Category Archives: Portfolio Commentary

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.

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.

Why Quality is Essential for a Concentrated Portfolio

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

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

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

My Old Approach: Trading, Not Investing

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Why 20-30 Stocks?

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

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

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

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

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

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

Of course: how much concentration is too much?

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

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

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

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

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

Peter Lynch had this to say:

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

This is what Greenblatt had to say on the topic:

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

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

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

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

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

Quality

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

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

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

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

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

His track record was astounding and he was very concentrated.

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

Carlisle explains in the book:

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

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

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

1) Think independently.

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

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

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

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

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

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

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

Position Sizing

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

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

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

Random

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

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

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.

Mistakes Have Been Made & Lessons Have Been Learned

I’ve been writing this blog for almost 4 years. I’ve learned a lot in that time. I have learned much more than I probably learned in the previous 20 years of following markets.

Writing about investing and talking to people about investing have helped me tremendously.

Some of the key things I’ve learned:

I Can’t Predict Macro

Anyone following this blog knows that I tried really hard to predict the macroeconomy.

This was important to me because I knew that value would outperform from the bottom of an economic cycle. I overestimated my ability to do this. The COVID meltdown and recovery (unemployment has gone down to 8%, which I couldn’t have imagined in April) makes me question my ability to predict this stuff.

What looked easy to predict looking back on history isn’t so easy in reality.

I spent three years waiting for the great crash to come that I thought was inevitable. When the yield curve inverted, I thought it was a fat pitch. CAPE at all time highs, a recession on the horizon – we’re going to have at least a 50% decline like 2000-03 or 1973-74.

The thing is, every cycle is different. I can study history, but the notion that I can predict things based on my study of history is a fool’s errand.

I should have ignored all that. I should have looked at high quality companies trading for dumb multiples in March and bought them. It doesn’t matter what the CAPE ratio is. What matters is what *I* own, not what’s in the index and how crazy it is. I should have listened to the advice of people like Peter Lynch and just ignored it.

And, instead of trying to predict the next recession and turnaround, I could have just bought and held sound value and waited. No one knows.

I Didn’t Think Like a Business Owner

I really bought in to the quant school of thinking. Nobody knows anything. You can’t predict the future of a business. (Ironically, I thought it was hard to predict the future of an individual business but thought I could predict the macroeconomy). Just buy quantitatively cheap stocks. Churn the portfolio. Sell a stock when it pops.

I no longer think this is the right approach. Business analysis is something that people can do. With a little common sense, I could have realized that my investments in tire companies and GameStop weren’t good investments. I should have realized that my theses around these positions were a stretch.

The quant school seems like a natural extension of the efficient market hypothesis. True value investing should be a rejection of this hypothesis. If Ben Graham and Warren Buffett taught us anything, it’s that thinking about an investment as an owner can yield good results.

It’s not worth buying a stock if you aren’t willing to buy the business in its entirety and hold onto it for 10 years if you have to. If the thesis is “a miracle will happen, the multiple will go up, and then I’ll sell it for a 50% pop,” then that’s probably not a long-term winning approach.

If you’re buying individual stocks, you have to have conviction in your holdings. You have to have enough conviction where you’ll hold when something goes wrong.

It’s probably a bad idea to buy into a business where you sweat before you read the latest K or Q. It’s not worth the aggravation and the lack of conviction will hurt results.

My Risk Tolerance Is Lower Than I Thought

I moved my entire 401(k) into the S&P 500 in March 2009. I told my family to do the same. I also told them to get out in 2006-07. This gave me the impression that I could accurately identify bottoms and tops in the stock market.

March 2020 turned out differently for me.

If I wanted to lie to myself, I could tell myself the comfortable lie that unpredictable events outside of my analysis changed things – but was it really unpredictable that the Fed wouldn’t let the global financial system unravel?

The uncomfortable truth, I think, is that I felt pain and I reacted to that pain. I made a behavioral error. It was probably because I have a lot more money than I did in 2009 and was looking at some rather scary losses. It was easy to say “stay the course” when I had a small sum in a 401(k) after working a couple years. It was a completely different experience after toiling a decade and saving a large amount of money and seeing a lot of it wiped out.

I was fortunate that I developed the Weird Portfolio prior to the crash. I built that portfolio so it could withstand an equity crash and I behaved correctly when it happened with that portfolio.

With this “enterprising” account that I track on the blog, I did not behave correctly. To try to fix this error, I’m going to try to own better companies. I don’t want to own companies where I need obsess over what the next gyration of the economy will be. I’m hoping that owning companies I have conviction in and are higher quality will help me behave better the next time this happens.

Pounding Predictions of Doom Into My Head Wasn’t Productive

Bearish predictions of doom generate clicks and ratings. I thought I was emotionally intelligent enough not to be swayed by them and rationally evaluate them.

But, I think constantly pounding that stuff into my brain didn’t do me any good. A constant reading of bearish articles and listening to bearish podcasts didn’t help me.

The thing is – bearish predictions of doom always sound smarter than optimistic takes. The idea that the Fed is going to destroy the dollar, cause hyperinflation, and that we’re in a debt bubble that will cause Great Depression 2 seems compelling to me.

Is it, though?

