Category Archives: Portfolio Commentary

2018: A Year In Review

myperformance

My Portfolio

This has not been a good year for my portfolio. I am below where I started, and I am down 16.4% for the year.

This is the second year in a row in which I have underperformed the S&P 500. This is certainly disheartening. The last two years for me have made a strong case for shutting up and putting money in an index fund, but I’m not ready to give up just yet. More on this later.

Buys

This quarter, I purchased a number of new positions. You can read the write-ups below.

Most of these companies are statistically cheap on the basis of earnings, cash flows, enterprise multiples, and sales. All have a strong financial position with low debt/equity ratios, good Z-scores, good Piotroski F-Scores. From a quantitative perspective, they’re all in the right neighborhood.

One position, Amtech, was purchased for the asset value. Amtech is selling below net current asset value and near cash. This is high quality for a net-net, considering that the company actually has earnings and positive cash flow. Most net-net’s tend to be terrifying perpetual money losers.

For the stocks I purchased for earnings, a common concern for them is that their underlying businesses are at a “cyclical peak”. I don’t believe we are going to have a recession in the next year, which is why I am comfortable purchasing them. I’ll explain more on my views of the macro landscape later in this post.

Sells

Below is a list of all of my sells this year:

2018sells

Previously, I tried to hold stocks for at least a year before selling them unless the stock was up significantly.

I loosened that rule up this year to give myself an escape hatch if the fundamentals deteriorate. For me, the biggest red flag is an actual loss at the top of the income statement. This helped me get out of two value traps early: Big Five Sporting Goods and Francesca’s Holding. I managed to exit Big Five with an 8.27% gain, which is incredible considering that the stock is down 62% for the year. Getting out of Francesca’s early was another great move, as it is down 87% for the year.

I try not to get married to positions. I think it’s important to keep an eye on the fundamentals of the companies I own. If the fundamental change, I should revisit my opinion.

International Indexing

This year, I also abandoned my “international indexing” strategy, which I pursued because of the poor opportunity set in the US combined with my poor skills in researching individual foreign companies.

The debacle in Turkey exposed this as a bad idea for me.

In order to stick with a position, I need to understand it. I don’t know anything about the situation in Turkey other than the market was cheap. That’s not a good thesis that will give me enough confidence to hold through a horrific drawdown.

I decided in the fall that this account should focus on my original mission when I set aside this money and started this blog. I set out originally when I launched this blog to hold individual positions in companies that I’ve researched. That’s what I am sticking with.

Misery Loves Company

This has been a difficult year for systematic value investing. As they say, misery loves company. Value investing has had a terrible year and my portfolio is not an outlier. Here are some examples:

  • The Russell 2000 value index is down 15.3%.
  • The Vanguard small-cap value ETF (VBR) is down 14.8%.
  • QVAL, the quantitative value ETF from Alpha Architect, is down 19.69%.
  • Validea’s 20-stock Ben Graham screen is down 15%. The 10-stock various is down 23%.
  • AAII hasn’t updated it yet, but as of November 30th the value screens did not have a good year. I suspect that when they update for December, the results will be a lot worse. As of 11/30, the Ben Graham “enterprising investor” screen (probably the closest proxy to what I’m doing) was down 15.5%. Their low price-to-free cash flow screen was down 12.5%. The high F-score screen was down 17%. Notably, the magic formula held up nicely this year. They show that screen with a gain of 7%.

The current situation could go many different ways, as is always the case in markets.

Traditionally, value stocks sell off before the rest of the market before a major calamity. They tend to be canaries in the coal mine. This was certainly the case in 2007. This is because value stocks are cyclically sensitive and, at the end of the expansion, they are the most vulnerable to a decline. This is also why they tend to rip in the early years of expansion, like 2003 and 2009. Everyone thought they were utterly doomed, but the world doesn’t end the way everyone was expecting. Stocks that had the biggest clouds hanging over them tend to perform exceptionally well once the weather improves.

The critical question, then, is: are we at the end of the economic expansion? Are we at the end of this cycle of economic development, or is the recent market sell-off one of Mr. Market’s typical bouts of insanity?

For possible answers, I turn to history.

Mr. Market’s meaningless temper tantrums

The market is replete with the corrections of the 10-30% magnitude that don’t reflect any reality in the real economy.

