at wonderful prices.

There are many examples of this phenomenon in markets. Defense companies with outstanding long-term track records were available at compelling deep value multiples in 2011 when the US government briefly pretended that it found fiscal discipline religion.

Apple was available at a 10 P/E in 2013 and 2016.

Domino’s pizza was available at deep value multiples in the early 2010’s. The same is true of Mastercard.

I’ve also provided examples of value investors who identified these opportunities, so you can’t say “Yes, but no one could have predicted that.”

The way I see it, if you can find a company with a wonderful track record and you can buy it at a compelling price – the odds are strong that it will work out.

What’s a wonderful company? It’s a company that has an outstanding track record. Their business is predictable. Margins remain relatively consistent. They have a track record of maintaining high returns on capital without the use of heavy leverage. They have a strong moat and would be difficult to compete with. A few punks with laptops can’t disrupt it. They’ve been through many economic cycles and they’ve survived. It doesn’t take a leap of imagination to envision positive long-term growth prospects (i.e., people will continue to order take out pizza on Friday nights, Mastercard’s volumes will increase as we abandon cash, Apple users like their phone and will replace it every two years, etc.)

I used to think it was hard to identify these companies but I no longer think that’s the case. It doesn’t take a genius to figure out that Coca Cola and Colgate have formidable moats and good businesses, for instance. I also don’t think it’s that hard to see that tire companies, video game retailers, steel companies, and airlines (all of which I’ve invested in) are bad businesses.

A wonderful company is the kind of company that I can put my money into and don’t have to watch the price every day and hold my breath whenever I read a K or Q. I don’t want to have to worry about where we are in the economic cycle. I know Howard Marks says you can “master the market cycle,” but so far the market cycle has mastered me.

A wonderful company is the kind of company that I don’t have to sell after a bad quarter (because it might be a sign that everything is about to fall apart for them) or when the stock doubles (because it’s now a no-growth business trading a highish P/E).

I’m tired of investing in no-moat bad businesses and living through that kind of emotional turmoil, praying I’ll be able to unload it at a higher price in the future.

It’s a totally valid style of investing, but it’s just not for me.

I want to own the kind of company where it wouldn’t be a big deal if the market closed down for 10 years and I couldn’t sell. I highly doubt that I will actually hold these stocks for 10 years – but that’s the way I want to think about it before I buy it. If I would be terrified to be locked in for 10 years, then it probably doesn’t make sense to invest in it at all.

I don’t want to have to figure out some complicated sum of the parts situation. I don’t want to have to pray that an activist comes along and saves me.

I’m not looking to identify a cyclical trough in an industry and sell at a top. I don’t want to flip something after 6 months or a year and act like I’m holding a hot potato.

This is valid approach, but I have failed with this approach, so I’m trying something different.

Does price matter?

With all of that said, I still consider myself a deep value investor and only want to buy things trading at a compelling margin of safety.

I want to pay bargain basement multiples. I’m not going to do a bunch of mental gymnastics and put together a DCF that crashes Excel to find a margin of safety. I want it to be obvious.

Many people are perplexed by the fact that I demand such a low price. Why restrict myself to EV/EBIT situations around 10x?

After all, for the last 10 years, price hasn’t mattered much. You could buy a wonderful company at any price and make out okay. In fact, the people who sell wonderful companies when the prices get silly are often mocked. #Neversell, as they like to say.

I disagree with this. Price does matter. Simply because it hasn’t mattered throughout the current bull market does not mean that this environment will last forever.

It is a mistake to buy a wonderful company and not care about the price and history has taught these lessons repeatedly.

The Nifty Fifty Example

The Silent generation encountered this in the early 1970’s with the Nifty Fifty.

The Nifty Fifty were mostly outstanding companies. They checked all the boxes for a wonderful company. High ROIC. Strong long-term operating history. They could easily survive a recession. It didn’t take much imagination to envision continued growth.

In fact, most of them continued to be outstanding performers over the very long run. Most of them are still around and have exceptional long-term track records. Procter & Gamble. McDonald’s. Coca-Cola. Philip Morris. 3M. Walmart. American Express.

If you bought and held these Nifty Fifty stocks for 20-30 years, things worked out for you even though you paid a high price. Jeremy Siegel makes this point.

As Warren Buffett likes to say, time is the friend of the wonderful business. The Nifty 50 are proof of that.

Of course, no one actually buys and holds stocks for 30 years.

What happened from 1972-1982 was a different story: multiple compression. Multiple compression is when the price/fundamental ratios goes down. It’s an ugly situation where the business can continue to succeed, but the price suffers as the multiple declines. It’s a foreign concept to modern investors, but it happens.

Lawrence Hamtil wrote an excellent piece about the Nifty Fifty here.