If these smart guys can really predict Great Depression 2, why couldn’t they have also predicted the bubble that would precede Great Depression 2 and trade that? How many of them have been saying the same thing for 20 years?

Maybe we’ll have another Great Depression. I don’t know. I don’t think these guys do, either. I might as well own a company at a sound valuation that could survive the flood if it happened. For the defensive portfolio, I might as well own something balanced and that will minimize my losses in the worst case scenario. Worrying all the time about the second Great Depression and the thousand year flood seems like a fruitless & miserable effort. Maybe it will happen, but no one really knows.

It seems to me like it’s best to have a portfolio with elements that can survive any economic outcome, which is what the weird portfolio accomplishes.

For this portfolio that I track on the blog, I might as well own companies that I’m confident could survive an economic catastrophe. I don’t want a company in my portfolio that is completely dependent upon a change in the season or the continuation of spring. If I wouldn’t own the business for 10 years or think it could survive a Depression, then I probably shouldn’t own it at all.

If I invest for the rest of my life like the Great Depression and dollar devaluation is going to happen tomorrow, I’ll condemn myself to poor results.

Better to have a plan for the worst and hope for the best.

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.

On the hunt: Outstanding Companies at Deep Value Prices

I am revising the objectives of the portfolio that I track on this blog, as outlined in an earlier blog post. Traditionally, I would buy any company if it was at a deep enough discount to intrinsic value.

Owning mediocre and bad businesses made me endlessly worry about the macroeconomy. I am sick of that.

Going forward, I don’t want to own a business if I’m not confident it can survive a severe recession.

I also foolishly messed around with market timing. After my failures in this arena, I believe a strategy shift is necessary.

My goal is to buy wonderful companies at wonderful prices. This is an outline of the way I plan to manage this portfolio in the future.

Warren Buffett likes to say: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.“

I want it all: I want to buy wonderful companies at wonderful prices.

Wonderful Companies

What makes a company “wonderful”? I want a company that I could own with confidence in the event that the stock market were closed for 10 years. Thinking like this focuses the analysis and eliminates many of the stocks I used to buy for short term multiple appreciation.

  1. An economic moat. I want a company that can resist the pull of competition. Moats can come in many forms. A moat can be a fantastic brand, like Coca-Cola, which people will purchase over a store brand. Moats can come from sheer scale that prevents anyone from competing with price. Wal-Mart would be an example of this. A moat could be geographic. Waste disposal companies are an example of this – it’s hard to build a new landfill because no one wants one in their backyard. Moats could be regulatory. The cigarette industry is an example of this. It’s impossible to start a new cigarette company due to government regulation, insulating them for competition. Moats can come from network effects, where size grows organically. Facebook is an excellent example of this. I don’t want to invest in fads (or technologies) that can easily be upended by a competitor.
  2. Consistent & strong operating history. I want to own predictable businesses with consistently strong performance over a long period of time.
  3. Favorable long term prospects. I do not want to own a melting ice cube in a dying industry. While I believe these are perfectly valid investments for short term multiple appreciation, I am looking for investments that I can hold for the long term with confidence.
  4. Low debt with high financial quality. I look for companies that have a debt to equity ratio below 50%. For larger capitalization stocks, I will tolerate more leverage (around 100%). I also want to see a high degree of interest coverage, ensuring that the company can survive a serious deterioration in earnings and cash flow. As Peter Lynch put it: “Companies that have no debt can’t go bankrupt.” If a company is utilizing significant leverage, they may be able to produce great results in the short run, but one mistake can kill the firm. I believe that the best way to minimize the risk of the portfolio is to focus on the balance sheets of the companies in the portfolio. Additionally, my research shows that combining balance sheet quality with statistical measures of cheapness leads to long-term outperformance. This approach dulls results during booms, but outperforms over the long run because it contains drawdowns during recessions. Other key measures of financial quality that I look at are Altman Z-Scores (bankruptcy risk), Piotroski F-Scores (overall financial quality), and the Beneish M-Scores (earnings manipulation).

Wonderful Prices

My goal is always to buy mispriced securities. I believe that the best place to find mispriced securities is among the cheapest deciles of the market. For that reason, I look for multiple metrics and valuation ratios which show that the stock is cheap relative to its history and its peers. I prefer stocks that have multiple measures of cheapness, as measured by valuation multiples. I don’t engage in complicated discounted cash flow analysis, because I think it’s simply a way to fool yourself into accepting your own biases about companies that you love with a false sense of precision. I’ve also noticed that while many value investors outperform, they often fail to outperform the most basic measures of statistical cheapness.

The key metric that I look at is Enterprise Value/Operating Income. This metric – the Acquirer’s Multiple – is best described by Tobias Carlisle in his book Deep Value. This outstanding ratio measures how attractive the company would be to a potential acquirer by comparing the actual earnings available to the owner at the top of the income statement and comparing it to the total size of the business, including debt.

There is also plenty of outside research showing that statistically cheap portfolios outperform. A good example is this excellent paper from Tweedy Brown, What Has Worked in Investing. My own research shows that cheap portfolios outperform for nearly every valuation metric.

The price is critical. If I pay a cheap enough price, I can still be wrong about the business and still make out alright. Additionally, if the problem causing the statistical cheapness is resolved, then I will obtain multiple appreciation on top of the performance of the business.