The most famous example of this is the crash of 1987, which had hardly any impact on the real economy. Mr. Market went into euphoric overdrive in the first half of 1987 (probably cocaine-fueled), with the market rising 22% from January 1st through the August peak. It then suffered a 33.7% peak to trough decline from August 1987 through December.

People are obsessed with another 1987 style crash happening again. Whenever the market has a nice run, Twitter is replete with comparisons of the chart to a stock chart of 1987.

I find this amusing. We should be so lucky. The 1987 crash had zero impact on the real economy and turned out to be an incredible buying opportunity. During the crash, Buffett’s friends (people like Bill Ruane and Walter Schloss) were at their annual conclave in Williamsburg, Virginia. They saw the panic for what it was and went to the phones to buy stocks.

Buffett used the crash to buy one of his most famous investments: his large allocation to Coca-Cola, which would set Berkshire’s returns into overdrive in the 1990s.

The people who are trying to predict the next crash of 1987 are missing the point. You can’t predict things like the crash of 1987. The trick is to identify the opportunities created by these events by buying new opportunities with a prudently calculated margin of safety.

Even indexers were fine in the crash of 1987 as long as they didn’t succumb to panic selling. Amid all of the “carnage” of 1987, the S&P 500 returned 5.25% that year. In 1988, the index returned 16.61%. In 1989, it returned 31.69%. It was a non-event, but market commentators are still obsessed with it.

Who suffered from the 1987 decline? Speculators. People who were leveraged. People who bought financial derivatives and exotic financial products. People who bought concentrated positions in speculative names. People who bought concentrated positions on margin. In other words: they’re the same people that always lose money over the long run and people who deserve to lose money over the long run.

Investors, in contrast to speculators, made out just fine in 1987. In modern parlance, these are the kind of people who thought they could predict volatility and went long in XIV. Alternatively, these are the kind of people who thought they could predict the price movement of cryptocurrency – i.e., a financial product best suited for anonymously buying heroin. Because blockchain is going to alter Western Civilization or something. Speculators always lose, and they’re always surprised when they lose. It’s so strange to me how people keep flocking to speculation like blood-sucking mosquitoes to a bug zapper.

What are some other instances of market downturns that didn’t reflect or predict anything in the real economy? In 1961-62 the market suffered a 28% drawdown. In the summer of 1998, the S&P suffered a 19% drawdown. ’83-’84 – 14% drawdown. 2011 – 19.4%. 1967 – 22%. 1975 – 14%. You get the idea. These things happen all the time.

Here is a young Warren Buffett talking about the 1962 hiccup. It sounds pretty familiar.

 

 

What particularly amuses me is how people are always trying to develop explanations for why these things happened. The 1987 crash is the most studied crash of all time with extensive media coverage. There still isn’t any consensus on what caused it. Some blame “portfolio insurance”. Others blame the Plaza Accords. Others still contend that the 1980s stock boom was a speculative bubble and the bubble never ended. They think the Fed has just been bailing out markets for 30 years and all of the gains since 1987 have been illusory.

Trying to predict and explain these things is a fool’s errand, unless you think you’re the next Taleb or Paul Tudor Jones (you’re not). I usually laugh at the commentators with impressive credentials and expensive suits who go on cable and explain why this stuff happened. Well, sir, if you look at the 200-day moving average, put this over the 50 day moving average, and if you look at the uptick in volume, and compare this to steel prices, and then take a look at these Bollinger Bands, and then look at the M2 supply’s impact on bond outflows, and compare this to the put/call ratio . . . blah, blah, blah

They might as well be astrologers. They might as well be ripping apart chicken guts and trying to predict tomorrow’s lottery numbers. Of course, this really shouldn’t be a surprise coming from the Wall Street elite. This stuff isn’t above them. They’re not all rational. These are people who buy healing crystals, after all.

The people who try to predict Mr. Market’s moods are like dutiful scientists following around someone at a bar after 15 tequila shots and trying to explain all of their behavior, trying to develop some rhyme or reason to it. “Hmmmm, very interesting, she is projectile vomiting after singing Sweet Caroline. Perhaps there is a correlation between vomit and Neil Diamond.”

