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Security Analysis Substack

I made a New Years Resolution to start writing up more companies. (I also would like to eat healthier and use less profanity, but I really enjoy Ben and Jerry’s and there are a lot of bad drivers.)

I want to turn over more rocks in the investment universe and do deeper dives.

This ought to add to my “crash wishlist” of companies which ought to be useful the next time that the market takes a dive. It will make me less reliant on stock screens if I’ve already done the homework.

I set up a Substack to facilitate these efforts.

Every entry in this substack will be a “company analysis” style post that I previously posted on this blog. Previously, I only wrote up companies that I decided to buy. Going forward, I am going to try to do more write up’s, including companies that I pass on.

I hope to analyze a lot of companies that are currently too expensive for my taste, but would be appealing at a more compelling price after a stock market crash, for instance.

I will still continue to update this blog and keep track of my portfolio in real time. I’ll continue to post my thoughts on investing concepts along with book reviews. I’ll continue to provide updates on my portfolio. However, the specific company level analysis will be posted in Substack.

If you would like to get on the mailing list, click here: https://valuestockgeek.substack.com/

Below is a copy of the first post, outlining the goals for the Substack. You can also read it here.

In Search of Wonderful Companies at Wonderful Prices

Greetings!

I have a blog where I track the performance of a real brokerage account where I invest my own money.

In the past, I only wrote about the companies that I decided to buy.

I’m starting this substack to do more company write-up’s. I am even going to write about companies that I don’t buy. I will still maintain my blog to track the performance of my portfolio, but I would like to use this substack as a medium to write up many companies – even ones that I pass on.

I am hunting for wonderful companies at wonderful prices, which I hold in a concentrated 12-15 stock portfolio.

“Wonderful companies at wonderful prices” is an extraordinarily tall order, but I don’t want to settle for anything less than that. I’m running an extremely concentrated portfolio, which means I have some very strict criteria. There are thousands of stocks globally, and I should be able to find 12-15 stocks meeting my criteria to fill up a portfolio.

I will pass on many companies because they don’t meet 100% of my criteria. Many will turn out to be great investments, anyway. I’m alright with that. I don’t need to be right about everything.

The sort of companies that I write up will meet most of my criteria. They have to at least pass a certain hurdle to get my attention to look deeply into it.

Because I am looking for cheap, high-quality businesses, you won’t find me writing up companies that are a cheap-dumpster-fire-with-potential (at one end of the spectrum) or excellent companies that are trading at very expensive prices (at the other).

To get my attention, it has to at least quantitatively look like it meets most of my criteria. This means I’ll write up companies like General Dynamics, but probably not Tesla (at one end of the spectrum) or a money-losing gold miner below tangible book (at the other end of the spectrum).

With all of that said, for every write-up, I will run through my checklist of criteria:

  • Can the stock deliver a 10% CAGR for the next decade?I am looking for situations where shareholder yield (dividends + buybacks) combined with modest growth in the business could deliver a 10% CAGR over the next 10 years.I would like the company to generate this shareholder yield with free cash flow that the business creates on its own. I’m not interested in companies that are issuing debt to buy back shares and issue dividends, which is a troubling sign.I do not want to rely on multiple appreciation (i.e., the P/E goes from 5 to 10) for my return. I tried for years to try to make money that way and failed at it. For future purchases, I am looking for businesses that are worthy of being held, not just traded for a pop in the next year.

    If I can’t meet this 10% hurdle, then I might as well own my asset allocation strategy, which I wrote about on Medium here.

    Owning individual securities is highly risky. Even the excellent situations that I’m looking for will have higher risks than a simple asset allocation strategy. If I can’t meet a 10% return hurdle as compensation for this risk, then I might as well own my asset allocation.
  • Has the business delivered consistent results over a long period of time? I am not looking for businesses where they endure a relentless boom-bust cycle. I want something with a proven track record of performance. I want a business that has survived recessions and thrived.

    I don’t want to rely on capturing a business at the nadir of a cycle and selling at a top. I will try to capture a business near a nadir – but I want the type of business where even if I get the timing wrong, I can still earn a decent return.
  • Does the return on equity consistently exceed 10% without the use of heavy leverage?This ties into my 10% return hurdle. Over the very long run (20+ years), the CAGR on most stocks is closely tied to the business’ return on equity over that time period.I would prefer a lot more than a 10% return on equity, but that’s the bare minimum to meet my return hurdle.

    I also don’t want companies that achieve a high ROE with the use of heavy leverage. Leverage works until it doesn’t. Even a rock-solid stable business can encounter unexpected trouble.
  • Is management sketchy?I don’t need the management team to be superstars. However, I do not want to be in business with someone who is dishonest or unethical. I don’t want to be in business with someone who can potentially be a fraud or engage in unethical practices that can sink a business. This means avoiding grifters, promoters, or the type of CEO’s that are obsessed with short sellers.
  • Is the company financially healthy?I discussed “low leverage” in the return on equity point, but there is more to financial health than low debt.In addition to a low debt/equity ratio, I will also take a look at the following criteria to assess financial health: 1) Interest coverage, 2) Altman Z-Score (bankruptcy risk), 3) M-Score (a measure that looks for signs of earnings manipulation), 4) Returns on capital consistently exceed the cost of capital.
  • Has the company consistently generated returns for shareholders? Is the industry in secular decline?I want companies that have already proven that they can generate returns for shareholders. I don’t want to speculate on companies without a proven track record. This means I will mostly avoid new & exciting companies. I’ll also avoid companies that appear to be in secular decline.
  • Has the company survived previous recessions? The economic cycle is unpredictable. This is a lesson I learned the hard way because I’ve tried to predict it and failed at it.I operate under the assumption that another 2007-09 recession can happen tomorrow. For that reason, I only want to hold companies that have proven themselves as able to endure past recessions without destroying shareholder value. If something had a 90% drawdown in 2008 and the firm was brought to the brink of bankruptcy, then I don’t want to own it in my portfolio.This criteria is also for my own psychology. I’m a risk-averse, pessimistic individual. When the world is going to hell in a handbasket, I don’t want to panic sell at the bottom. If I hold a business that has the ability to survive, then I can continue to hold it.
  • Does the company have a moat?I am looking for businesses with strong defenses against the competition. If a competitor can copy the company’s business model and kill it, then I’m not interested in owning it. If the product is commoditized and a lower price can causes customers to switch, then I’m not interested. I want businesses that have the ability to survive and are worth being held for long periods of time. I’m not interested in fads. I’m interested in businesses that will continue generating excess returns for the next 10 years.
  • Is the stock cheap on an absolute and relative basis?I want to pick up bargain securities that trade with a margin of safety.There are two reasons for this: 1) I want multiple appreciations to be a potential source of returns even though I don’t want to rely on it. 2) I don’t want to get killed by multiple compression. Coca-Cola in the late ‘90s was a wonderful business, but the market bid it up to a P/E of 50. It spent the next 10 years delivering zero returns to shareholders even while the underlying business grew.I want the cheapness of the stock to be obvious. I am not trying to find a margin of safety by torturing a DCF until it gives me the answer I want. I want actual quantitative bargains with low multiples.If I can maintain my discipline in this area, then it will keep me out of the hottest stocks and the hottest industries. That is by design.
  • If I was forced to hold the stock for 10 years, would I be terrified?This point combines all of the above criteria. I want to own businesses worthy of being held and I want to own them at compelling prices. If the thought of not being able to sell is terrifying, then I probably shouldn’t own it at all.