Portfolio Management

10-15 Stocks. The situations that I am looking for – outstanding companies at cheap multiples – do not come along very often. There are not many outstanding companies and it’s rare for them to become statistically cheap.

For this reason, I have to be a concentrated investor.

My research shows that, at a minimum, a 10-15 stock portfolio should minimize volatility. My goal is to be fully invested with at least 10 positions at a given time.

Sell rules.

I will sell positions for the below reasons.

a. The stock has reached an extreme valuation relative to its history.

b. A more compelling bargain is available.

c. The business has lost its competitive advantage.

d. To limit a stock that has grown to be too large a percentage of the overall portfolio.

Cash. I hold cash when I have trouble identifying stocks that meet all of my criteria.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Strategy Shift

You might have noticed that lately I’ve been buying different kinds of stocks than I did in the past.

You might have also noticed that I’m buying bigger positions.

It’s a shift in strategy.

I summarized what I’m looking for in this blog post: Wonderful Companies at Wonderful Prices. I am trying to buy outstanding companies at deep value prices.

Previously, my focus was on obtaining multiple appreciation from beaten up companies. I didn’t want to hold them for the long-term. The goal was to have a widely diversified portfolio of 20-30 stocks. Buy depressed, beaten up situations (with sound balance sheets) – then sell them when they’re close to intrinsic value. You have to sell because they weren’t the kind of companies that were good businesses for the long haul. The goal was to flip them.

This is a great strategy. It’s a low P/E, low debt/equity strategy that returns about 15% a year in the backtest. I thought I could stick to it.

I couldn’t. The problem emerged in March when lock-downs were creating closures throughout the entire economy. This was the most unprecedented self-imposed economic catastrophe of my lifetime.

The issue is that the businesses I owned weren’t good businesses – they were mostly cyclical situations and I knew it. If the economy were unraveling, how were a bunch of no moat & cyclical businesses going to mean revert?

In terms of value investing, I’m perfectly comfortable with under-performing for a long time period.

What I’m not comfortable with are losses – and beaten up cyclicals are going to result in catastrophic losses during a Depression, which is what I thought was happening in March. You can look at the returns of small value during the Depression and you’ll see this to be true.

When the market recovered, it became clear to me that I had fallen into a trap that I thought would never happen to me: I grew pessimistic with the rest of the crowd. I panicked. I even bought a short ETF. Fortunately, it was a small position and I sold when the market went above the 200-day.

I did this is because the market – by every measure – is insanely overvalued. I still think that’s true and that the index is going to deliver flat to negative returns over the next 10-20 years.

Sure, the rest of the market was overvalued (and still is), but I should have ignored that and pounced on the value where I could find it. I don’t own the market. I own the stocks in my portfolio.

I could react to this realization in two ways.

I could spend the rest of my life as a perma-bear complaining and worrying about macro. Or, I could recognize that macro is unpredictable and I should stick to what I can wrap my brain around.

The purpose of this brokerage account that I track on this blog was to try to go after the wild goal of outperforming the market. To give it my best shot.

I thought the best way to do this was Ben Graham’s classic low P/E, low debt/equity strategy in a 20-30 stock portfolio. Buy a compressed P/E, sell for a 50% pop, then move on to the next target. Repeat. Make sure I own 20-30 positions. Stick with it.

It turns out that when the turds hit the fan, though, that I couldn’t stick with it. What good is an investment strategy if you can’t stick with it?

In many ways, I’m happy I didn’t stick with it. Being 50% cash before the crash was a good thing. My max drawdown this year was only about 20%. Meanwhile, deep value had a nearly 50% drawdown. If I stuck to the stocks I owned and didn’t sell – by my calculations I would have had an even worse drawdown than the deep value universe. Nearly 60%.

Instead, year to date, I’m outperforming all of the value ETF’s because I contained that drawdown.

Selling was a good decision for most of the stocks that I’ve owned through the history of this blog. I wrote a post about how selling all of them was a good decision.

I still think that a 20-30 stock low P/E, low debt/equity stocks and churning it is a good strategy. I still think it will return 15% a year for someone who can stick with it over 20 years.

What emerged in March, though, was that I’m not the investor who can stick with it. Owning these kind of businesses during a severe economic shock is terrifying.

As I sat in cash while the market ripped higher – it became clear that I panicked at the worst possible moment.

This realization caused me to really do some soul searching and check my priors. It quickly became apparent that I was wrong about the macro picture.

It’s partly a product of my own mind. I’m a pessimist at heart and think most people are full of it – this leads me to be naturally drawn to predictions of doom.

It turns out that my instincts about the macro-economy were completely wrong. Perhaps I should have read my old post on the matter, The Dark Art of Recession Prediction, where I wrote “Macro is fun, but it’s probably a waste of time.”

If only I listened to my own advice.

After realizing all of this, I considered moving this account to my asset allocation strategy, the Weird Portfolio.

That’s where I have most of money. I never panicked with that money. From January 1 – March 31, it was only down about 14%. Long term treasuries and gold did their job. I stuck with it and the portfolio recovered, with year to date gains.

With that strategy, an investor will frequently under-perform. That’s not something I really give a damn about. I can watch QQQ investors make bank and I don’t care.