I suppose much of it has to do with the rise of the efficient markets theory. If markets are efficient and they reflect all available information, then Mr. Market’s temper tantrums must actually mean something.

From their perspective, it can’t be my simple explanation: people are crazy and stuff happens. It can’t be that Ben Graham got it right in the 1930s and that much of financial theory since then has been a big waste of time.

Mr. Market gets it right (sort of)

Occasionally, Mr. Market gets it right and the carnage is tied to real turmoil in the real economy that will cause a real impact on the fundamentals.

Sort of, anyway. Even when Mr. Market gets it right, he overreacts. Mr. Market usually believes every bad recession is the end of Western civilization and the market suffers a 50% drawdown that would not be justified if markets were truly efficient. This is evidenced by the fact that the market normally snaps back by 50-100% in a year or two after the bloodbath.

The ’73-’74 drawdown is one example of an authentic event. The S&P 500 suffered a peak-to-trough decline of 48%. Oil drove the economic funk. With US oil production peaking in the 1970s, the US economy became more reliant on oil imported from OPEC nations. When OPEC colluded to restrict supply in response to US support for Israel, oil skyrocketed. This caused a severe and brutal recession in the United States.

The 2008 event was tied to real economic activity, as we’re all aware of and I don’t need to repeat. Banks were failing and it felt like the system was falling apart.

How about 2000? Many cite the 2000-02 market as one long bear market. I divide it up into stages. The initial fall in 2000 was simply Mr. Market throwing a temper tantrum. There was no catalyst. In 2000, people suddenly realized that it was crazy to pay 100x earnings for Cisco, even though it was a great company. They realized it was insane to pay 10x sales for IPOs of dot com companies that didn’t make any money. It was simply a mood wearing off.

Side note: Cisco was the first stock I ever bought. I sold it after I read “The Intelligent Investor” and realized it was crazy to own it.

In 2001, however, the deflation in the stock market along with 9/11 began to have a real impact on the economy, which triggered the more serious sell off of 2002 and early 2003.

What is this thing – a meaningless temper tantrum or something real?

The key question is whether or not the recent decline is merely Mr. Market panicking or if he is predicting real damage in the US economy.

To answer that, we should ask what distinguishes speculative panics from real events.

The most significant difference between a real event and speculative BS is that there is no consensus explanation for speculative panics. There are plenty of scapegoats for the crash of 1987, the “flash crash” of 2011, but no consistent broadly accepted explanation. In contrast, there is no doubt what caused the market declines of 1981-82, 1973-74, 1990, 2008.

Is there any consensus on what caused the recent collapse? Not really. Speculation abounds: the market is concerned about trade wars, the Fed hiking interest rates, hedge funds are “de-risking.” There isn’t any consensus. There isn’t a clear bogeyman. That leads me to believe that the market is not accurately predicting any carnage in the real economy within the upcoming year.

I also doubt we’re entering a recession for the following reasons:

1) The yield curve hasn’t inverted. While some rates briefly inverted this year, there is a lot of noise in the shorter end of the curve (under 5 years). The inversion that accurately predicts recessions, the 2 year versus 10 year, has not inverted. It’s also worth noting that the inversion usually happens a year or two before the recession begins in earnest. The fact that it hasn’t happened at all leads me to believe that rates are not yet high enough to push the economy into a recession.

yieldcurve

2) There has been no discernible change in the unemployment trend. October 2018 marked an all-time low in the unemployment rate. The unemployment rate usually begins to tick upward before the onset of a recession. The unemployment rate started to rise in the first half of 2007, months before the beginning of a bear market or the start of the recession in December 2007. The unemployment rate also began to rise in the fall of 2000, the summer of 1990, and the fall of 1981. I would expect the unemployment rate to begin tipping upward if a recession was imminent.

unemployment

broader unemployment

3) Household leverage is healthy. Think about what causes a recession. Typically, it is driven by monetary policy. In a boom, interest rates are cut and households accumulate debt, which drives the expansion. In the later stages of a boom, the Fed increases interest rates. The higher debt burden plus the higher interest rates restrict the cash flow of households. As they cut back to deal with the stress on cash flows, this pushes the economy into a recession. Currently, household debt payments as a percentage of disposable income are near all-time lows, despite the recent increases in interest rates.

leverage

4) There isn’t any sign of a slip in broad economic indicators. In fact, most of them are at all-time highs. Here are a couple: truck tonnage and industrial production.

trucktonnage

industrialproduction

The Opportunity For Value Investors

In the last couple of years, I have been concerned about rich equity valuations. I invested anyway in the best bargains I could find. I invest for the market that exists, not the one that I wish for. I wish every year could offer up 2009-style bargains. I also wish pizza, cookies, and ice cream didn’t cause me to gain weight. Unfortunately, my wishes are not reality.

