Category Archives: Portfolio Commentary

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.

Q1 2020 Update

s&amp;p500

Performance

I continue to under-perform the S&P 500. I’m in year #4 of putting this blog together after setting out to out-perform the market with a value portfolio.

It’s not working so far. I believe this is because of where we have been in the market cycle.

I still believe that small value will demonstrate exceptional performance when it usually does: when we are emerging from a recession and bear market.

This is what we saw in years like 1975, 1991, 2003, and 2009. Small value delivered the following performance in those years:

1975 = +53.94%

1991 = +42.96%

2003 = +37.19%

2009 = +30.34%

Meanwhile, value always lags at the end of a bull market. It then goes down with the market during the recession.

Then, it delivers the out-performance emerging from the recession. This cycle doesn’t look any different to me.

Of course, we are not there yet. This is 2008 (small value -32%), not 2009. This is 1990 (small value -19%), not 1991. This is 1974 (small value -21%), not 1975.

We are only at the beginning of a recession and a bear market. Historically, this isn’t when the small value premium is delivered.

Based on the seriousness of shutting down large chunks of the global economy, this is likely to be a worse recession than the global financial crisis. The economy never grounded to an absolute halt during the GFC and that’s what is happening now.

What makes my under-performance even more incredible is that I anticipated a recession and went into the year with a significant amount of cash. Going into year end, I was roughly 30% cash and bonds. Going into March, I was nearly 50% cash.

Despite all of that cash and bonds, I still under-performed the S&P 500!

My assumption was that my cash would provide a nice cushion against the downturn I thought was coming in the market. The fact that I held so much cash and still under-performed is absolutely staggering.

Of course, this happened because most of my portfolio was in the deep value universe. Value is a universe that was annihilated this quarter.

Take a look at some of the popular value ETF’s this year:

QVAL – Down 40.23%

VBR – Down 34.98%

SLYV – Down 37.36%

Looking at the deep value EV/EBIT < 5 universe, the performance is even worse.

evebit5universe

If I bought and held all of my stocks, then I would be looking at a very similar result today. My move to cash turned out to be the right decision.

Of course, my move to cash is not what a value investor is “supposed” to do. You’re not supposed to time the market, you’re not supposed to pay attention to macro, and you’re supposed to stick to the process no matter what. That’s what all of the mental models say and that’s what all of the experts say.

I’m done with all of that. I’m going to trust my own analysis going forward rather than mental models and superinvestor quotes.

Trades

I sold off most of my portfolio over concerns about the extreme recession and bear market that is unfolding.

I opened hedging positions with TAIL and SH to stay market neutral against the stocks that I still hold. I sold the short term bond ETF when rates went negative.

I bought one new position this quarter, American Outdoor Brands, a firearms manufacturer. You can read about the stock here.

The End of the Bull

How Bull Markets End

Since I started the blog, I have been worried about the next bear market.

Equities were rich and excess was everywhere. Venture capital firms were practically setting money on fire, as rich people gambled on the next Uber and Facebook, leading to situations like WeWork.

Private equity multiples and the leverage behind those deals grew more and more extreme.

We then had an ICO and crypto bubble, which bore many similarities to the dot com bubble. It was a mania. Manias are sure to end in tears.

Of course, market manias rarely end without a catalyst. That catalyst is typically a recession. In this cycle, we simply avoided a recession for longer than normal, so the mania grew more extreme.

I knew that once a recession came along, the market would be punished in an extreme fashion. I also knew that the frothy environment wouldn’t end until the recession came, so I stayed mostly long.

Now, the recession is here. It arrived faster and with more ferocity than I could ever have imagined.

Going into this year, I assumed that a recession was coming due to the yield curve inverting earlier in 2019.

The yield curve is the most reliable indicator of a recession that we have because it is a good proxy for how tight or loose the Fed is. I was really amused at everyone trying to rationalize the inversion earlier this year.

All of the “experts” lectured us about how inversions don’t matter, despite the yield curve’s excellent track record in predicting recessions. It’s different this time!

I expect the track record of the yield curve to remain intact. It will be even more useful during the next recession, because everyone will continue to dismiss the indicator.

Next time, they’ll say the 2019 inversion didn’t matter because what took down the economy was the Coronavirus. Then, a year later, we’ll have another recession.

We were headed into a recession and bear market without the Coronavirus. The Coronavirus is making a situation that was already unfolding into something more catastrophic to the global economy.

The Coronavirus is turning this from what would have been a normal, run-of-the-mill recession into the worst one that we’ve experienced since the Great Depression.