What I do give a damn about is losses. That’s something the weird portfolio excels at containing. The Weird Portfolio delivers a satisfactory – but not outstanding – rate of return and contains losses with low volatility.

Of course, that’s not the point of the money I set aside to track on this blog. To put in Ben Graham’s terms, the weird portfolio is for the defensive investor. I’m defensive with most of my money. This account is for the enterprising investor.

The point of this money was to play the game. To try to outperform, as maddening as that can be.

The truth is that I had little conviction in my positions. How can you have conviction in bad businesses with no moat when we’re facing a severe economic downturn?

This led me to a simple conclusion: if I’m going to buy stocks, I need to own businesses that I have long-term confidence in. I need to own businesses where I won’t obsess over the yield curve, unemployment rates, or the CAPE ratio. I don’t want to own a steel company or a bar in Florida and constantly worry about the impact of the macro-economy on those stocks. I want to own better businesses that I’m not going to panic sell when the economy looks like it is headed to the woodshed.

I don’t want to hold mediocre or bad businesses in the hopes of multiple appreciation. While this is a perfectly valid strategy, I think my behavior shows that I don’t have the intestinal fortitude for it.

Of course, the trouble is, there aren’t many high quality companies that sell for a margin of safety. They are rare birds. I certainly can’t fill up a portfolio with 20-30 of these situations, even though I know that’s the optimal portfolio size.

The situations that I want to buy (and can have enough confidence to hold when the economy goes to hell) are rare gems: wonderful companies at wonderful prices.

I want wonderful companies at distressed prices. As Buffett once put it, I want Phil Fisher companies at Ben Graham prices. Moreover, I want them to be able to resist a recession. I want them to have solid balance sheets with enough cash to survive a recession. I don’t want businesses that are easily crushed by the inevitable recession. I want them to have a moat that resists competition. I want to have it all – high quality at a deep value price. Stocks like this don’t come along very often – but they are available.

This naturally leads me to more concentration because there aren’t many of these situations. My research shows that the first dozen positions does most of the work in eliminating volatility, so that’s what I’m going to aim for.

It’s not optimal for maximizing Sharpe ratios. That portfolio is around 25 stocks.

Of course, I can’t find 25 wonderful companies at wonderful prices that I’m comfortable holding during an economic catastrophe. I’m going to have to be more concentrated now that I’m being more discerning.

The stocks I’ve bought recently which fit this mold are:

Biogen

Charles Schwab

Enterprise Product Partners

Biogen is a good example of what I’m looking for. It’s absurd that a company like that (a 23% ROIC over the last 10 years that has grown revenue at a 12% clip) trades at 7x EV/EBIT.

Enterprise is another example. There is no reason that a quasi monopoly should trade for 5x cash flow with an 11% dividend yield. That’s the kind of situation I want.

Charles Schwab is a firm with secular growth propsects. It should inherit more AUM as investors move away from high fee advisors and products. It’s hard to imagine how it won’t continue to grow AUM over the next 10 years. It has grown book value at a 12% rate for the last decade with a 12% ROE. At 1.8x book, it’s a steal. It traditionally traded for 4x book.

These are the kind of situations that I want. For all of these companies, I’m confident that they will deliver a return without any multiple appreciation. Schwab’s book value will continue to grow. Enterprise will continue to serve as an energy toll road and continue to churn out growing dividends and resist competition. Biogen will continue to main a strong research pipeline and create more high margin drugs. With multiple appreciation – the return will be outstanding.

I made each of these positions approximately 8% of my portfolio – with the goal of finding at least a dozen of these positions when fully invested.

I believe they are wonderful companies at wonderful prices. I don’t need multiple appreciation for them to do well over the next 10 years. I’m confident that the business will deliver strong long term results. I think I’ll get multiple appreciation on top the actual business results, but I won’t need it for my return.

I also realize that I can’t find a dozen of these situations right away. When I started this blog, I filled this account up with 20 stocks. Obviously, I can’t do that with this approach because there aren’t that many of these stocks.

I’m still going to have to hold a lot of cash and sit around and wait for a wonderful company to sell for a wonderful price. That’s fine by me. If I know I hold a great, non-cyclical, business and own it for a price that I think is outstanding – I can hold onto that position with confidence and not sell.

I’m not going to force myself to be fully invested and buy businesses that I don’t have confidence in just to fill up a portfolio.

The best strategy isn’t the one with the best Sharpe ratio or the highest CAGR. It’s the one that you can stick with. I think this is an approach I’ll be able to stick with.

We’ll see.

So, if you’ve noticed a change, you’re right. I’m running a more concentrated portfolio with a bold goal: wonderful businesses at wonderful prices. Let’s hope it works out.

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.

Q2 2020 Update

Performance

Year to date, I am down 17.77% and the S&P 500 is down 3.9%.

This is actually pretty good in context of my deep value strategy. VBR, the Vanguard Small Value ETF, is currently down 22% YTD. QVAL, the deep value Alpha Architect ETF, is currently down 26% YTD.

The deep value universe of stocks with an EV/EBIT multiple under 5 is currently down 30% YTD.

17% isn’t all that bad in this context.

Due to my large cash position going into the crash, I was only down 26% at the lows, while most of this universe was in a nearly 50% drawdown.

