It wasn’t a bad quarter. I slightly underperformed the S&P 500, and I have a very slight edge YTD, leading the S&P total return by 1.02%.
This doesn’t sound like much of an accomplishment, but I’m pleased with it considering the way that small-cap value was absolutely crushed in Q2.
VBR, Vanguard’s small-cap value ETF, was up 17.83% on May 3rd for the year. It is now up only 13.96%.
VBR is the scaled-back softcore version of a small-cap value fund. It delivers the small cap value premium and outperforms, but it’s watered down so it is easier to stomach than the real thing. The median P/E for VBR is 14.4 across 847 stocks at an average market cap of $3.4 billion.
The more hardcore, concentrated, deep value funds were absolutely crushed in the 2nd quarter. QVAL, for instance, was up at the peak of 19.31% YTD in April. It is now up only 10.31% YTD.
Looking at the universe of stocks that trade at an EV/EBIT multiple less than 5, they were up over 20% in February. The rally then completely fell apart once the yield curve inverted and the trade war heated up. This universe of stocks is now up only 2.91%.
I’m happy I avoided the same fate.
I would have suffered the same fate, but I sold a significant number of stocks at the high. I sell for five reasons:
(1) The stocks are back up to their typical valuation ratios. If I bought a stock at a P/E of 10, hoping it would get up to 15, I’ll sell when it gets close to 15. I’m not buying stocks to hold onto them for decades of earnings growth. I am buying undervalued stocks and selling once they hit intrinsic value.
(2) The positions are over a year old, the story has changed, and I can find more appealing buys.
(3) The stocks have rallied back to their 52-week high.
(4) The fundamental results of the company are deteriorating and signaling that it is a value trap.
(5) A change in the news around the stock affects the entire reason I bought it.
Here are all of the stocks I sold this quarter:
It felt wrong to trade so much, but the market move was nothing normal, just like the move in December was not normal. The inversion of the yield curve also spooked me. I am a bit more trigger happy to sell, as I think we’re on the brink of a recession soon.
I think that the market is going to get crushed once we have a recession, and small-cap value won’t be a place to hide. After that, I think small-cap value is going to have a strong run of out-performance. I don’t feel that we’re in a place where I can buy value stocks and stop looking at it. This isn’t an environment where I can set and forget a portfolio, as I believe we’re on the brink of a big move to the downside. I might be wrong, but I think we’re at a dangerous juncture.
At one point this quarter, I was 50% cash. Regardless of how wrong it felt to sell a bunch of stocks after only holding them for a few months, it turned out to be the right move and helped me hang onto the gains I had accrued YTD.
With the cash, I slowly deployed it into many new cheap positions. Most of these stocks have been hammered over trade war anxiety. New positions and links to the write-ups are below:
6. Twin Disc
10. Weyco Group
Nearly all of the stocks that I bought this quarter are cheap because of two main concerns: (1) They’re in economically sensitive industries, and the markets are concerned about a recession, (2) They’re vulnerable to the trade war.
I actually agree with the market’s concerns about a recession, which has me concerned. Whenever I agree with the consensus, I second guess my opinion.
As for the trade war, I think it has been a ridiculous overreaction. According to the US Census Bureau, the US exported $120 billion worth of goods and services to China in 2018. We imported $539 billion. Those are big numbers, but they aren’t really a big deal in the grand scheme of things. US GDP is $19.39 trillion. Imports from China represent about 3% of our GDP. How much will that decline as a result of the trade war? Let’s say it’s 20%, which seems extreme. That amounts to .6% of our GDP. And we’re not going to lose .6% of our GDP. The slack will likely be picked up elsewhere.
I’m a free trader and think trade is good for our country and the world. It saddens me that the Republican party, which used to the champion of free trade, is now abandoning that position. At the same time, I like the fact that a bunch of people who hated free trade now comprehend that tariffs are a tax just because Trump articulated a protectionist position. In terms of my own views on trade, I agree with every word of this.
While the rhetoric is bad and I disagree with it, I think the retreat from free trade will wind up being more rhetorical than anything that translates into actual policy. It’s all a bunch of posturing and bravado, like everything else in our political system.
This creates an opportunity for value investors who are willing to buy into this uncertainty. One way or another, this trade war is going to be resolved. It’s either going to result in the worst case scenario, or we’re going to reach some kind of deal. Either way, once the uncertainty is lifted, I think these stocks will do okay.
The ultimate worry for the market is something like the Hawley-Smoot tariff. Years ago, I read in Jude Wanniski’s The Way the World Works, that nearly all of the market moves during the 1929 stock market crash were tied to headlines about the trade war. The specter of this tariff hangs over the market, but I don’t think we’re facing anything of that severity today.
(Ben Stein covered the Hawley Smoot tarriff better than anyone in Ferris Bueller’s Day Off.)
Regardless of how much the Trump administration tries to put the genie of globalization back in the bottle, it’s a fool errand. We’re too dependent on trade, and the long-term trajectory of the human race is to trade with each other. Think about it. It’s a natural evolution. The entire trajectory of human civilization has been towards more integration, more trade, more specialization.