Future write-up’s will analyze companies on all of these points.

Random

One of my favorite rush songs. I was fortunate enough to hear them play it live back in 2011.

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.

Intel (INTC)

Key Statistics

EV/EBIT = 8.96x

FCF/Price = 7%

Debt/Equity = 49%

Return on Equity = 29.5%

Dividend Yield = 2.53%

The Company

Intel is the world’s dominant manufacturer of chips for PC’s and servers.

Intel was founded in 1968 by Gordon Moore and Robert Noyce. They left Fairchild Semiconductor to form their own company. They positioned themselves at the forefront of the new industry and sought to have the fastest chips in the market.

Gordon Moore coined “Moore’s law”: the number of transistors doubles on a chip every two years. The law became a target for the company and Intel has frequently had the fastest chip in the market. Intel itself has been the driving force behind Moore’s law becoming a reality. They have sometimes been outpaced by their competition, but they have always been able to regain their dominant position.

Over time, demand for chips has increased and Intel’s business grew with it. They developed close relationships with PC manufacturers, and this tight relationship along with strong R&D made them the dominant chip company.

Intel’s dominance has its roots in their development of x86 architecture, which was pioneered by Intel in 1978 and is still used by most PC’s and servers. Most PC software was written for the x86 architecture, giving Intel a sticky position in the PC market. AMD also makes x86 chips, but Intel remains the dominant player.

Below is the growth of Intel’s business over the last twenty years. In the last 10 years, EPS has grown at a 19.9% CAGR through a combination of growth in the business and buybacks.

Does this look like a falling knife?

My Take

Intel has high ROE, an incredible track record, secular growth prospects (we’re going to need more chips 10 years from now today than we do now). Why is it selling for a 8.96x EV/EBIT multiple?

The stock is cheap for two reasons: 1) Intel has recently fallen behind its rivals technologically. 2) The market prefers companies that outsource chip manufacturing and focuses more on chip design, a capital-light business.

Technological decline

In recent years, Intel has fallen behind the technological curve. I think this is temporary. The market seems to think it is permanent.

In July 2020, Intel announced that their 7-nanometer chips (nm – nanometer is a metric for measuring the size of transistors on the chip & smaller is better) were behind schedule and wouldn’t be released until 2022. In contrast, Samsung and TSMC have already transitioned to 5 nanometer manufacturing, making it clear that Intel is falling behind the curve. The delays mean that Intel will temporarily fall behind rivals AMD and Nvidia, who will likely gain more market share in the next couple of years. After the announcement, Intel shares fell by 9%.

Additionally, Apple announced that they are ending their reliance on Intel chips. Apple computers have used Intel chips since 2005. Apple is going to start using its own chips. Microsoft is making a similar move and announced that they are going to use their own chips in their products.

The perception in the market is that Intel is falling behind, squandering their cash flow on buybacks while they lose their competitive position, mirroring the similar decline of IBM.

Meanwhile, Intel spent $13.3 billion on research & development in 2019. This compares to $2.8 billion for Nvidia, $1.5 billion for AMD, and $3 billion for Taiwan semiconductor.

For all of the concerns over Intel’s loss of their competitive position, they still spend more on R&D than anyone else. They aren’t squandering their future to buy back stock and pay dividends, which is the popular narrative. This R&D spend has obviously been misspent – but the cash is available to make better chips.

Additionally, revenues, earnings, and cash flows have not declined. Through all of this, Intel has been consistently growing. 2020 was actually an excellent year for Intel, as lockdowns boosted demand for PC’s and Laptops.

Intel still has the dominant position in the PC market. Their revenues massively outpace that of any of their rivals.

They are pushing for faster and better chips. They aim to create 1.4 nanometer chips by 2029. Chip design & manufacture is an arms race and the key driver of that arms race is the money spent on R&D. I think that the company spending 375% more on R&D than the next rival will eventually be able to make a better chip.

In-house fabrication vs. a focus on design

Intel designs & fabricates computer chips.

The market prefers chip companies that don’t fabricate their own chips, like Nvidia, who outsources their manufacturing. Designing chips is a more profitable business than manufacturing them.

This is why Nvidia is rewarded with an EV/EBIT multiple of 86.2 and Intel with 8.96. This vast difference in valuation shows a simple narrative: Intel is a dying company and Nvidia will eventually dominate.

Even with the “bad” business of chip fabrication, Intel sports excellent margins. It currently has an operating margin of 32.8%, compared to Nvidia at 26.1%. With that said, Nvidia has significantly higher ROIC because chip design is more capital-light. Nvidia’s ROIC is 51.7% vs. Intel’s 21%.

This is why the market wants Intel to focus more on design.

Dan Loeb has recently announced a significant position in the stock and is pushing Intel to make strategic changes. This is why the stock went up 5% after Loeb’s activism was announced.

Management was already moving in the direction of outsourcing more production. Bob Swan is relatively new and is changing course from the management of the last decade, which oversaw the erosion of Intel’s competitive position. Management indicated recently that the “Ponte Vecchio” graphics chip may use outside factories, for instance. They also announced that they plan on outsourcing more manufacturing to TSM, another chip stock that has gone parabolic in 2020.

If that’s why they wanted to do, anyway – then I think Loeb’s activism will easily push them in a positive direction.

Prospects

I think it’s a fairly safe bet that Intel will pursue a strategic change, particularly considering that it was already considering going in a different direction.

It also seems unlikely to me that the company spending 375% more on R&D than its next competitor will remain behind the curve for long.

In addition to making faster chips for x86 style PC’s and servers, Intel is also acquiring smaller companies. Mobileye, for instance, is an important subsidiary. Mobileye is focused on self-driving car technology. Intel is also making significant investments in artificial intelligence, covered in this article by Fast Company. Nvidia has positioned itself as the AI leader, but I think Intel can catch up.

The incentives are strong to turn this situation around and Intel has the cash to make it happen.

They have fallen behind technologically and management has failed to execute over the last five years, but I don’t think that any of this is fatal or permanent.

Moat

Does Intel have a moat that defends it from competition?

I believe it has a moat. With that said, it isn’t as strong as other companies I have purchased recently like General Dynamics. The moat is also currently under attack, which is why the stock sells for a such a cheap price.

Intel’s moat is derived from its scale and tight relationships with the dominant manufacturers of PC’s.