With that said, I missed my chance to gobble up bargains at the lows because I thought the worst wasn’t over.

A Mixed Bag: Good Decisions & Bad Decisions

In the last year, I made some key decisions. Some of them turned out to be good moves and some look like mistakes.

I started accumulating cash last year when the yield curve first inverted. I thought we were going to have a run-of-the-mill recession and I thought due to the overvaluation of the market that this would be enough to cause at least a 50% crash.

I went into the March crash nearly 50% cash. This was a good decision. When I saw that the recession wasn’t going to be a run-of-the-mill affair and was turning into the worst recession since the Great Depression, I started selling my cyclical positions aggressively. By the bottom, I was nearly 80% cash.

I was also convinced that the selling wasn’t over. I saw an index at internet bubble valuations hitting the worst economic event since the Great Depression and assumed that the crash would continue. Value stocks aren’t a place to hide during a crash, so to stay market neutral, I bought a position in an S&P 500 inverse ETF to stay market neutral. This was not a good decision.

What I didn’t anticipate was the extent to which fiscal and monetary policy were going to go full-throttle in an all out effort to boost the stock market and the economy. As a result, the S&P 500 rocketed upward and my short position was beat up.

As a result, I lost about 15% on the short position. I finally got out of it when the S&P 500 went above the 200 day moving average. Fortunately, it wasn’t enough to hurt my overall YTD results.

At the lows, net-net’s started to re-appear and the number of stocks below an EV/EBIT multiple of 5 increased. I didn’t buy any of them, thinking that the economic downturn was going to continue melting down the market with no regard to valuation. I didn’t buy enough at the lows. This was not a good decision. There were many stocks I should have bought and I didn’t.

One position I bought near the lows has worked out marvelously – AOBC, which has turned into SWBI. This is a gun manufacturer. You can read my write up here. I noticed that AOBC was trading at a low multiple to book value while simultaneously background checks were surging due to COVID. Gun sales continue to be strong, and this continues to skyrocket due to the unrest currently gripping the country.

I’m currently up 189% on this position. Obviously, buying SWBI was a good decision. I sold a piece of this position when it grew to 10% of my account from 5%. I plan on doing the same thing once this happens again.

I recently purchased a net-net, Friedman Industries. You can read my write up here. It is yet to be seen if this was a good decision, but I think that the risk-reward makes sense.

Looking Ahead

Currently, the market continues to be strong and seems invincible.

I’m not short after getting my butt kicked in my short position, but I’m still not bullish. I’m currently 80% cash and still only have a handful of positions.

It’s still yet to be seen how COVID is going to shake out.

I am finding it hard to figure it out. On one hand, the lockdowns worked, we flattened the curve. On the other, now that the economy is being re-opened, cases are surging. Skeptics say that this is simply because of more testing. Those who sounded the alarm on the virus say this is concerning.

I don’t know how this shakes out. What I do know is that the the present state of the economy is not good. Unemployment looks poised to reach its highest levels since the Depression in the 1930’s. Many businesses have been completely destroyed, and the number of businesses that are being destroyed continue to mount.

On the other hand, unprecedented levels of fiscal & monetary stimulus might create a new economic boom as the economy re-opens.

I don’t know how the economy shakes out, either. My instincts tell me that the economy is screwed, but my instincts can be wrong. We went into this with unprecedented levels of leverage and the only way that a lot of businesses are surviving is by taking on even more debt, making them even more fragile. On the other hand, the fiscal & monetary stimulus might work.

I don’t know how the virus shakes out and I don’t know what’s going to happen to the economy. The way I see it, the current situation is replete with massive uncertainty.

Uncertainty is something that an investor should get paid for with a cheap valuation.

Investors aren’t getting paid for that uncertainty.

What I know for certain is that the market is not cheap by any stretch of the imagination. From a market cap to GDP perspective, the market trades at 147% of GDP. At the peak of the internet bubble, we were at 140%. That’s right – we are beyond the valuation of the most extreme bubble in American history and we’re in the midst of the worst economic calamity since the Great Depression.

If the market were to return to 100% of GDP – the S&P would crash to near 2,000. If we were to return to the lows of the last two nasty bear markets, we would fall to nearly 1,500 on the S&P.

The CAPE ratio is at 29 – higher than the peak of the real estate bubble although not as high as it was during the internet bubble.

Looking at the value universe I operate in, it is currently only an average opportunity set. There were many stocks in the EV/EBIT < 5 universe at the lows, which was a pretty decent opportunity but not as big as 2009. There are now 75, which is a pretty average opportunity set.

An average opportunity set and a market trading at internet bubble valuations is not compelling. It’s definitely not an opportunity when we face the wide range of possible outcomes that we face today.

As a result, I’ll continue to be cautious and hold a lot of cash. If I find more stocks like SWBI or FRD that look like big opportunities, I’ll buy. What I won’t do is fill up my portfolio with subpar opportunities.

The large cash balance definitely weighs on my mind. Cash is a terrible investment long term, but I want to have the dry powder if the market crashes again.

I’ve considered deploying it into my passive asset allocation that you can read about here, but haven’t made up my mind on that yet.