I do not understand the logic of the bulls who assume that the economy will just snap to life when everything re-opens. Will restaurant traffic immediately return to normal once everything re-opens? Will people return to movies, restaurants, and airlines right away? Will the millions of unemployed people suddenly get their jobs back?

Firms are going bankrupt right now. Their revenues are down 90%. Are they just going to spring back to life once everyone goes back to work? What about the deeper effects on the economy? Everyone’s spending is someone else’s income. Everyone’s debts are someone else’s assets. We’re witnessing a meltdown in asset values and income.

There is no way that is just magically resolved over a couple of months because the Fed is accommodative and some people get a $1,200 check and people can return to work. The bull case strikes me more as denial of reality than a valid thesis. It looks like an unrealistic fantasy to me.

Of course, this wouldn’t be the first time I’ve been wrong. I just think it’s highly unlikely that I am.

Valuation

Valuation is destiny and the market has been overvalued since 2014.

The pundits have mocked bears since 2014.

The overarching attitude has been: “You keep talking about the CAPE ratio, but the market went up 20% last year, so you’re wrong and valuation doesn’t matter!”

The bulls were wrong in thinking valuation no longer mattered. The bears were wrong in assuming that valuations would come down without a recession. Based on the yield curve, a recession wasn’t a serious thing to worry about in the mid-2010’s. It wasn’t even a major concern at the end of 2018.

Overvalued markets don’t come down to Earth on their own. There needs to be a catalyst. In market history, the catalyst is typically a recession.

Valuation alone doesn’t push the market down. The multiple-compression comes during the recession.

The extent of a big equity drawdown is a combination of the overvaluation of the market and the severity of the recession. The bears miscalculated in the mid-2010’s because they didn’t take into account the fact that a recession was unlikely. The bulls miscalculated last year because they didn’t realize a recession was baked into the cake and a severe re-adjustment was likely going to happen based on how frothy the market was.

And yes, the market was insanely frothy. It was even worse than the internet bubble.

Last year, market cap/GDP went above its internet bubble highs.

Market cap/GDP is very good at predicting 10 years worth of returns.

What it doesn’t tell you is the sequence of those returns.

Usually, the sequence of those returns is wild and correlated with the timing of recessions and recoveries. In 2000, market cap/GDP suggested a .4% rate of return. The actual result was a .9% rate of return from that level. Market cap/GDP was a pretty damn good indicator through this lens.

Of course, the market didn’t return .9% per year for a decade in a straight line. This return happens in extreme bull and bear runs. When a very mild recession came in the early 2000’s, an overvalued market was knocked down to Earth.

From 2000-2003, the market went down 44%. Then from 2003-2007, it went up 90%. Then, from 2007-2009, it went down 50%. Then, from 2009-2010, it went up 50%. The market never moves in a straight line.

Let’s look at another decade with sky-high valuations that suggested poor returns: the 1970’s.

From 1973-1974, the market fell 45%. 1975-1980, it went up 200%. Due to inflation, all of these moves were null and the market was essentially flat over that period.

These returns were predictable based on valuations. What was less predictable is the sequence of those returns based on the timings of recessions.

An even better indicator of market valuation is Jesse Livermore’s indicator: the average investor allocation to equities.

The indicator predicted the poor returns of the 1970’s. It also predicted the poor returns of the 2000’s. It also anticipated the significant bull runs of the 1980’s, 1990’s, and 2010’s.

allocation

There is always a lag with the data for this indicator, but the latest data in Fred showed a 46% average investor allocation to equities at the end of last year. This was not as extreme as the internet bubble, when this went up to 51%.

Plugging this model into my equation based on this metric, this suggest a .7% return for equities for the 2020’s. Pretty similar to the 2000’s.

Market cap/GDP was at an all time high at the market peak this year, at 151% of GDP. This also suggests flat to negative returns to the 2020’s.

Will the path to these returns look like a straight line for a decade, or will it be like Mr. Market’s insane mood swings . . . that has always been the case through the history of markets?

Right now, we’re facing the worst recession that we’ve experienced in 90 years at record valuations.

We should see at least a 50% drawdown from the highs. We had a 50% drawdown during less serious recessions with less overvalued markets. Why won’t it happen this time? Because markets are more efficient? Give me a break.

Does the last 30 years look like an efficient market to you?  Does it look like investors carefully calculate future economic prospects and cash flows during periods of prosperity and bear markets?