Even with its recent manufacturing issues and the upcoming loss of Apple, it remains the top chip company. Intel did $71 billion in revenue last year. In contrast, AMD did $7.1 billion and Nvidia did $10.9 billion. TSM, which focuses on the manufacturing process, produces $35 billion in revenue. Intel is overwhelmingly the dominant player.

Competition is nothing new for Intel. It has battled AMD for decades. The sheer scale of Intel’s design & manufacturing capabilities gives it a cost advantage over its rivals and usually this results in Intel’s victory. Additionally, because x86 is the primary architecture for most PC’s, Intel’s dominance gives it a foothold there.

The recent worries over Intel losing customers is another major reason that the stock is down. Apple, for instance, used Intel chips in their PC’s and will use their own chip design in the future.

With that said, Intel still has relationships with the dominant sellers of PC’s. As of 2019, Apple represented only 7% of the PC market and is a relatively minor player. The big ones are Lenovo (24%), HP (22.2%), and Dell ( 16.8%). A bulk of all of these products run on Intel chips.

Of course, Intel can’t rest on that dominant position, as the world is subject to rapid technological change. Intel needs to use its scale and cash flow to solidify its future.

Recent manufacturing issues aside, I think that Intel is committed to maintaining its competitive position in the future. This is probably best reflected in its R&D budget.

The scale and vastly superior size of Intel’s R&D budget gives it an advantage over rivals. The stock is now selling for a cheap price because this is in question, but I fail to see how Intel’s overwhelming $13 billion annual spend on R&D won’t eventually result in them winning. This is a war and the company with the most troops (dollars) should ultimately win. Any innovation in this industry is going to be quickly commoditized. It’s a constant fight to develop the best and fastest chip. Intel’s R&D spend ought to get them there, even though they’re suffering temporary setbacks.

Intel’s acquisition of AI and self driving businesses also shows a commitment to their future: like Mobileye and Habana Labs.

This is not a company squandering its competitive position on buybacks, which seems to be the consensus view in the market.

Quantitative Considerations

Intel has a high degree of financial quality. The Z-Score is 3.54, implying that they have practically zero chance of going bankrupt in the near future. Debt/equity is only 49%. Return on equity is 29.5% despite the low leverage. With an M-Score of -2.88, there are no signs of earnings manipulation.

It seems unlikely that the stock will deliver negative returns over the next 10 years, unless they are completely overtaken by competitors.

Shareholder yield is high. The dividend yield is currently 2.53% and share count was reduced by 5% last year. They also have the margins and cash flow to sustain this yield that without ruining their business.

Intel isn’t operating in a declining industry. They are simply losing ground to rivals. It seems likely that semiconductor demand will be higher in 10 years than it is today.

Between EPS growth and shareholder yield, it seems likely that Intel stock could deliver a 10% CAGR over the next 10 years without any multiple appreciation.

With that said, at a 8.96 EV/EBIT multiple, I think a multiple re-rating is likely. Companies like Nvidia trades at 83x and AMD trades at 99x because they have temporarily leapt ahead. TSM trades at 27x. If the multiple re-rates, then the CAGR should be a lot higher than 10%. A 20x multiple seems reasonable for a high ROIC company with a dominant competitive position.

All of this said, I don’t have any special insight or knowledge into the chip industry. What I do understand is that 1) the incentives are there to turn this around (Bob Swan just became CEO in 2019 and seems determined to change course. The company is now attracting activists like Loeb), 2) the money is there to turn this around, 3) chip demand is not an industry in secular decline, 4) despite its trouble, Intel remains the dominant chip manufacturer with overwhelming financial resources to stay dominant.

Intel strikes me as a wonderful company at a wonderful price.

There is a leap of faith involved here. Faith is needed to believe that Intel will be able to turn around a deteriorating situation. I think they have the resources to do so. I think the incentives are there to do so. There is new management and activists are involved. The wonderful price is a result of the uncertainty. By the time that the uncertainty is gone, it will be 20x EV/EBIT and the opportunity to purchase a company of this quality will be gone.

Also, I think it’s worth noting that I looked at Intel back in October and I actually passed on it. Loeb’s involvement changed my mind. Now that it is attracting activists like Loeb (and Intel is listening), I think that the risk/reward is compelling. I think it’s a situation comparable to Microsoft in 2012 or Apple in 2013. It’s a strong company with a lot going for it, but it has been mismanaged for a few years and will benefit immensely from some activism & change. It has the resources & incentives to turn things around.

Checklist

  • Can the stock deliver a 10% CAGR for the next decade? The dividend yield is currently 2.5% and it is sustainable. Intel consistently buys back shares and share count is down 5% in the last year. Revenues grew over the last decade at a 7% rate. Even if that declines, a low growth rate combined with the shareholder yield could easily result in a 10% CAGR. Currently, the free cash flow yield is 7% and free cash flow is likely to grow in the future. At a P/E of 9, multiple appreciation on top of the growth & yield seems likely. It is easy to imagine how the stock could deliver a 10% CAGR for the next 10 years, if not more. Pass.
  • Has the business delivered consistent results over a long period of time? Despite the recent troubles, Intel has been able to consistently grow sales, cash flow, dividends, and earnings over the years. It is free cash flow generative. Pass.
  • Does return on equity consistently exceed 10% without the use of heavy leverage? Intel has averaged a 21.5% return on equity over the last decade with minimal leverage, passing my 10% hurdle. Pass.
  • Is management sketchy? Management has been transparent about the problems facing the company. The recent trouble has nothing to do with dishonesty or fraud. They aren’t shifty promoters or grifters. They aren’t obsessed with short sellers. Bob Swan strikes me as a competent and transparent leader who is committed to fixing the current situation. Pass.
  • Is the company financially healthy? Intel has a debt/equity ratio of 49%, which is low. The Altman Z-Score is 3.52, so no bankruptcy risk. M-Score is -2.88, so there are not any signs of earnings manipulation. Interest coverage is robust at 31. WACC is estimated at 4.5% and ROIC has averaged 19% for 10 years, so the company is not a net destroyer of capital. Pass.
  • Has the company consistently generated returns for shareholders? Is the industry in secular decline? The company has consistently generated positive returns for shareholders. Intel has generated a 11% CAGR since 2010. It returned only a 3% CAGR since 2000, but was in a bubble at that point. Chips are not an industry in secular decline. We will need more of them 10 years from now than we do today. Pass.
  • Has the company survived previous recessions? Intel did not report losses in earnings or negative free cash flow during the last two recessions. Cash & earnings declined slightly, but the company was never in any dire trouble. The stock drawdown was serious in the early 2000’s (80%), but this was due to the overvaluation of the stock, not the performance of the business. Pass.
  • Does the company have a moat? Intel has a moat in terms of its dominance of the still-dominant x86 architecture and tight relationships with PC manufacturers. Its scale also give it cost advantages over competitors. It has an overwhelmingly larger R&D budget than its competitors. However, Intel’s moat is under attack. With that said, I think that Intel has the financial resources to survive the current assault on its moat. With new management and activist involvement, it is likely that they shift their strategic direction. The current troubles are also a source of the compelling price. If I wait for the issues to be resolved, the “wonderful price” will likely be gone by that point. Pass, with reservations.
  • Is the stock cheap on an absolute and relative basis? EV/EBIT is currently 8.96, the P/E is 10, and the forward P/E is 11. The free cash flow yield is 7%. These metrics are cheap on an absolute and a relative basis. Pass.
  • If I was forced to hold the stock for 10 years, would I be terrified? I wouldn’t be terrified if I was forced to hold this company for 10 years. The industry isn’t in secular decline and the company is not a mall-retailer or Kodak-style melting ice cube. Intel is financially healthy, so I think the possibility of a bankruptcy in the next 10 years is approximately zero. They’ve shown resilience in past recessions, so I would be comfortable holding through a nasty recession. The stock isn’t expensive, so I don’t think it can be destroyed by multiple compression if interest rates go up or if the broader market embraces reason. While they could see their moat erode over the next decade, I don’t think that this is an investment which could result in a permanent loss of capital or suffer a catastrophic drawdown. Pass.