My goal when I started this blog was to focus on Ben Graham’s low P/E, low debt/equity strategy during the good times. When the bad times arrived, I was going to buy net-net’s. The net-net’s started appearing in March and I didn’t buy enough of them. I barely had time to research any of them before they disappeared.

My instincts tell me this isn’t over and I’ll get another chance to buy them. We’ll see.

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.

Portfolio Position in Troubling Times

fork

Goodbye, shorts

I dumped my short position yesterday. It looks like I screwed up with this bet. Fortunately, it wasn’t a fatal bet.

I lost 15% on the position and I’m up slightly over the last few months overall, thanks to the performance of the stocks that I still own. I owned it mainly to stay market neutral and didn’t make a big bet on it, so it’s an outcome that isn’t the end of the world.

I’m still happy that I have been cautious this year. I’m down only 22% YTD, which is a lot better than the deep value universe that I operate in. The universe of stocks with an EV/EBIT multiple under 5 is down 40% YTD. It was previously down nearly 50% and I avoided nearly the entirety of this drawdown. I also outperformed this universe last year, when I was up 32%.

I still badly lag the S&P 500 since I started this blog in December 2016 – which is very disheartening – but I’ll take the good news where I can.

My passive approach (small value, long term treasuries, gold, international small caps, and real estate) has handled the crisis excellently, down only 5% YTD after being down only 20% in the worst of the crisis. I’m often tempted to put this brokerage account into that passive approach, but I still enjoy the hunt of picking stocks and trying to figure out the macro picture.

Positioning

I bought only a couple stocks during the depths of the crisis – VLGEA (super markets) and AOBC (guns – now SWBI). VLGEA is flat, but AOBC has been an outstanding performer. I am up 80% on the position. It looks like my thesis – that COVID would drive higher gun sales – is proving to be correct. I couldn’t have anticipated nationwide riots, but that appears to be helping out the position, as well.

While I am no longer short, I still hold a lot of cash. 78% of my portfolio is still cash. Needless to say, I am still quite bearish on the market, even though I don’t want to be short it.

The Market

If I’m bearish, why aren’t I holding onto the short position?

I know that a trend following element is absolutely essential to shorting.

I walked into the short with an eye on the market’s 200-day moving average. Recently, the S&P 500 crept above the 200 day moving average.

200dma

As a value investor, I have always talked a lot of smack about trend following, but I have been changing my mind after examining the evidence.

A great resource on trend following is Meb Faber’s paper – A Quantitative Approach to Tactical Asset Allocation. The approach advocates owning asset classes only when they are above their 200 day moving average. The approach reduces drawdowns while still delivering the market’s rate of return.

A trend following strategy like that gets out of the market when it falls below the moving average and stays invested when it is above.

Looking at the S&P 500 over the last decade, an investor would have only been out of the market a few times. They mostly turned out to be false alarms that didn’t see the market make a massive move lower. This includes the 2011 debt ceiling showdown, the oil market chaos in 2015-16, and the December 2018 meltdown.

Where a trend following strategy helps is during the big, nasty draw-downs. An investor following a trend system would have sold in February, avoiding all of the mayhem that occured in March. It would have also kept an investor out of the market during most of the 2000-03 50% drawdown. It would have also kept an investor out of the market from 2007-09 during that 50% debacle. Trend following buys in late in the game – but who cares? They avoid the cops showing up to the party, and then arrive a little late to the next one.

When a market is solidly above the 200 day moving average, it usually continues rallying higher, even when the fundamentals don’t support it.

Paul Tudor Jones is probably the most vocal advocate of using the 200 day moving average as a trend indicator. He had this to say about the approach:

My metric for everything I look at is the 200-day moving average of closing prices. I’ve seen too many things go to zero, stocks and commodities. The whole trick in investing is: “How do I keep from losing everything?” If you use the 200-day moving average rule, then you get out. You play defense, and you get out.

Historically, it is a very bad idea to be short the market when it is above this level.

While it is often maddening to value investors like me, the fact of the matter is that there is nothing to prevent something absurd from getting a lot more absurd. This is a lesson that value investors who have been short stocks like Tesla have learned the hard way.

It’s something that people who were short the Nasdaq in the ’90s also learned the hard way. An investor could have looked at the market in early 1999 and concluded that it was absurdly overvalued. They would have been correct. Even though they would have been correct, it wouldn’t have stopped the market from wiping them out by doubling before melting down from 2000-03.

Unrelated: “The Hard Way” was a pretty funny early ’90s flick.

 

There is nothing to keep an absurd market from getting more absurd.

As a value investor, I have a visceral hatred of following the herd, but I think it’s important to keep tabs on the movements of the herd to prevent me from getting trampled by it.

Absurdity

Make no mistake: I think what’s going on is completely absurd, but I’m not going to fight it.

The real economy has been eviscerated. We have Depression level unemployment – approaching 20%. America’s corporations are surviving by leveraging up, making them even more fragile than they were before the crisis. Even the tech giants that have enjoyed the biggest gains of the rebound have seen their earnings dissipate.

The Fed is providing liquidity, but that’s all that the Fed can do. Jerome Powell isn’t a sorcerer who can create a 1999 economy out of 1930s unemployment. The Fed is preventing the system from collapsing, but that’s not the same thing as fixing the damage that has been done to the actual economy. The Federal government is providing fiscal stimulus, but that isn’t enough to replace a job or re-create the actual productive economic activity that has been eliminated.