1990-2000 – Up 300%

2000-2003 – Down 45%

2003-2007 – Up 90%

2007-2009 – Down 50%

2009-2020 – Up 250%

Rather than carefully and rationally calculating future cash flows, it looks to me like markets simply extrapolate what is going on at the moment and assume that it will last forever, leading to extreme swings.

The bull case seems to be based on the idea that markets look forward and will see past this.

When has that ever been the case in markets? Looking at market history, I don’t see a group of rational actors that can see past the noise and look at the long-term picture of an economy.

At the peak of every expansion, markets get bid up to multiples that suggest it will never end. During most recessions (at high valuations, anyway), markets crash like prosperity will never come back.

Markets aren’t this efficient mechanism that we read about in finance textbooks.

This is how markets work. During prosperity, we have a wonderful bull market where multiples expand. Then, they come crashing down once we have a recession, based on how high multiples are and how bad the recession is. Fear and greed. It’s an eternal cycle of human emotion.

Why won’t this happen again, when we are facing the worst economic crisis we’ve had in a century? Have we broken the economic cycle? Are investors seeing the world more rationally than they did in the past?

This sounds absurd to me.

The Future

Of course, once all this is over, if history is any guide, we’ll have another rip-roaring bull market. We had a nice bull market from 1932-37 and we had a great bull market from 2003-07.

The good news is that the yield curve has un-inverted. Short term rates are now negative. I would expect this to continue.

Once the bond market begins anticipating a recovery, I would also expect longer term rates to start increasing again. This is happening now, but there is always a lag between the shift in monetary policy and its impact on the real economy. In the next year or two, markets will rebound. Of course, rebounds don’t happen after a mere 20% drawdown in the S&P 500 and at the opening gates of a recession.

curve

The virus isn’t going to last forever. At some point, we’ll have a vaccine. At some point, the lock-downs will end. At some point, fiscal and monetary stimulus will have an effect on the economy. That doesn’t seem like it will happen anytime soon, though.

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.

Do I trade too much?

water

Buffett: Hold Stocks Forever

One of the most common criticisms I get from other value investors is that I trade too much. This is mainly because value investing has come to mean whatever Warren Buffett says it means.

Buffett recommends that the best holding period is forever. Buy a great business at a fair price and hold onto it for decades. This has become the commonly accepted wisdom among value investors.

Buffett’s views on holding periods is best summarized by the below quotes:

Our favorite holding period is forever.

Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years

My activity is entirely inconsistent with this philosophy.

I argue that Buffett’s approach is only one method of value investing.

It is a perfectly valid approach. But it’s not the only valid approach.

Graham: Two Years or 50%

Graham had a different view. It is also one that makes more sense to me. Graham’s view was that an investor should calculate a stock’s intrinsic value, buy below that intrinsic value, and then sell when it reached that intrinsic value. In other words, Graham believed in simple, easily comprehensible, rules-based value investing.

This is different from holding onto stocks in great businesses for decades on end no matter what.

Graham explained his rules in the following interview:

Q: How long should I hold onto these stocks?

A: First, you set a profit objective for yourself. An objective of 50 percent of cost should give good results.

Q: You mean I should aim for a 50 percent profit on every stock I buy?

A: Yes. As soon as a stock goes up that much, sell it.

Q: What if it doesn’t reach that objective?

A: You have to set a limit on your holding period in advance. My research shows that two to three years works out best. So I recommend this rule: If a stock hasn’t met your objective by the end of the second calendar year from the time of purchase, sell it regardless of price. For example, if you bought a stock in September 1976, you’d sell it no later than the end of 1978.

In other words, Graham recommended that an investor should sell a stock after a 50% gain or after holding for two years, whichever comes first.

This view makes sense to me.

I estimate what I think something is worth, then I sell when it hits that value. I don’t think I’m capable of figuring out which stocks among the thousands available in the investable universe will overcome the odds and compound for decades on end. I do think I’m capable of identifying a bargain and selling when it is reasonably close to its intrinsic value.

There are drawbacks to this strategy. I will never own a stock that compounds throughout the decades. I’ll never buy and hold Nike for 40 years. I’ll never become a millionaire by investing in the Amazon IPO.

I also don’t care. I can achieve perfectly satisfactory results without trying to buy these lottery tickets.

My approach is a high turnover approach, which increases costs and taxes. This is a big deal for someone like Buffett and not so much for me. Buffett is a megaladon and I’m a gnat in the belly of minnow. My trading account that I track on this blog is in an IRA and brokers don’t charge commissions any longer. I have miniscule sums of money and I can’t influence the price of a stock.