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.

2020: Year End Review

Performance

The performance of the active account that I track on this blog was poor. This was mainly due to my mistakes.

It has been four years since I began this experiment: move money to a fresh investment account and track the trades in real time on a blog.

The great thing about this exercise is that it has forced me to rub my nose in my errors. This is a live trading journal. Putting my thoughts down here makes it impossible to delude myself.

This is now year #4 of poor performance. I’ve had three years of underperforming the market and 1 in which I basically matched the performance of the market. I’ve outperformed the deep value universe, but that is little consolation.

In 2020, I lost 2.98% compared to the S&P 500’s gain of 18.37%.

With that said, it could have been even worse.

My max drawdown this year was only about 20% compared to the 50% drawdown that occurred for the EV/EBIT < 5 universe that I track. That universe is down 7% for the year. It’s also pretty good performance considering I managed to recover from a 20% drawdown when I was 80% cash and also owned a short ETF.

The March drawdown was contained because I went into that crash nearly 50% cash.

I also sold aggressively as the crash went on, eventually building my cash balance up to 80%. I should have pounced on the value that was available at that time, but didn’t because I assumed this was another 1973-74 and 2007-09.

I even bought a short ETF. Fortunately, I had enough sense to get out of that position when the S&P 500 went above the 200-day moving average.

Mistakes

I made a number of mistakes including:

  1. Timing the market.
  2. Attempting to predict the macro-economy.
  3. Trading too much.
  4. Purchasing bad businesses in the hopes of flipping them for some multiple appreciation.

I previously thought that an astute investor could predict the macroeconomy using things like the yield curve, valuation metrics, and statistics on debt.

This year finally rid me of that belief. I don’t think anyone could have predicted that a pandemic would decimate the market in March. I also don’t think anyone could have predicted that the market would bounce off the lows in March. Those that bought in March got lucky it didn’t turn into a 2008 debacle. It could have easily turned into that.

The last time we saw action in the market like this (when the market collapsed and then bounced back into bull territory) was in 1987. I thought this one was going to unfold more like 1973-74 or 2007-09, considering that the impact of lockdowns was reflective in the real economy. The 1987 crash was a purely market event. Nothing was wrong in the real world.

Lessons

My errors this year caused me to revisit the entire approach that I had to investing.

I’ve had four years of getting my butt kicked by the S&P 500, and then I failed to accurately call the macroeconomy this year.

This summer it started to become apparent to me that I made an error as I watched the unemployment rate collapse as the lockdowns ended and stimulus kicked in.

I considered moving this account to my passive strategy, the Weird Portfolio. That’s how I am investing most of my money and the strategy has been working for me. I thought about giving up on this pursuit of trying to pick stocks.

This account was money that I specifically set aside to apply Ben Graham’s “Simple Way” strategy. Put another way, this account on the blog is a variable portfolio: an account where I can pick stocks and try to actively beat the market.

My frustrations over this account made me reconsider whether it was worth all of the aggravation of analyzing stocks and actively trading. For four years, I have been pounding my head against a wall with nothing to show for it. The amount of effort I’ve put into this has basically been a part time job. It’s really frustrating when you put all of that effort into something and have nothing to show for it after four years of trying. I probably would have been better off with an actual part time job. Effort spent delivering pizza would have been a more productive use of my time.

Ultimately, I decided to continue. Rather than give up, I decided to learn from my failures and try something new. Instead of trying to flip bad businesses and time the economic cycle, I decided that I would try a longer-term approach. I would buy businesses worth owning for the long haul and purchase them at attractive prices.

The positions that I purchased in the last four months reflect this philosophy:

General Dynamics

Charles Schwab

Enterprise Product Partners

Biogen

These are all businesses that I am confident will grow over time and I purchased them at attractive prices. These aren’t the kind of stocks that I need to immediately sell as soon as there is an operational hiccup or if they hit a reasonable valuation. I used to own things like Gamestop and the Gap, which needed to be sold as soon as they rose in price or if the operations fell apart.

For a company like General Dynamics, if the economy rolls over tomorrow, I don’t have to worry about the business collapsing. I don’t have to frantically get the sell order in as soon as it hits my target price.

I am saying “no” to a lot of stocks that I would have purchased aggressively a few years ago. If it’s not at a compelling price, it’s a no from me. If I would be terrified to be stuck in the position for 10 years without selling, then I’m saying no.

No more compromises.

I am trying to look at the market less as a trader and more as the owner of businesses. I want to rely less on multiple appreciation as a source of returns and buy the sort of businesses worth holding.

I used to check my portfolio multiple times a day. I deleted the app on my phone. I have been checking it less and less. I still probably look at it too much, but at least I’m making progress. I would like to get to a state where I only look at it once a quarter.

Cash Drag

My pursuit of wonderful businesses at wonderful prices comes with a problem: there aren’t a lot of them. This means I wind up holding a lot of cash, which is a drag on returns.

I decided to put the cash into my asset allocation strategy, the weird portfolio.

Currently, 53% of this account is invested in my weird portfolio strategy.

Eventually, my hope is to be fully invested in 12-15 wonderful businesses purchased at wonderful prices.

As I hunt for these rare opportunities, the remaining balance of this brokerage account is in my asset allocation strategy to prevent cash drag.

To put it another way, I hope to never have another year where my frantic trading activity looks like this. This was a ridiculous waste of time and activity.

The Weird Portfolio

Speaking of my asset allocation strategy (which is how I invest most of my money), I have been pleased with the reception to it. I wrote a long-form Medium post about it and I’ve enjoyed discussing it.

I spent two years researching and refining it. Writing it all down was helpful for me.

The portfolio served me well this year.

When I was idiotically bailing in March with this account, I stuck to the weird portfolio.

I knew the treasuries and gold would restraint the drawdown. I knew that if the Fed’s money creation spurred inflation, I had gold and real estate. I knew that if we had a double dip recession, I had long term treasuries that would go up if the Fed eased more. I knew that if prosperity resumed, small value would rip.