Wall Street doesn’t care. It has doubled down on its commitment to the Fed put – the idea that the Fed will have the power to prevent any further meltdown in the market. The actual earnings capacity of the market has been decimated, but the markets are completely ignoring this.

The bear thesis of the last decade – that the markets are fraudulent and being manipulated by the Fed – has now turned into the bull thesis. Buy stocks because the Fed will make it go higher. Earnings and the economy don’t matter. This is dangerous and absurd thinking.

One take is that the market believes we will swiftly return back to normal with the economy re-opening. Maybe, but I think this is a dubious bet. I’m sure activity will resume and life will go back to normal, but it’s not going to be 100% of where we were before. There will be a number of businesses (like bars & restaurants) that will not re-open, because they couldn’t survive a 100% drop in revenues. Meanwhile, furloughed employees won’t be immediately re-hired, as businesses take a wait-and-see approach to bringing them back on board.

Nor will everyone in the economy immediately leap back to normal. Everyone isn’t going to re-book their vacations, even if 70% of them do. Businesses aren’t going to resume all of their business trips and conferences. Older people will likely wait until it’s clear that the virus has either been overblown or that we have a vaccine. They also command most of the disposable income, so that’s a major hit to the economy.

There also isn’t a guarantee that there won’t be a resurgence of the virus once the lockdowns end. We flattened the curve, but who is to say this won’t start spreading all over again? This virus started with a handful of people in China and spread all over the world. Once we resume normal activities, won’t it start spreading all over again?

Most of the damage from the Spanish Flu occurred during the second wave of the virus. Will we have a second wave of this virus? Will that trigger another round of economically destructive lockdowns? I don’t know, but the probability of that happening is not zero.

Call me a pessimist, but I don’t see a lot to be optimistic about these days. The market is partying like it is 1999 while the economy is in 1932.

I’m still holding a lot of cash even though I am no longer short, simply because I think that the risks are massive and the market is behaving like they don’t exist.

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.

The value of the market, the value of value, and some soul searching

easter2020

Macro Valuations

I’ve written a lot about how the market is really expensive, no matter which way you slice it.

Meanwhile, we are facing a grim economic reality in which 6 million people are losing their jobs every week and cash flows are evaporating for American companies. Some estimate that unemployment will hit 20% (Great Depression levels) and GDP will take a massive hit, making the Great Recession look like a footnote.

Call me crazy, but I think valuations should be a lot lower in this environment.

My theory about market valuations is simple: the higher they are, the harder they fall.

Valuations don’t matter until we have a recession. When expensive markets run into a recession, they get annihilated. Because we can go for a decade without a recession, that’s a lot of time for valuations to run up to unsustainable levels. It’s also plenty of time for investors to get complacent and think valuations don’t matter. That was the prevailing attitude at the end of the ’90s and it has been the attitude recently.

The history of markets shows that markets move with earnings and cash flows over the long run and then exhibit speculative extremes in the multiples that investors are willing to pay for those earnings and cash flows.

Markets tend to extrapolate the present and assume current conditions will last forever and then get surprised when the environment shifts.

My goal (in my active account, anyway) is to take advantage of these sentiment shifts for individual stocks and the broader market. I want to buy from Mr. Market when he is depressed and sell to him when he is euphoric.

With market cap/GDP presently at 131%, macro valuations suggest that the market will deliver a negative return over the next decade. History suggests this negative return doesn’t happen in a straight line and that there will be a big bull market and a face-ripping bear somewhere in there. I think that the face-ripping bear is happening right now and we’re in the middle of it.

Right now, the markets are rallying because investors are realizing that the Fed won’t allow the system to collapse (I agree with this). They also think that the Fed they can engineer a quick and rapid recovery and pepper over rich valuations (I don’t agree agree with this).

Everyone seems to be getting very bulled up and cocky.

I think they are making a mistake.

It’s also possible that I’m making a mistake, so I decided to take a look at some additional data to figure out if that’s the case.

Value Investing Vs. The Market

Value purists would say that I shouldn’t pay attention to all of this nonsense.

They would argue that I’m not investing in the market. I’m investing in individual businesses. I’m not investing in the stock market, I’m investing in individual value stocks.

Unfortunately, it is impossible to assemble a group of 20-30 stocks that are not correlated with the market. Whether I like it or not, my stock portfolio is correlated with the market. The market matters.

To get around this and be less correlated with the market, I could concentrate in 5-8 of my “best ideas.”

I think this is a path that can cause permanent impairments of capital. A blow up in one or two positions can endanger the entire portfolio.

I’m also skeptical that I really have any “best ideas.” The best ideas of the best investors in history often blow up.

This is why diversification is the path I’ve chosen and I think 20-30 stocks is the best way to prevent portfolio blow ups while still offering the opportunity for outperformance.

The disadvantage of diversification is that I am more correlated with the market’s returns.

The Value of Value

With all of that said, I am worried that my focus on the valuation of the overall market is blinding me to the bargains within the deep value universe.

For this reason, I decided to take a look at the absolute valuation of the cheapo segment of the market. To do this, I used Ken French’s free data available on his website.