Hamtil’s piece breaks down many of the track records of these companies for 10, 20, and 30 years.

While many of these excellent companies went on to have excellent 20 and 30 year returns (because time is the friend of the wonderful business), they delivered very poor results over the next 10 years from 1972-82.

Coca-Cola (the textbook example of a wonderful company), went on to deliver a 11.83% CAGR over the 20 years from 1972-92, but for the 10 years from 1972-82, is delivered a negative CAGR of 6.93%.

Coca-Cola continued to grow from 1972-82, but it didn’t matter. Multiple compression crushed the stock. It fell from the lofty heights of a 47.6x P/E multiple.

The same thing happened to Disney, another textbook example of a wonderful company. Disney – which traded at an 81x P/E in 1972 – delivered a -3.78% return from 1972-82. Because time is the friend of the wonderful business, it delivered a 10.81% return if you held through 1992, but who actually did that?

Everyone says their time horizon is long, but no one in the real world actually holds stocks that long. Everyone overestimates their real risk tolerance and time horizon.

This also assumes that during the Nifty Fifty you actually picked out the right companies. There were some that turned out to be long-term duds. Polaroid and Sears were also Nifty Fifty stocks, for instance.

The 1990’s

The same thing happened in the 1990’s.

Many people’s memories of the 1990’s bubble are foggy. They think it was all IPO’s like They think it was all cash burning garbage.

Modern FANGM investors scoff at comparisons of today’s great companies to the garbage bin of the 1990’s dot com craze. Google is certainly not a, for instance.

The thing is: the bubble companies of the late 1990’s weren’t all garbage. The late 1990’s bubble included many exceptional companies and went beyond technology stocks.

Coca-Cola was one of them. In 1999, Coca-Cola traded at an EV/Sales multiple of 8x. The EV/EBIT multiple was 30x. From 1999-2009, it continued to grow earnings and sales, but it didn’t matter for the price of the stock. The EV/Sales multiple declined from 8x to 3x. The EV/EBIT multiple compressed from 30x to 10x.

The stock was essentially flat from 2000-09, delivering a .7% CAGR. The business continued to perform, but it didn’t matter for the investor in the stock.

Microsoft is another example. Like Coke, Microsoft grew its business from 1999-09. Revenues and earnings steadily increased. They maintained high returns on capital. Their moat wasn’t breached. However, the stock was essentially flat during the period, returning a .64% CAGR.

Wal-Mart wasn’t exactly, but it still participated in the 1990’s bubble. In 1999, it traded at an EV/EBIT multiple of 40x. From 1999-09, it continued growing. The return wasn’t as bad as Coke and Microsoft, but still lackluster: only 3.63% and flat for most of the decade.

Some would say that this multiple compression was reflective of reality: two recessions, for instance.

I think that’s a little nuts. I don’t think it takes a genius to figure out, for instance, that a 30x or 40x multiple is high. Nor does it take a genius to figure out that Coca-Cola is probably going to make it through the Global Financial Crisis and people will continue to buy their products at the supermarket.

I don’t think wildly changing multiples are reflective of economic reality, which is what the EMH crowd would say. I think they’re reflective of the fact that people are crazy, Ben Graham was right, and the gyrations of the stock market are best described by the manic depressive mood shifts of Mr. Market rather than the elegant economic theories taught in classrooms.

Anyway, as history has proven, an exceptional business can deliver poor returns if you pay too high of a price. Investors in the 2000’s and 1970’s found this out the hard way.

This also assumes that you actually identified a wonderful business. What if you’re wrong? What if you think you’re buying Coca-Cola, Wal-Mart, and McDonald’s in 1972, but you’re actually buying Kodak, Sears, and Polaroid?

Many of the ‘buy wonderful businesses at any price’ investors will also console themselves in the work of Jeremy Siegel, who points out that if a Nifty Fifty investor held through the pain of the 1970’s, that they eventually made it on the other side okay. I think this is very unrealistic. My guess is that most people didn’t hold, and likely sold after a decade of poor performance.

Margin of Safety Matters

Buying a great business isn’t enough. A great business can easily experience multiple compression if bought at too high of a price.

Moreover, there are no guarantees that a great business will stay great. What if that dynamic changes? It’s one thing to buy a Microsoft at a high P/E and earn flat returns for 10 years and then make out okay after 20, but what if it’s not Microsoft? What if the business looks great today, but still falls apart?

I think you can use some common sense to identify great businesses, but I also think it’s possible you can be wrong about a few of them.

Multiple compression and the possibility of an error about the business are why I think a great business should only be purchased with a substantial margin of safety.