This year (which felt like four years of market history), the portfolio did what it was supposed to.

In Q1, gold and treasuries restrained the drawdown. As the economy recovered, the “offense” pieces of the portfolio kicked into high gear. As people worried about inflation from the Fed’s actions, gold did well.

When the vaccine news came out in Q4, small value went nuts while LT treasuries went down.

The portfolio did what it was supposed to do. While I was trading like a maniac in this account, I let the rest of my money sit in my asset allocation and do what it was designed to do.

When all was said and done, the weird portfolio returned 10.87% and I had a max drawdown of 13.66% this year. I think that Ben Graham would refer to this performance as satisfactory.

Most importantly, it was a stress free return. I knew that no matter what happened to the economy, I had something in the portfolio that would benefit. No crystal balls or newsletter subscriptions required.

Macro

In past year-end posts, I included a big section with my predictions about the macro-economy. I’d talk about the yield curve, valuations, inflation expectations, the value-growth divide, etc.

I’m done with that. I have no idea what’s going to happen next. Maybe more lockdowns will cause economic turmoil. Maybe the vaccine makes the economy roar back to life. Maybe the Fed’s actions cause USD to decline and inflation to ramp up.

Markets looks frothy. We’re clearly in a “risk on” environment. There are stocks that are expensive. Of course, I don’t own those stocks. I don’t own market cap weighted indexes. So, what’s the point of worrying about it?

I have no idea what will happen next and I’m tired of thinking about it. I know nothing.

I have been following the market and investing for over 20 years. I started this bad habit in high school.

The entire time I thought that I could predict the macroeconomy if I thought hard enough and analyzed things. After 20 years of trying, I now concede that it’s impossible.

I’ve also finally realized is that no one else knows what is going to happen, either. I’ve wasted a lot of time and mental energy worrying about forecasts and predictions from “experts.” They don’t know what is going to happen, but that won’t stop them from plugging their predictions on Twitter, on podcasts, in book form, etc.

I stopped following these people on Twitter. I’ve muted their accounts. I stopped listening to their podcasts.

The reality is that no one knows wtf will happen with the dollar, inflation, or interest rates. Anyone who claims that they can do this is either a fool or a charlatan.

The finance industry is wretched hive of fools and charlatans.

What I do know is that I have an asset allocation that ought to protect my money no matter what happens and should deliver a decent return over the long haul.

In this account, I own some really great businesses that I bought at attractive prices. I think that strategy is evergreen.

Hopefully, this strategy will deliver satisfactory returns. While that’s not a guarantee, I can say with certainty that this approach will reduce my self-imposed stress.

Random

I re-watched Deep Space Nine this year. I watched it in high school and never revisited it. I’m glad I did. Through adult eyes, the show had relevance I never picked up on when I was younger. I recommend watching it. This is a great guide to watching it.

Three episodes stood out to me as the absolute best. They all had pretty heavy themes:

  1. Duet. An examination of war crimes.
  2. The Visitor. An episode about how obsession can impact your life. Also a good analysis of the relationship between father and son.
  3. In the Pale Moonlight. This one is all about moral compromise in war.

Also, CBS should remaster it in 4k. This is a good example of what that would look like.

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.

Predictions are Worthless

I hope you had a great Thanksgiving!

Macroeconomic Predictions are Worth Less Than Used Toilet Paper

This year, it finally became clear to me that the macro economy is truly unpredictable and most predictions are worth less than toilet paper.

I previously thought that you could predict the economy to a limited degree – i.e., you could use things like the yield curve and valuation metrics to show when animal spirits were high and a collapse was near. Now, I don’t even think that is possible.

The economy is more unpredictable than the actions of an individual that has recently consumed 10 shots of vodka and three red bulls. They’re not going to pass out – they’ve had 3 red bulls, after all. Of course, their brain is completely shut off from any semblance of rational thought. Who knows where the night will lead? Probably nowhere good, but the specifics will be quite unpredictable. Butchered karaoke? A fall on concrete? An ill-advised romantic liaison? An iPhone in a toilet?

Actually – scratch my earlier comment – 2020 showed that toilet paper can be quite valuable and worthy of brawls similar to those over big TV’s on Black Friday.

Let’s go with this: macro predictions are worth less than used toilet paper.

Who could have predicted in January that a pandemic would spread throughout the world and that governments would respond by completely shutting down their economies? An economic shutdown is something they didn’t even pursue in 1918. Shutdowns were like using shotgun blasts to kill a mouse. As fun as that sounds, it isn’t the ideal solution.

In April, who could have predicted that the pandemic wasn’t going to spread as fast as we feared? Who could have predicted that once restrictions were lifted that GDP would rapidly recover and unemployment would begin declining?

There are a bunch of people who did recognize COVID early on – but with rare exceptions, these are mostly the same people who have been predicting a Mad Max style economic apocalypse every day for the last 10 years. From a markets perspective, they had their day in the sun for a month.

There are also folks who “predicted” the turnaround in markets and the economy and went all-in on stocks in March, but how useful is that if they didn’t successfully predict the March crash ahead of time and have cash to deploy?

It was also quite possible that a 30% decline wasn’t enough. Market history would suggest that that the decline would be more like 50% if the recession were anything like 1973-74 or 2007-09.

My conclusion is simple: trying to predict this stuff is impossible and a waste of brain matter.

I suppose that prediction can be viewed as a fun little game. Maybe it’s financial entertainment (isn’t that an oxymoron – like vegan chili?).

Unfortunately, for many people (including me), it turns into a lot more than that and people start thinking they can predict macro like they’re the next Stanley Druckenmiller (they’re not).

Where is the hyperinflation?

Since 2010, I’ve consumed a lot of very bearish content.

The details differ but the same thread pervades all of it: The Fed and quantitative easing are insane, the Fed is fueling a debt binge and a bubble in stocks & real estate, and the system will eventually collapse because of it. Zimbabwe, hear we come.

When you consume enough of this content, you eventually want to sell every stock you own and load up on gold/puts/bitcoin. In more extreme scenarios, you may want to load up on guns, ammo, and canned goods. They’ll only take the Chef Boyardee from my dead, cold hands.

The trouble with this “the Fed is destroying the financial system” line of reasoning is that it has been wrong for a long time, even though it is quite convincing.

This was all of the rage circa 2010, as we emerged from the financial crisis. The Fed responded to that financial crisis aggressively. Back then, I thought that all of this “printing” would eventually have some kind of dire consequence.

After all, as someone who grew up Catholic, I always assume that any degree of fun or success will be swiftly punished.

This video became widespread around this time that sums up the zeitgeist pretty well:

There was also this letter to Ben Bernanke written by some of the greatest financial minds of the planet warning that quantitative easing must be stopped.

From the letter: “The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.”

The problem is that the hyperinflation and dollar collapse never happened.