I restricted the data to the post-1990 universe. I’m considering the post-1990 period to be the modern era in which valuation multiples have been elevated.

I’m not expecting to be able to buy stocks at 1980 single digit CAPE valuations, for instance.

Let’s start by looking at cash flow/price.

Cash Flow/Price

cashcheap

At the end of 2019, the value segment of the market was close to its mean.

Not particularly exciting.

VBR (the Vanguard small value ETF) is down about 30% year to date, so I’d estimate that this is probably close to 20% now from 15% at year end 2019. That’s really encouraging, as it implies that the value segment of the market is close to its 2009 and early 2000’s levels. Those high levels will probably set the stage for tremendous performance in the upcoming years.

Interestingly, value was very expensive for most of the 2010’s. I think this is the key factor in value’s under-performance in the last decade. Value was expensive versus its long-run mean.

cashexpensive

Meanwhile, in compounder-bro-land, the market is more expensive than it was during the internet bubble. No surprise there.

Something interesting to note: this glamorous segment of the market was cheap in 2010 and the early 1990’s, likely setting up the excellent performance for glamour in the 1990’s and the 2010’s.

Book to Market

In most environments, last year’s cash flows are a good proxy for what’s happening next year.

In Quantitative Value, Wes Grey and Toby Carlisle found that trailing-twelve-month earnings work better than normalizing them. It’s a very surprising result, but it suggests that last year’s earnings tend to be a good proxy for next year’s.

Of course, we are not in a normal environment. Many businesses are seizing up and revenues are collapsing with economic lockdowns in place. This makes this current environment unlike any recession we have experienced since World War II.

For this reason, I think book value is useful in this kind of environment. When earnings disappear, different metrics of value are useful even though earnings-based metrics work better in the backtests.

booktomarketcheap1990

From this perspective, the value segment of the market was very cheap relative to its mean in the early 1990’s, the early 2000’s, and 2009. This makes sense, as those periods coincided with tremendous performance for value.

Like cash flow to price, this was also expensive through most of the 2010’s, explaining value’s woes during the last decade.

By this metric, at the end of 2019, value stocks were expensive.

With VBR down 30%, I estimate this is probably up to 190%. That is pretty good. It’s not as cheap as it was in 2009 or the early 2000’s, but it’s getting there.

expensive

Meanwhile, in compounder-bro-land, the market was more expensive at the end of 2019 than it was during the internet bubble.

Interestingly, it’s also evident that this segment of the market was cheap at the dawn of the 2010’s. This likely drove the tremendous performance of this segment of the market for the last decade.

Considering that QQQ is flat year to date, this segment of the market likely still beyond internet bubble extremes.

Good luck, compounder bros. I think you’re going to need it.

Soul Searching

Looking at this data, it suggests to me that I might be too cautious right now.

While the broader market is overvalued, the value segment of the market is approaching levels of cheapness last experienced in 2009.

On the other hand, this can get a lot cheaper, especially if the broader market tanks. This is particularly true considering that cash flows are about to disappear for a lot of businesses.

I could be allowing my emotions to blind me, which is a classic behavioral investing mistake. I am concerned about losing my job, for instance. I have a sizable emergency fund, but the idea of losing my job still worries me and can be clouding my thinking.

Earlier this year, I was contemplating selling my house and moving in search of another opportunity.

Now, I worry if I will be able to sell my house at a decent value. What job opportunities will even exist with the economy in lockdown?

Emotional stress might be interfering with my ability to see things clearly.

When I launched my blog, my hope was that I could build a portfolio of net-net’s when the next bear market arrived. During the boom, I’d stick to low price-to-earnings stocks and then shift my focus to net-net’s and negative enterprise value stocks.

There were net-net’s two weeks ago, but many of those bargains have since disappeared.

Is it possible that the opportunity to buy net-net’s emerged and disappeared in two weeks?

Maybe.

My gut tells me this is not the case and I will have an opportunity to purchase a portfolio of 20-30 high quality net-net’s and negative enterprise value stocks, but this French data makes me second guess that.

During this meltdown, I’ve been tempted to simply throw everything into my asset allocation which is down only 7.9% year to date. This allocation doesn’t try to predict the future and has caused me no stress.

If this market truly has passed me by and I’m wrong about everything, then I need to do some serious soul searching and re-evaluate my approach.

For now, I’m not ready to give up on my active account just yet. I do think there will be an opportunity to buy net-net’s and negative enterprise value stocks at some point during this bear market.

If not, I may need to simply pursue my asset allocation strategy and stop trying to pick stocks and predict the future.

It could also make more sense to focus more on arenas of the market where I can have more of an advantage, such as dark stocks and international net-net’s.

With that said, I don’t think I’m wrong, even though I’m open to that possibility.

I think it’s a bit of a fantasy to think we’ll have a 1987-style decline and 1988-style bounceback. After all, during 1987 and 1988, it was a time in which the economy was booming and we didn’t have a recession. Mr. Market was just being crazy. We faced a similar outcome at the end of 2018 and throughout 2019, another period in which we didn’t have a recession. Mr. Market was just being crazy.

This does not strike me as a comparable situation.

We’ll have to see, I guess.

This is a hard game, indeed.

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.