In my view, a portfolio of great businesses purchased at bargain basement multiples has a high probability of succeeding over the long run. If I buy at a cheap enough price, if the business doesn’t succeed, at least I didn’t pay too much. If the business succeeds, then I’ll get multiple appreciation on top of the performance of the business and the result will be outstanding. Meanwhile, multiple compression isn’t high on the list of concerns when bought at a 10x EV/EBIT multiple.

The darlings of the current era are probably wonderful companies. Most of them, anyway. I think the prospects of Google and Facebook are better than that of Netflix and Tesla.

But even in the case of Google and Facebook, I don’t think investors are thinking about the following questions: What if their multiples compress? What if we’re all wrong about the outstanding nature of these businesses and something happens where they cease to be wonderful companies? If we’re wrong about the business, multiple compression is going to be severe. If we’re right about the business, multiple compression can still result in a lost decade.

Even though price hasn’t mattered for the last 10 years, I still think price is important.

I think it’s a bad idea to abandon margin of safety and “never sell.”

Call me old fashioned: margin of safety is still an important concept.


Boom Like That: It’s about the architect of a Nifty 50 company, Ray Kroc

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.

Q3 2020 Update

Performance Overview

Year to date, I am currently down 14.42%. This is obviously worse than the S&P 500, which is up 5.58% through the end of Q3.

I am faring much better than most value ETF’s this year. VBR is down 18.15% YTD. QVAL is down 18.6%.

Much of my outperformance vs. value is due to trading & market timing, which is something I want to move away from. I was 50% cash going into the March crash, and that cushioned my losses when the crash happened.

I anticipated a recession last year when the yield curve inverted and accumulated cash as positions reached my estimate of intrinsic value.

I then failed to recognize the outstanding opportunity in March and didn’t buy enough value that was available.

I still have a lot of cash – 70% of my portfolio is cash. I will deploy it when I can find value and I’m not going to become fully invested right away.


I explained my shift in strategy in earlier posts. I am going to stop trying to flip bad, cyclical, no moat, businesses at low P/E’s. That’s a good strategy and the research shows it works. Of course, a bulk of the return happens in the early years emerging from a recession. The only way to capture that return is to hold onto it through thick and thin or to accurately identify where we are in the market cycle. Cyclicals are where you want to be in a 2009 or 1975, for instance. They’re not where you want to be in 2008 or 1974.

This strategy is wholly dependent upon the economic cycle and holding those companies is extremely difficult during a shock like COVID.

Going forward, I am only going to buy the sort of business that I would be comfortable holding through a downturn. I only want to own the kind of business that I would be willing to hold for 10 years if the stock market were shut down. This means I am going to become very concentrated – and very picky.

I bought three companies that express my new strategy:

Charles Schwab


Enterprise Product Partners

I sold the following positions:

Dick’s Sporting Goods (99% gain)

Friedman Industries (15% gain)

Village Supermarkets (5.7% gain)

RMR (a 35% loss)

Smith & Wesson (for a 169% gain)

Getting out of Friedman, Village, and RMR was an expression of my strategy shift. They simply aren’t the kind of outstanding businesses that I am looking to hold for a long period of time.

I bought Smith & Wesson early in the pandemic, anticipating that gun sales would increase with heightening economic turmoil and unrest. When it reached a Sales/EV valuation on par with the last time gun sales surged, I sold.

Dick’s also benefited from the pandemic, as camping goods and home exercise equipment sold well. I sold as it’s not dirt cheap anymore. It has also benefited from COVID and my sense is that stocks benefiting from the pandemic are played out, as seen in a lot of the prices.

Macro Observations

In 2019, I thought we were going to see a 50% decline with a standard recession. I thought we were headed for a standard recession when the yield curve inverted in mid 2019 and started preparing accordingly.

I thought this would be an event like 1973-74. When COVID began to trigger nationwide lockdowns, I thought the decline would be much worse than 1973-74 and more like 1930-32.

I then got extremely defensive and sold more positions, peaking around 80% cash and opening a small short position.

The stocks I owned weren’t of the highest quality – they were bad businesses at compressed multiples and my goal was to flip them for a higher multiple. I didn’t think that was going to work in the Depression I thought was unfolding triggered by nationwide lockdowns.

My move to cash in this brokerage account doesn’t even fully express how freaked out I was. I stocked up on canned goods, ammunition, and took cash out of the bank.

In March/April, I figured that we would be near 20% Depression level unemployment by October.

That is not what happened.

After peaking at 13.7% unemployment in May – unemployment has plummeted once the economy re-opened and stimulus kicked in. We now have a 8.4% unemployment rate.

To give some perspective, after the financial crisis (in which unemployment peaked at 10%), unemployment did not reach 8.4% until early 2012.

In other words, the job recovery we’ve had in 4 months is equivalent to what took 3 years after the financial crisis.

The economy re-opened, massive stimulus was poured into it, and we made tremendous progress against COVID.