Here is a look at the inflation rates by decade:

The 2010’s actually had the lowest average inflation in the last six decades. This is quite surprising after a “money-printing” tsunami has engulfed the world after the financial crisis. The US dollar also strengthened in the 2010’s.

There are a lot of explanations for why inflation didn’t happen. I tend to think it has something to do with the declining velocity of money.

Whatever the explanation, the key thing is that everyone was wrong.

When I hear people complain about inflation today, I think it’s pretty funny. I remember as a teenager in the 1990’s that people were elated that inflation was so “low” because their baseline was the 1970’s. It was viewed as an economic miracle that inflation was only 3%.

It’s funny how three decades of low inflation can transform people’s perspectives. Now that memories of the 1970’s have faded, 2% inflation is viewed as unacceptable debasement that will trigger the collapse Western Civilization.

Meanwhile, 10% inflation in the 1970’s didn’t cause a collapse, but we were unfortunately subjected to disco.

The Doomers will go on to say that inflation is here, but the government is lying about inflation rates. They’re not wrong, the government is lying. Indeed. The higher numbers on my bathroom scale have nothing to do with the pasta I’ve eaten in quarantine – the scale is obviously broken and fraudulent.

Healthcare & Education

The Fed hating Doomers will often point to health care and education as examples of inflation that aren’t covered by the official statistics.

First off, healthcare and education are included in the CPI. If you want to read the actual methods that the government uses to calculate CPI, then read it here.

Of course, why bother reading about the BLS’s actual methodology when you can hate on the Fed and rely on anecdotes for inflation? Have you been to the grocery store lately?

But, whatever. Let’s take the argument at face value. Healthcare and education are examples of inflation that the government is misleading us about.

The relevant question is this: are the increases in healthcare and education caused by the Fed?

Healthcare costs have outpaced inflation since the 1960’s. Education costs have outpaced inflation since the 1960’s.

If the price increases of a good exceed inflation by a few percent a year – and you compound that over 50 years – it will become extremely expensive. That has basically been the story with healthcare & education since the 1960’s.

If these increases weren’t caused by the Fed, then what caused them?

I would argue that government policy caused them.

The Higher Education Act of 1965 made it very easy for students to borrow money to go to college. The government also started to back student loans in the 1960’s as a result of this legislation. This meant that a flood of money (with little price consciousness) poured into a limited resource – higher education. This made price increases outpace inflation.

Compound that for 50 years, and you get really high tuition rates.

Where does the money go? Anyone who has been on a college campus in the last 20 years can tell you. There are recreation centers better than most private gyms fully equipped with “free” saunas and personal trainers. There are administrators with titles like deputy vice president of community climate affairs that make $158,000/year.

Healthcare is a bit more complex but the dynamics are the same. There is little price consciousness in healthcare. No one directly pays for anything. Your health insurance company pays.

This dynamic came out of the high tax rates of the 1940’s. As tax rates increased during World War II, employers looked for ways to pay their employees in ways that wouldn’t be taxed. They found that health insurance was a good way to reward employees and avoid the tax man. Employees liked it.

The result was that health insurance became linked to employment. As health insurance became widespread, instead of going to a doctor and paying out of pocket, everyone started using health insurance for even routine treatments and check-ups.

When people stopped paying directly, they became less price conscious, and this helped fuel inflation in the healthcare sector. Before all of this, you would just pay out of pocket and would shop around for the best price. If your doctor charged you $500 for aspirin and a band aid, you’d say: “What the hell, man?”

With health insurance, you went anywhere you wanted and didn’t really care about the price because the insurance company was paying for it. Compound this for 50 years, and you get a situation where a Band-Aid costs $629 in a hospital.

I was briefly without health insurance and found it annoying how it was hard to get a cash price. When I called a doctor’s office to explain that I would pay with cash, it made their heads explode and they couldn’t quote me a price.

Also, in the 1960’s, the federal government introduced Medicare, which covered the healthcare of seniors. Seniors are the biggest consumers of healthcare. This – predictably – led to increases in the cost of healthcare.

The government kept trying to Band-Aid healthcare inflation over the following decades, but it only compounded the problem.

The core problem with healthcare is that traditional laws of supply and demand don’t work because no one is directly paying for anything. If you compound something that outpaces inflation over 50 years, you get really high prices.

US healthcare costs are now 17.7% of GDP – which are the highest in the world.

The US has an odd healthcare system that combines capitalism with government-fueled taxpayer cash and no price consciousness. It’s like we took the worst aspects of both socialism and capitalism and combined them into an unholy hybrid – like orange juice and toothpaste.

Bottom line, I don’t think that the increases in healthcare and education have anything to do with the Fed, even though they are blamed for all of the problems in the world.

What to Do?

Perhaps you’re like me and you often worry about this sort of thing.

What if the Doomers are right and the economy is a ticking time bomb about to unleash a tsunami of hyperinflation?

They’ve been wrong for 10 years and never apologize for their failures or are held accountable – but let’s take these arguments at face value.

There are many ways to protect a portfolio from inflation without betting the ranch that it will actually happen.

Personally, I have 20% of my asset allocation in gold. Over time, gold will largely retain its purchasing power. It will also be worth something even if the US government collapses, as it has retained value for 5,000 years of human history.

Note: with gold, the road to “retaining purchasing power” is incredibly rocky and volatile, but gold prices have a track record of going bonkers when inflation rates are accelerating when interest rate sensitive assets are getting crushed.

I also have 20% in real estate. Real estate ought to also keep up with inflation. Not only will property itself increase with the inflation rate, but rents will increase with inflation as well.

Another solution is TIPS – or treasury inflation protected securities.

My preference is for gold instead of TIPS because I’m a worrier who is concerned with things like the collapse of the US government and the dollar. This is a side effect of downloading too many bearish predictions of doom into my brain.

If you’re not as worried as me about total collapse, then TIPS are a fine solution. TIPS are treasury bonds that adjust the principal balance for inflation. The coupon on TIPS are determined based on the inflation-adjusted principal of the bond, so both the interest and the principal are adjusted for inflation.

It makes a lot of sense to protect a portfolio from inflation. It ought to be a goal of every portfolio.

Inflation is certainly one of the greatest risks that an investor faces. Over time, a slow and steady rate of inflation will erode the purchasing power of currencies. This is very bad for someone whose asset allocation is cash-in-a-mattress or Walter White’s storage locker:

A rising inflation rate will also cause issues with other assets, as higher interest rates will lead to lower prices for stocks (P/E’s will decline) and bonds (interest rates will go up and bond prices will go down).

However, while inflation protection is essential for a portfolio, that’s different from making a one-sided bet that high inflation is a guaranteed outcome.

There are also plenty of ways to protect a portfolio from a sharp decline in stocks. I use long-term treasuries, but that is far from the only solution. Hedging strategies are also available. Cash helps. Most inflation solutions (TIPS, gold) also tend to hold up well in a crash.

Having these elements in a portfolio as insurance is different from trying to predict them.