My strategy isn’t scalable, either. At least, it’s not scalable to Warren Buffett’s level. Warren Buffett commands the one of the largest pools of investable cash (that is constantly growing!) in global markets. He can’t nimbly move in and out of stocks. It’s like an elephant trying to nimbly move in and out of a swimming pool.

Buffett’s strategy is entirely valid, but it’s not the only valid strategy.

What’s a Wonderful Business?

Buffett recommends buying wonderful businesses. Well, what’s a wonderful business?

A wonderful business is a business that can earn high returns on capital over long periods of time.

This is extremely hard to do. It’s extremely hard to do because we live in a capitalist economy with a lot of competition. If someone has a business where they can earn high returns, other businesses are going to swoop in and do the same thing, which will reduce those returns.

This is why Warren Buffett focuses so much on the concept of a moat. Those high returns on capital can only be sustained if there is something about the business that helps it resist competition.

Where do moats come from? They can emerge from a lot of places. Some businesses might have a geographical moat, like a toll bridge. Others might have a regulatory moat, where government policy helps sustain their advantage. Brands are another form of moat. Are you willing to pay a premium for a Nike swoosh? You likely already have, many times over.

Buffett has identified many moats in good brands. After successes with other wonderful businesses such as American Express and Disney in the 1960’s, Buffett recognized the power of a moat through his investment in See’s Candy in the early 1970’s.

See’s Candy can earn high margins because it has a recognizable and enduring brand. Munger explains the moat below:

“When you were a 16-year-old, you took a box of candy on your first date with a girl and gave it either to her parents or to her. In California the girls slap you when you bring Russell Stover, and kiss you when you bring See’s.”

People are willing to pay a premium for See’s because of the enduring quality of the brand. That’s not something that an upstart competitor can easily disrupt.

The same is true for Coca-Cola. Coca-Cola has a strong brand. If you face a choice between a store brand Cola and Coke, you’re going to pick Coke.

It won’t make much of a difference in your personal finances or grocery bill if you pay 40 cents a can versus 30 cents a can. Why wouldn’t you chose a marginally more expensive quality brand that you’re familiar with over one that you have no familiarity with? Meanwhile, that small difference in price creates large profit margins that are sustainable over long periods of time.

Moats Are Hard to Find

Situations like Coke and See’s sound deceptively easy to identify.

A key problem is that moats are much harder to identify than we realize.

The concept of moats was popularized by Buffett, but it is rooted in the ideas of Michael Porter.

The ideas of Michael Porter have been widely disseminated throughout business education programs. In the 1980’s, it was first taught at the Ivy Leagues. By the 2000’s, it was disseminated and understood far and wide.

My MBA is about as far away from the Ivies that you can go. I earned my MBA at a cheap state school, but even I was taught the gospel of Michael Porter. Much like the efficient market hypothesis, which was drilled into my head during my Finance undergrad degree, Porter’s ideas were treated as gospel truth.

There’s a problem with the ideas of Michael Porter: there isn’t any proof that any of it is true. Dan Rasmussen explains much better than I ever could in this excellent article in Institutional Investor. Rasmussen explains:

Porter’s logic suggests that firms with competitive advantage would earn excess profits, so profitability margins should be a guide to which firms have the most-sustainable profit pools. Yet profit margins have no predictive power in the stock markets. In fact, academic research suggests that margins are mean-reverting and provide little information about future profitability. The implicit certainty of Porter’s view of the world — that margins are persistent, that competitive advantages result from permanent structural features of industries, that “excess profits” come only from distortions in market structure — could lead investors to overpay for current performers. The theory leads not to an investing edge, but to the most common of investing mistakes.

It’s harder than hell to distinguish between a business that is enjoying a temporary edge between one that is an economic franchise.

It’s also hard as hell to figure out if an economic franchise which has endured for decades is about the completely fall apart. One of the best examples of this is Kodak. In the 1990’s, Kodak looked like it had an impenetrable moat. Then digital cameras came along.

Morningstar has put significant resources and intellectual depth into identifying moats. As highlighted in this excellent article by Rupert Hargraves, companies christened as “wide moat” don’t outperform over the long run like they theoretically should. Are you a better analyst of a moat than the talented people at Morningstar who have devoted themselves to solving this problem?

The same phenomenon is also highlighted by Tobias Carlisle in Deep Value. Carlisle cites Michele Clayman’s analysis of Tom Peter’s book “In Search of Excellence” as an example.