With that said, the recent sell-off has helped the situation. It’s not 2009 cheap, but it’s a much better situation than it has been in a long time. The Shiller P/E is down to 27.69, which is hardly cheap but is better than it has been in a few years. The latest data isn’t available, but I’m sure that the average investor allocation to equities has also declined, which is also good news for future returns.

The drawdown has produced an ample number of cheap stocks, which is great news for value investors. The high number of cheap stocks is unprecedented for a healthy economy.

In December of 2016, there were only 47 stocks in the Russell 3,000 with an EV/EBIT multiple under 5. In December 2017, the count was down to 40. There are now 90 of these stocks, which is historically very high. Such a high number of cheap stocks bodes well for value. In past years when there have been more than 80 of these, as a group, these cheap stocks have delivered an average annual return of 32%.

The year 2000, in particular, was an incredible year for the relative performance of this group. This group of stocks with an EV/EBIT multiple below 5 delivered a 28.35% return compared to a loss of 9.1% in the S&P 500. This was extraordinary out-performance. The good times made the careers of a number of value investors who were new to the game and weren’t already tarnished by the under-performance of value in the ’90s, like David Einhorn.

Everyone knows that value has under-performed for a decade and this is similar to the late 1990s. The thinking goes that this under-performance will lead to another period like the 2000s when value stocks crushed expensive stocks. For the last few years, I wanted to believe that this situation was bound to mean revert soon. The main factor that made me doubt this reversion to the mean was the low number of cheap stocks that were available.

What made value roar in the early 2000s? The ’90s bubble led to a plethora of bargains in the small-cap value universe. The depth of these bargains led to an incredible performance in the early 2000s. Looking at the dearth of cheap names in 2016-2018, my concern was that even though value had under-performed recently, I didn’t see the quantity of bargains that I knew existed circa 2000.

The recent sell-off has changed that dynamic. There were 101 stocks with an EV/EBIT multiple under 5 back in 2000. Now, there are 90. A week ago, there were 108.

This leads me to believe that we are entering a situation very similar to 2000. Just like 2000, the economy is fundamentally healthy and not in a recession. A recession would negatively impact all stocks, not merely the pricey growth-oriented names. Meanwhile, there are a massive number of bargains to choose from.

Despite my under-performance in the last two years, I am now more optimistic than ever.

I think we will see substantial out-performance for value and I think my portfolio of diversified value names should perform well. Value stocks are no longer merely cheap on a relative basis; they are cheap on an absolute basis as well.

Moreover, the sentiment that the value factor is played out and over-farmed is more widely accepted than ever before. You even see this in the behavior of so-called “value” investors. Value investors in recent years have thrown away the old metrics and adopted a “can’t beat ’em, join ’em” philosophy. “Value” guys are out there pitching Facebook, Amazon, and the like. Usually, the pitch involves wildly overoptimistic metrics plugged into a DCF model along with talk of “moats”. Excellent value investors like David Einhorn are treated like out of touch dinosaurs.

Everything feels right to me. The time for value is now, and I am wildly excited for the upcoming year in a way that I wasn’t previously.