As the last year and decade have demonstrated, this stuff is unpredictable. The best economic minds thought that higher inflation was certain in 2010 and they were completely wrong. In March, it looked like the US economy was headed into a second Great Depression. That didn’t happen, either.

The beauty of a good asset allocation strategy is that you don’t have to predict anything.

With something like the weird portfolio, I sleep well at night knowing that no matter what unfolds in the macro-economy, I’m covered. I own an asset class that will do well in most macro environments.

I think that’s the better way to approach this stuff rather than pursue the fool’s errand of attempting to predict the future.

Also, the weird portfolio isn’t the only solution. There are plenty of others. I learned a lot from Harry Browne’s Permanent Portfolio, which you can read about here.

The key takeaway is that macro is completely unpredictable. Anyone selling you a prediction is either a fool (this is the case with my predictions) or has an agenda – like pumping up the price of an asset, selling ads on a podcast with provocative content that boosts ratings, or selling books.

Don’t get swept up in it.

Shut it off.

Prepare, don’t predict.

Random

If you are looking for a different take on the Fed (from someone who actually got it right in 2010), then I highly recommend the work of Cullen Roche. This is an excellent post he wrote addressing common misconceptions about the Fed.

One of my favorite TNG episodes:

Eat any good books lately?

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.

Beware of Gurus Peddling Predictions

My Macro Obsession

I have a problem that I think a lot of investors have: I love macroeconomics.

There are few things more fascinating to me than trying to predict the economic cycle. I want to know if we’re going to have a recession or if we’re going to have a boom. I want to know if inflation and interest rates will roar back to life. I like to look back in history and analyze the twists and turns and hope that can shed light on what will happen next.

It’s a fun exercise, but it’s largely a waste of time.

The trouble with my macro-obsession is that it has led to poor investing decisions and outcomes. I failed to buy a number of stocks that were attractively priced in March because I was convinced that the United States was headed for a second Great Depression. I looked at the overvaluation of mega-cap stocks and used that as a reason to avoid other, more attractively priced, stocks that were outside of that universe.

I was completely wrong and blew it, as did many others in the market. At least I admit it.

Getting that wrong was a humbling experience for me.

I could have doubled down — I wasn’t wrong, the Fed is merely compounding their errors! I wasn’t wrong, the collapse was simply delayed! I’m not wrong; the government is lying about the unemployment and inflation statistics!

Do those responses seem like a rational explanation, or are they an example of bargaining and an attempt to rationalize an error?

Instead, my experience has led me to a different conclusion: macroeconomics is really hard and a waste of time. I want to have a portfolio that is prepared for different macroeconomic outcomes — but I’m not going to bet on a single one of them unfolding.

Some might say that macro prediction is worthwhile. I might have been a dummy about it, but they’re not dummies and they can do it!

Well, the question I ask of them: How many people can you name off the top of your head that became rich with their macroeconomic predictions?

If you go through the Forbes 400, there aren’t any macroeconomists. In other words, no one who has devoted themselves to a study of what makes the world’s economy tick have been able to get rich by predicting economic cycles, currencies, or interest rates.

Macro Gurus

The most famous macroeconomist in history is John Maynard Keynes. What is most interesting about Keynes is that he started out investing by trying to predict the economic cycle. He tried to predict recessions, currency movements, and the prices of commodities.

In the early 1930’s, he lost 80% of his money. He failed at attempting to predict macro-economics. This caused him to move on from top-down economic analysis to a focus on value investing: buying individual businesses at a discount to their intrinsic value.

If Keynes can’t do it, what makes you think that you can?

Within the Forbes 400, there are only two people who have used macro-economic predictions to consistently make money: George Soros and Ray Dalio.

For those two individuals, it’s also important to note that they don’t bet everything on a single outcome, and they are frequently wrong.

Dalio successfully predicted the financial crisis of 2007–09, but he has also been saying that we are in a situation similar to 1937 for most of the last decade. The 1937-style market decline has never materialized. He also proclaimed that “cash is trash” in early 2020 shortly before the COVID crash, when many hoped that they had more cash in their portfolio.

Dalio isn’t the only one who can get macro wrong.

There are plenty of other gurus who got things wrong.

Here is a macro prediction from Seth Klarman:

“By holding interest rates at zero, the government is basically tricking the population into going long on just about every kind of security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can’t stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate.”

This was not from April 2020. It was from May 2010. If you invested $10,000 on the day that this prediction was made, you would now have $35,000. Klarman got it wrong.

It’s also worth noting that Klarman isn’t rich because of macro predictions: he’s rich because he shrewdly buys assets when they are at a sharp discount to his estimate of intrinsic value, which he is quite skilled at calculating.

George Soros is famous for a successful bet against the British pound in 1992. He has become a billionaire by making outsized macro bets. But he’s hardly foolproof.

In 1987, he argued that the world’s reliance on the dollar would lead to: “financial turmoil, beggar-thy-neighbor policies leading to world-wide depression and perhaps even war.”

It didn’t happen.

In 1998, he made similar predictions in his book “The Crisis of Global Capitalism” and those predictions did not materialize.

If Soros frequently gets it wrong, then how is he successful as a macro trader?

The thing is: he’s a trader and he acknowledges errors and corrects positions when they’re wrong. He never bets everything on a single prediction. Soros makes many bets and never bets the ranch on a single outcome. He’s flexible and will move out of positions when he is wrong. Soros himself has said: “I’m only rich because I know when I’m wrong.”

In 2010, a who’s-who of the financial world wrote a letter in the Wall Street Journal imploring the Federal Reserve to stop their quantitative easing program. In their words, they believed that quantitative easing would risk “currency debasement and inflation.”

They were wrong! The reality is that the 2010’s witnessed some of the lowest inflation on record. The US Dollar actually strengthened after quantitative easing.

Of course, perma-bears and Fed critics will scoff at this. They’ll say that if you actually measure inflation by their metrics — inflation is actually higher than the government’s lies!

Another argument is that inflation hasn’t come through actual increases in the prices of goods — the entire stock market boom of the last 10 years has been inflationary.

Another argument would be that the only reason that the USD has strengthened is because other central banks have ramped up their “money printing” more than the rest.

Does this sound to you like sound reasoning, or does it sound like bargaining and attempt to rationalize a prediction that was wrong?

They never seem to consider the possibility that they just got it wrong. What’s more likely? That they were wrong 10 years ago, or that government statistics are lies and the debasement occurred anyway?

As for the “it didn’t affect prices of goods, just assets” — well, if all of this “money printing” was going to cause asset inflation, then why didn’t these people buy financial assets? Why weren’t they able to predict that it would cause a decade long bull market and successfully position for it?

Hindsight is 20/20. No one likes to admit that they’re wrong, so they invent excuses instead of facing the possibility that they might have just been wrong.

The reality is this: no one can predict the macro-economy. The two people on the Forbes 400 that were actually able to predict macro are error prone. When they do make errors, they own up to them and quickly correct their position. This is a sharp contrast to the macro guru’s that you’ll find on Twitter.