In the early 1980’s, Tom Peters identified key attributes of “wonderful” companies and assembled a list of truly wonderful companies. These were companies with high growth rates and high returns on invested capital.

In 1987, Michele Clayman analyzed the stock performance of these “excellent” companies. The portfolio underperformed the S&P 500.

Adding insult to injury, Clayman also assembled a list of companies with the opposite characteristics of excellence – bad returns on capital, low growth rates. Guess what? The unexcellent portfolio outperformed both the S&P 500 and the “excellent” portfolio by a wide margin.

Of course, a modern value investor would argue that they weren’t really excellent companies because they didn’t have a moat to defend those high returns on capital.

These investors would say that the companies that they are purchasing today actually have a moat. Okay. What’s more likely? That these investors have found a moat or a business enjoying a temporarily good situation that will ultimately be eroded by competition? I would say that the evidence suggests they are unlikely to find a moat.

Coca Cola: A Case Study in Moats

The Moat

Buffett gobbled up Coca-Cola shares after the stock market crash of 1987. He knew Coca-Cola was one of the ultimate American brands and had a strong moat which allowed it to earn high returns on invested capital.

A key source of Coke’s moat was its long and successful marketing campaigns. Coke was everywhere for 100 years. Baseball games. Logos printed on every billboard. Indelible images pounded into the American psyche, like Santa Claus drinking an icy cold Coca-Cola and smiling.

The success of Coca Cola’s marketing was best demonstrated during Coca-Cola’s debacle with New Coke. In 1985, Coca-Cola tried to change their formula. They tested out their formula in taste tests and people preferred it.

Once the new flavor was released, the public hated it. Coke executives quickly realized that Coca-Cola’s success had nothing to do with the actual taste: it had to do with the public perception of the Coca Cola brand, which Coke spent decades establishing. The people associated messing with Coke’s flavor with messing with a part of Americana itself. Coke ultimately relented and brought back the old flavor in the form of “Coca-Cola Classic.”

This is a great documentary from 2003 on the debacle, the People vs. Coca-Cola.

I grew up on a steady diet of Coke marketing and Coke products. Coke’s aggressive marketing has made me associate that brand with an image of America itself.

The sugary sweetness was an immediate appeal. The sugar and caffeine high that came afterwards made me feel good. It was usually served to me at happy occasions: family events, movies, birthday parties. My mind quickly associated the taste of Coca-Cola with good times and good feelings.

Generations of children had the same experience. This made for a hell of a moat, probably the ultimate moat in the history of business.

A Wonderful Business at a Fair Price

Modern value investors are obsessed with identifying Coke-like businesses. They want to identify these wonderful businesses at fair prices and hold onto them for decades of compounding success, following Buffett’s example.

As justification for their frothy purchases, they cite Buffett’s transformation from buying stocks below working capital to buying wonderful businesses at fair prices.

Of course, the price of Buffett’s Coke purchase was hardly modern compounder territory. Buffett bought Coke at a P/E of 12.89 in 1989 and 14.47 in 1988.

Furthermore, I think that Buffett holding onto Coca-Cola for decades was a mistake. He should have sold it in the late ’90s.

Coca-Cola has treated Berkshire exceptionally well. Coca-Cola has compounded at a 13% rate since 1986 in comparison to the stock market’s rate of 10% during the same period. In other words, Coca-Cola turned a $10,000 investment into $660,653. The US stock market turned the same $10,000 into $270,528.

What is missing from the raw CAGR is the sequence of these returns. From 1986 to 1998, Coca-Cola grew at an astounding CAGR of 27.68%. However, from 1998 through 2020, Coke has only appreciated at a CAGR of 4.74%. 10 year treasuries have returned 5.31% with a lot less stress.

An investor would have been better off investing in 10-year treasuries in 1998 than investing in Coca-Cola.

Did Coca-Cola’s business change? No. Coca-Cola has continued to be a great business since 1998, growing earnings and earning high returns on invested capital. It didn’t matter for the stock.

What changed was the price. Coca-Cola got up to a P/E of 40x in 1998. The price grew faster than the fundamentals.

The valuation mean-reverted in the 2000’s despite the performance of the underlying business, causing the less than satisfactory result.

Buffett should have sold Coca-Cola in the late ’90s, but he didn’t.

Why didn’t he?

It could be for public image reasons. Berkshire had become so closely associated with the company. If Buffett sold, it would be a blow to the public image of Berkshire and Coke.

He also couldn’t nimbly move out of it, as it had grown into a massive portion of the Berkshire portfolio.