We all started off as a bunch of naked hunter-gatherers in little clans struggling to survive to 30. We had to do everything on our own. We would hunt our own meals. The outside world was dangerous. We went from these small clans to villages. People start to form specializations. With agriculture, this intensifies. Some people work in the fields, others hunt. Eventually, we raise our own livestock. We start to form larger communities of villages, then nations. With the advent of industrialization and mass communication, we become more integrated. With Moore’s law barrelling along and making communication nearly instantaneous throughout the world, we become more interconnected. People like Trump and Bernie Sanders can try hard to put this genie back in the bottle and try to embrace economic isolationism, but they’re fighting a losing battle against the long term trajectory of human civilization.
To put it in perspective, the Hawley Smoot tariff took the average tariff from around 5% to 20%. This, without a doubt, intensified the effects of the Great Depression. From that peak, it has plummeted ever since. That’s not going to stop. I don’t care how hard they try.
I’ve gone a little off track. To put it simply: I think the trade war is overblown and is an opportunity for investors.
As far as stocks that have been hammered over recession anxiety, I own them because they trade like the recession is already priced in. Forgetting about single digit P/E’s (P/E can be misleading at a cyclical peak), even on the basis of Price/Sales and Price/Book, they’re at some of their lowest levels in a decade. This suggests to me that a recession is already priced in, which is why I’m willing to take the risk and buy them.
As stated before, I think we’re due for a recession, which is why I have been trigger happy to sell once stocks hit my target price. If the market enters a bear market, it’s going to occur because of real recessionary weakness in the economy, not Trump’s trade rhetoric.
It’s also a significant reason I’m holding a little cash ready to go. Right now, my cash balance is $10,898, which represents 20% of my portfolio. Some of this is CD’s, which mature throughout the year. A bunch of them also mature in December when I typically do a big rebalance, but I can get out of them if the market crashes and serves up a nice opportunity.
The Fed is signaling that they are cutting, but they are effectively tightening. They still haven’t cut rates, and the balance sheet is still shrinking. I don’t think it’s a coincidence that much of the volatility and trouble in the markets began in early 2018 when they started really reducing the balance sheet in earnest.
Meanwhile, the 3-month and 10-year bond yields have inverted, which is always an indication that a recession is occurring in the near term. Everyone is making excuses for why “this time is different,” but those are the most dangerous words in finance. There is always an explanation for why the yield curve doesn’t matter every time it inverts. In the late ’90s, for instance, the explanation was that the US budget surplus caused the inversion. In 2006, it was the “global savings glut.” There’s always an excuse, and it’s always wrong. We’ll just have to wait and see, as no one has a crystal ball, but my thinking is that we’re getting a recession.
I think this recession will create a significant opportunity for investors. Right now, the average investor allocation to equities is at 43%. This suggests a return over the next 10 years of 4-5% in US equities. That’s better than we can get in bonds, but it’s nothing particularly exciting. If stocks have another big rollover, I’m hoping for an opportunity to buy at much more attractive valuation.
Writing & Research
I was busy this quarter tinkering with some fun research of my own.
One of the biggest questions for value investors has been the correct number of stocks to own in a portfolio. Concentration is in vogue among value investors, but from a quantitative point of view, 20-30 stocks is ideal.
Each additional stock in the portfolio helps reduce volatility and cushion maximum drawdowns, but each additional stock in the portfolio has a declining marginal benefit in reducing volatility.
The volatility & drawdown reduction is maximized around 20-30 positions. Beyond that, adding more stocks is a waste of time and doesn’t do much to reduce risk. The ideal portfolio seems to fall somewhere in the 20-30 range. Ultra concentrated portfolios, while they offer the opportunity for substantial out-performance, run an equally high risk of a major blow up.
It sounds nice to say: “I concentrate in my best ideas.” How did that work out for Bill Ackman when he piled into Valeant or his Herbalife short? Are you smarter than Bill Ackman? I think Bill Ackman is a genius. I’m certainly not smarter than him.
Because I have strong doubts about the ability of anyone to predict the future, I think concentration is really dangerous, no matter how much homework you do or how much you think you know. Even the most stable, sure-thing investments can fall apart with a law, a new technology, an upstart competitor, a scandal. Concentration is Russian roulette for a portfolio.
At the same time, you don’t want to dilute the potential for outperformance too much. The difference in terms of volatility doesn’t change much between 30 stocks and 100 stocks in a portfolio. 20-30 seems to be the sweet spot.
I think survival is more important than outperformance, which is why I prefer a portfolio of 20-30 stocks. A portfolio of this size still offers an opportunity for outperformance, but greatly reduces the possibility of a blow up.
The portfolio I track on the blog doesn’t represent all of my money. The rest of my money is held in more diversified asset allocations.
I’ve been on the hunt for an ideal asset allocation for a long time. Of the existing menu of choices, the one I like best is David Swensen’s, which I wrote about here.
As much as I like Swensen’s approach, I didn’t agree with it completely, so I set out to design my own strategy. My asset allocation strategy isn’t for everyone, but it works for me. It almost delivers an equity return, avoids lost decades, cushions against panics, and protects in inflationary environments.
Here is some ’80s ear candy.
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.