If there aren’t any rich macroeconomists — if there aren’t any rich financiers who did it by predicting the macro economy — if the only two people that got rich from macro make errors — then what makes you think that you can do it? What makes you think that your favorite Twitter guru can do it?

Be Wary of Gurus Bearing Predictions

There are a many gurus in the financial world. They make their proclamations on Twitter, on podcasts, or on TV. They sell books proclaiming their predictions. They exude total confidence.

My question is simple: if they can predict what’s going to happen, then why aren’t they already rich from it? What makes them better than George Soros, Ray Dalio, or John Maynard Keynes?

This is the reality that I wish I absorbed earlier. I suppose it’s something I had to learn via experience.

The reality is that nobody knows what is going to happen.

Most of the people confidently proclaiming financial predictions are selling something. Always approach their predictions through that prism. What are they selling? How do their proclamations tie into what they are selling?

They are attempting to sell books. They want higher ratings on podcasts. They want you to subscribe to their videos or sell ads.

Saying something like: “Have a balanced portfolio prepared for different outcomes” does not generate clicks and ratings. Proclaiming our imminent doom does generate ratings and clicks.

They have an agenda and it’s important that you realize that before consuming that content.

This doesn’t mean that macroeconomics is a total waste of time or should be ignored. I simply think that it is folly to imagine that any of us can predict the next turn in currencies, inflation, interest rates, or the economic cycle.

It does make sense to imagine how a portfolio would react in different situations. There should a plan for different outcomes. I think it makes sense to hold a diversified portfolio of assets that will deliver a return in different macro environments.

This is what Harry Browne tried to do with the Permanent Portfolio, which is a better template to think about these matters than trying to find the guru with the right crystal ball. The Permanent Portfolio is prepared for different macroeconomic outcomes. I have my own spin on this with the Weird Portfolio.

Whatever the mix, it doesn’t matter. The key is to acknowledge that macro prediction is really hard and likely a waste of time.

While it makes sense to have plans for different outcomes, it doesn’t make sense to think that you can actually predict the twists and turns of the macroeconomic landscape. Prediction is a fool’s errand and I’m a fool for attempting. I was a fool for trying to do this. At least I own up to it.

Will the Doomers eventually be right and will we have inflation? Well, I own some gold in case that happens. Will we have another deflationary bust? I own long term treasuries if that happens. I have some cash in an emergency fund. Will the US be replaced as a superpower? I have assets in other countries in case my country falls behind.

Will civilization collapse? Well, then it won’t matter how a portfolio is positioned, anyway. Guns and canned goods will carry more value than gold bars, puts on the S&P 500, or Bitcoin. (I have guns and canned goods, too, because I’m a bit paranoid!)

If you find yourself totally absorbed in a single macroeconomic thesis, I would caution strongly against it. The greatest names in Finance frequently fail at that game. There aren’t any rich macroeconomists.

Be careful out there and be wary of gurus peddling predictions.

Random

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.

Swing, You Bum!

I hope you had a fun Halloween!

60% Cash

For most of this year, I’ve had most of this account in cash.

At the end of last week, 60% of this account was in cash, earning nothing.

With my new strategy – a concentrated 12 stock portfolio of wonderful companies purchased at wonderful prices – it is going to be difficult to deploy all of this cash right away.

I am on the hunt for rare birds – wonderful companies at wonderful prices. My goal is to fill up a portfolio with 12 of these positions. The problem is that these situations are rare, so it will take some time to find 12 of them.

So far, I have 4 of them: Charles Schwab, General Dynamics, Enterprise Product Partners, and Biogen. I need 8 more.

I find myself going through many different stocks, and passing up on most of them. Each week I am researching at least three different companies. I am saying “no” a lot.

This is a sharp contrast to my old approach, where I would settle for lots of subpar stocks just to fill up a portfolio and hit the 20-30 stock target that you’re “supposed” to own.

My biggest hurdle – only buy positions I would be comfortable holding for 10 years if I was forced to – is particularly rigorous.

I am finished with settling with mediocrity in my portfolio. I am no longer going to settle for 80% conviction. If I buy a stock, I want to be 100% comfortable with the business and the valuation. I only want to swing at the fat pitch.

Warren Buffett explains this philosophy better than I can: “The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot. And if people are yelling, ‘Swing, you bum!” – ignore them.”

The Temptation to Swing

With that said, being 60% cash is a tad ridiculous. It’s a stealth form of market timing, which is something I want to move away from.

If there is one thing that 2020 has taught me, it’s that I am unable to time the market and predict macro. Market timing isn’t something I should do, whether it’s overt (like my purchase of short ETF in March), or stealth (like keeping 60% of this portfolio in cash).

Another issue with holding all of that cash is that it tempts me to buy stocks that I don’t feel 100% comfortable with owning.

This leaves me with a unique problem: what to do with 60% of my portfolio that is sitting in cash, earning nothing?

I could simply buy SPY, but that’s not something I want to own. The market is ridiculously expensive and I don’t think market cap weighting is the optimal way to invest, as I’ve talked about on this blog.

I also don’t want to go 100% small value. I still want something that will be cushioned if stocks drop, so I have “dry powder” to pile into wonderful businesses at wonderful prices. Small value isn’t a place to hide during a severe recession.

The Weird Portfolio Solution

Fortunately, I already had a solution and it was staring me in the face: the weird portfolio.

Why have most of this account sit in cash, when I’ve already developed a sensible asset allocation: global small value, real estate, gold, and long term treasuries?

This is an asset allocation with built in protection for multiple economic environments and an asset allocation that I am confident will grow over time.

Why not use the weird portfolio for all of this cash I’m sitting on?

Rather than hold cash while I await the opportunity to buy wonderful businesses at wonderful prices, I will hold the weird portfolio instead.

That is what I do with the rest of my money outside of my cash emergency fund, so I will do the same for the cash in this account.

I think it will prevent from settling for subpar businesses or subpar prices.

The urge to “swing, you bum” is strong and hopefully this will reduce the temptation to swing at subpar pitches. I only want to swing at the fat pitch. While I wait, I’ll camp out in the weird portfolio.

Random

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.

Trades

Rather than have 60% of my portfolio sit in cash while I await the opportunity to buy a wonderful business at a wonderful price, I moved my cash balance into my weird portfolio approach.

As I’ve stated – my criteria for buying individual stocks are now very strict and I’m not going to settle for something I’m not 100% comfortable with. It will take a long time to find 12 of these positions. Rather than hold cash while I hunt for these opportunities, I will have my cash balance in my weird portfolio approach.

I think this is a better approach than sitting on such a large cash balance.

Bought 56 shares of VBR @ $115.31

Bought 62 shares of VSS @ $103.17

Bought 85 shares of VNQ @ $77.40

Bought 66 shares of VGLT @ 96.80

Bought 335 shares of SGOL @ $18.173

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.

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.

ETF’s > DIY

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.

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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.