Cases are up, but deaths are remaining at the same level we had in July. This is incredible to me considering that the lockdowns have been significantly rolled back in most states.

When deaths were declining in April & May, I assumed that they would surge once things re-opened. They did slightly, but not to the extent that I imagined.

It’s certainly possible we have a devastating second wave in the winter, but no one really knows.

It’s possible the economy takes another leg down.

No one knows that, either.

Meanwhile, the market has gone absolutely insane. The market has embraced risk to an extent that hasn’t been seen since the late ’90s.

The bubble has kicked into high gear. Every marco-valuation metric is now off the charts insane. Market cap/GDP and price/sales for the S&P 500 is now beyond 2000 internet bubble valuations.

I thought the COVID recession would end this bubble, but it simply sprayed gasoline at a raging inferno of speculation. Daytrading is now popular again, as bored sports gamblers decided to throw cash around in the public markets.

After living through the ’90s bubble and trading it as a teenager, I never imagined we’d see this kind of speculation ever again.

The posterchild for this insanity is Nikola. Nikola offered the promise of clean big rig trucks, but didn’t actually have products to sell yet. Fine in the VC realm, but in the public market? It then started trading like it actually achieved some kind of tech breakthrough when nothing had occured.

There is no doubt that a speculative fever is gripping public markets.

I know this will end in tears. It always does.

When, how, why? No one knows. But there is no way in hell that this speculative mania ends well.

I Don’t Want to Worry about Macro Any More

The best way to handle a bubble, in my opinion, is simply not to participate.

I thought I could predict when this would end – but that’s clearly not something I can do.

I also thought I could predict the economic cycle. I succeeded in anticipating a recession, but I got COVID all wrong.

My simple conclusion after failing and stressing about the overvaluation in the index and macro conditions is this:

I don’t want to worry about this stuff any more!

The simple way to alleviate my worries is to own outstanding businesses that I’m confident can survive an economic shock. If a 15% unemployment rate can kill the company, then I don’t want to own it.

I’m going to stop analyzing stocks and start analyzing businesses more deeply.

I am assembling a list of businesses that I think are outstanding. They have consistent, strong results. They have a competitive advantage. They have high returns on capital that they have sustained for a long period of time. They are not only businesses that I would be comfortable holding through a severe recession, but they are businesses I would be comfortable owning for 10 years if the stock market were shut down tomorrow and I couldn’t sell.

This list is akin to a Christmas list. I’m not buying any of them yet. I am going to watch these companies and wait for them to sell for a wonderful price.

At some point, many of these businesses will sell for cheap prices.

Many would say that outstanding companies will never sell for a wonderful price. I’ve found that simply to not be the case in my research. I cited a handful of examples in my blog post, Wonderful Companies at Wonderful Prices. There are many more examples, which I’ve posted about on Twitter. It is possible to buy wonderful companies at deep value prices.

I have plenty of dry powder. Like I said, 70% of my portfolio is cash. The plan isn’t to predict when the madness ends. The plan is to slowly deploy this cash and wait for wonderful businesses to sell for prices that I think are absurd and then hold for years.

This can happen in a lot of ways. A market crash would obviously offer that kind of opportunity and crashes happen all the time.

Mr. Market can offer it in the absence of a crash. There is no logical reason that Apple sold for a 10 P/E in 2016, for instance.

There can be a random, temporary event. Lockheed Martin sold for a 6x EV/EBIT multiple in 2011 when the defense budget was cut slightly, as if the Federal government had finally found spending religion. Fat chance.

How a wonderful business sells for a wonderful price doesn’t matter. What matters is that it happens frequently for all kinds of reasons. What I am going to do is sit on my butt and wait for the right opportunity.

I want to own the quality of businesses where I don’t have to know where we are in the economic cycle or when the bubble explodes or where the S&P 500 is headed or what the Fed is going to do. I’m sick of worrying about all of that.

I’ve also finally conceded that I can’t predict the economic cycle after two decades of trying.

Looking back, the worst thing that ever happened to my investing process was predicting the housing crisis and calling the bottom for stocks in March 2009. I saw a bubble forming and told my family to get out of stocks in 2006. I also told everyone I knew to go all-in in March 2009.

Successfully doing that – identifying a bubble in 2006 and identifying the low in 2009 – convinced me that I could predict the market & economic cycles.

My incorrect call in March has finally made me concede that I can’t. The future really is unknowable.

With this stock picking portfolio, I’m going to buy the quality of businesses where I won’t have to worry about any of that garbage any longer.

Meanwhile, I’ll have the confidence that most of my money is in the Weird Portfolio – a portfolio with plenty of built in protections and safeguards for most economic outcomes.


What is Judge Reinhold doing in this?

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.