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.

Trades

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

Biogen

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.

Random

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.