Random & Personal

  • I read a number of good books this year. Chief among these is Margin of Safety by Seth Klarman. I wrote a blog post about it here. Saudi America was another great read, which I wrote about here. Here are a few other standouts I read this year:
    • Seinfeldia. If you are a Seinfeld and Curb Your Enthusiasm fan like myself, this book is a must read. It’s all about the birth of Seinfeld and the history of the show, with an inside scoop on all of the details of production.
    • Keeping at It. This was Paul Volcker’s autobiography. It was an amazing read about my favorite Fed chairman. You’ll come away with a sense of how hard economic policy is. Everything Paul Volcker did now seems so clear, but at the time it was extraordinarily hard and uncertain.
    • Brat Pack America: A Love Letter to ’80s Teen Movies. I grew up on a steady diet of movies from my favorite decade, the 1980s. This was an in depth homage to all of them. The author clearly has a deep love of the decade and the movies and music it produced. It shines through in this book. He ties each movie into larger cultural trends which were happening at the moment. He also interviews many of the creators of these movies and visits the real life locations in which they happened. Highly recommended.
  • This was a challenging year for me professionally. I’ve worked in back office banking operations for 11 years. I’ve moved up within banking operations on a pretty standard track: I started as a temp, I was hired full time to an analyst position, then a senior analyst position, then I was promoted to be the supervisor of a small team. Last December, I was promoted to a VP-level manager position overseeing 25 staff members on 4 different teams. It was a tough transition for me and I struggled to adapt to the high level of responsibility.
  • Managing the stress of the new job was hard for me. Every day brings a new crisis, a new emergency, a new demand, a new threat to deal with. Every five minutes my inbox blows up with a new problem. It’s particularly rough when faced with the constant challenge from upper management to reduce staff and increase efficiency, especially when clients and upper management are also constantly demanding better results with less resources.
  • Managing people is hard. You can’t come down too hard: you’ll hurt morale. You can’t be too easy on everyone: they will take advantage of it. Everyone has unique problems: people going through medical issues, people having trouble with their spouses, people dealing with challenging situations with their children and care for their children. I have a moral obligation to accommodate these personal issues, but management doesn’t want me to be too accommodating. Audit and controls are also a major focus and source of conflict. Like everything else, there is nuance to this. We need to have stronger controls, but we can’t tighten the controls so much that the client suffers. Meanwhile, a failure in controls results in intense backlash and threats to my employment. There are no easy solutions to every problem. Every decision I make seems to have some unforeseen consequence that I didn’t anticipate.
  • With all of this said about my job, I think I delivered and performed well in a challenging environment. I haven’t gotten my review yet, so I’ll have to wait and see if my boss agrees. I also get paid pretty well to deal with all of this, so I shouldn’t complain too much! I also tend to think too much instead of stopping and smelling the roses. There are people out there who have it a lot worse.
  • With that said, as this blog expands it audience and I interact with so many great people in the financial world on Twitter, I yearn to get out of the back office and do something different with my life professionally. I yearn to do something more rewarding than ensuring other people’s trades in weird financial products are processed more efficiently. Doing something different would also enable me to stop being anonymous on this blog and on Twitter. I have no idea what this change could be, but I’m yearning for a change. I have no idea what or when. Hopefully I’ll figure this out.
  • This was also a tough year for me personally, as I alluded to in this blog post. This was tough to handle on top of all of the professional stress. I am now 10 years sober and I’m very proud I didn’t give in and fall back into the arms of my old nemesis, booze. I think I need to make my mental health more of a priority in the upcoming year to prevent me from relapsing.
  • I found myself watching Star Trek III a lot this year. It is such an underrated movie in the wake of Star Trek II. This is the ending and it should be heart warming to every nerd out there.

 

 

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.

Macro Environment & Upcoming December Rebalance

Jitters

October’s price action seems to have given many investors the jitters. Mr. Market doesn’t quite need a defibrilator or even Pepto Bismol, but he is at least popping a Tums. This expansion and bull market have been long. They are going on 10 years now, which is relatively unprecedented. Unemployment is at historic lows. Meanwhile, the Fed is raising rates, which is usually the beginning of the end.

Valuations don’t help with the anxiety. Everyone knows that valuations are stretched. The CAPE ratio currently stands at 30.94, giving the market an earnings yield of 3.23%. The average investor allocation to equities is presently 44%, giving us an expected 10-year return of 2.3%. In other words, the realistic return that investors can expect over the next 10 years is probably somewhere in the vicinity of 2-4%. This does not provide much of a premium to the 10-year treasury yield, which is currently 2.993%. The AAA corporate bond yield is now 4.14%, a significant premium to what we can expect from equities.

yields

A 2-4% return for US stocks isn’t going to happen in a straight line and it isn’t going to be evenly disbursed across all stocks. Stock market return averages are an average of abnormal returns. There are going to be years when stocks will advance by 30%, and there will be years when they decline by 50%. The decline will likely coincide with a recession.