In fact, it’s quite possible that Buffett realized Coke was expensive, couldn’t sell for the public image reasons, and this may have been a major reason that Berkshire purchased General Re, which helped dilute Coke as a percentage of Berkshire’s holdings.

I’d also argue Buffett was in love with the business and couldn’t bring himself to sell.

Problems with Wonderful Businesses

Coke’s price run-up in the ’90s and Buffett’s mistake by holding on outlines a major problem with buying wonderful businesses.

If the business is indeed wonderful, how can an investor bring themselves to sell when the price gets ahead of the fundamentals?

Another major problem with moat investing is that moats are ridiculously hard to identify. I would argue that even Coca-Cola’s moat isn’t certain to persist into the future.

While it was socially acceptable to give children sugar water when I was a kid, that dynamic is different today. Coke has tried to get away from this problem by diversifying into other products. Still, I find it hard to believe that Dasani will have the same marketing grip over future generations that Classic Coca-Cola had over previous generations.

If Coke’s moat is uncertain, then what moats are certain?

If it’s possible that Buffett – the greatest business analyst of the last hundred years – is making a mistake by holding Coke, then what are the odds that you going to make a mistake by buying the business that you think has a wide moat? I am certainly not a business analyst that’s as good as Buffett.

It is also increasingly difficult to acquire these businesses at “fair” prices. Investors fall in love with wide-moat businesses and bid them up to prices which are likely going to create disappointing future results.

For example, modern value investors are buying things like Visa and Costco because they are wonderful businesses with moats.

I certainly agree that, on the surface, Visa and Costco have incredible moats. Visa controls a significant portion of the global payment system and it’s unlikely that a competitor can disrupt that. Costco controls an ever increasing portion of America’s retail spending habits and maintains that by maintaining low prices and locking in consumers with memberships.

Neither of these businesses can be acquired at the kind of “fair” prices that Buffett acquired companies like See’s and Coca-Cola.

Look at the current EV/EBIT multiples of these wonderful businesses:

Coca-Cola – 24.14

Costco – 19.91

Visa – 23.42

Additionally, Buffett didn’t buy Coke and See’s at crazy, or even slightly high, prices. They were incredible bargains!

As mentioned earlier, for Coke, Buffett bought it at a P/E of 14 and 12. The enterprise multiple was likely much lower than that raw P/E suggests. See’s was purchased for $25 million. Sales were $30 million the year that he bought it. Profits were $4.2 million.

Buying a company for less than its annual sales and at a P/E of 5.95 is nothing like buying today’s compounders at EV/EBIT multiples over 20.

Yes, See’s wasn’t a net-net, but it was hardly a situation where Buffett and Munger threw caution to the wind and paid a sky high valuation for a great business that compounded over time.

Do I Trade Too Much?

Let’s return full circle to the question I asked at the beginning. Do I trade too much?

I don’t buy wonderful businesses and hold them for all the reasons described above. I buy cheap stocks and then get out when the fundamentals deteriorate or they get close to intrinsic value. I certainly trade more than the Buffett-style compounding value investors, who would waive a ruler at me like a nun in Catholic school for betraying the faith.

I went to Catholic school and this was a frequent occurrence.

I trade even more frequently than Graham’s rules recommend.

Not only do I sell at intrinsic value, I often sell at mere 52-week highs. I’ll also sell if I notice a deterioration in the performance of the business, often relatively quickly after I buy them.

A major reason I sell so quickly is because I know I’m not necessarily buying wonderful businesses. I’m buying businesses at what looks like a bargain price regardless of its underlying quality. I get out when I see signs of a deterioration in the business, which helps me avoid value traps.

I’d argue that the approach works, even though I’ve lagged the S&P 500.

As with all things, I like to look at the evidence and not the dogma.

Here is a comparison of stocks I’ve sold, comparing my sale price to the current market price.

price1

2

sells

selling

I’m not following the Buffett scriptures, but it seems to me like I’ve made some pretty decent sell decisions.

I think I will continue to follow my own path instead of sticking to an investing religion dogmatically.

Summary

  • Buffett believes in long term holding periods. Graham recommending shorter periods. I agree with Graham.
  • Wonderful businesses with moats are extraordinarily hard to find. It’s also hard to find in any quantitative sense.
  • There isn’t any empirical evidence that proves that wonderful businesses outperform over long periods of time. In fact, the opposite is true.
  • I get criticism for trading too much, but it seems to be working out for me. I’m going to chart my own path and not stick to an investing dogma like it’s a religion.
  • You do you. There isn’t any one true faith in investing.

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