Recession Watch

At the same time, while it’s evident to me that valuations are stretched, I do not believe we are going to have a recession in the upcoming year. This is the main reason I am comfortable remaining 100% invested in stocks that I feel are at attractive valuations, including cyclical stocks.

I believe that the Federal Reserve is the cause and cure of every recession. Right now, the yield curve is flattening but has still not inverted. The Fed typically chokes off an economic expansion by tightening too much. They then usually save the day by aggressively responding to the downturn by cutting rates, often overshooting and causing other problems. This seems to have been the case in the mid-2000s.

Despite the tightening of the last year and the flattening of the yield curve, the curve is still not flat and it is still not inverted. Scott Grannis recently had a great post about this here.

curve

Typically, once the yield curve inverts, we get a recession within a year or two. Right now, the 10 year is at a .22% premium to the 2 years. This implies that the Fed hasn’t yet taken things too far with rate increases. A recession, therefore, does not appear to an imminent danger. To put this in historical perspective, this is where the yield curve was in 2005, 1997, and 1988.

Another thing that tends to happen before a recession is that the unemployment rate shifts its trend. The unemployment rate began to change direction back in 2000, long before the beginning of the recession in 2001. It also did this in 2007 before the Great Recession went underway. There is no sign that the unemployment has shifted course.

unemployment rate

This is further evidence that a recession is not imminent.

Another indicator that I look at is household debt payments as a percentage of disposable income. This shows you the sensitivity of households to rising interest rates. This is not worrisome at all.

households

December Rebalance

Hopefully, this gives context to decisions I am going to make in my portfolio in the upcoming month.

I am currently gearing up to rebalance my portfolio in December. I will sell many positions that are on their 1-2 year birthday and replace these positions. I have my eye on many stocks, which are listed below. If anyone has done any work on these securities, I would love to hear from you.

I’ve spent the last few weeks researching the below positions. They meet my quantitative criteria, and I am attempting to determine whether or not I feel they are likely to recover from the problems that the market perceives.

candidates

My opinion on the likelihood of a recession impacts what kind of stocks I own. In particular, it will determine whether or not I will buy stocks that are cyclical and closely tied to the performance of the macroeconomy. An example of this would be a company like Micron (MU), a cheap position that bears suspect is cheap because it is at a cyclical peak. Another example would be Thor (THO). These would be positions I wouldn’t own if I thought a recession was going to occur in the upcoming year. Some examples of cyclical positions on the above list that I am looking at include Manpower Group (MAN) and Hollyfrontier (HFC).

I’m also looking at cheap retail positions like GAP (GPS) and Chico’s (CHS), even though they have been historically graveyards for my portfolio.

It also determines whether I am comfortable holding cash. When a recession is imminent, I will likely move more of my portfolio to short-term treasuries while I wait for compelling bargains to appear. A 1-year treasury is expected to yield 2.69% right now, which compares favorably to what I expect from US markets over the next decade.

Of course, I fully acknowledge that my predict the future is as good as anyone else’s. This is the reason that I always attempt to purchase undervalued securities with a margin of safety. A margin of safety is very much a margin for error.

I’m also eagerly anticipating the next recession. While I would like to avoid some of its damage, I suspect this is the moment when I am going to find truly compelling bargains, which are now in short supply in the US. It will be an opportunity to buy sub-liquidation net-net’s extraordinarily cheap security on an earnings basis, as well. It will be an opportunity to do very well, and I’m looking forward to it.

Hopefully, this sheds some light on my thought process as I select new stocks to fill my portfolio in the upcoming month as we look to 2019 and my portfolio (and this blog) turn 2 years old. Let’s hope the “terrible twos” doesn’t affect my money.

Random

  • I have been reading Paul Volcker’s book, Keeping at It. It’s a great book from a man that I believe is the greatest Fed chair of all time. I wrote about it here.
  • Work has been extremely stressful lately, especially because of issues in my personal life that I’ve hinted at previously in this blog. My main struggle these days is maintaining a positive attitude, mainly because I am in a leadership position at work and it is important for me to keep everyone’s spirits up. I’ve slipped up recently, but I want to make more of an effort to stay positive this month, especially with the holidays coming up.
  • I gave up sugar back in October. So far I’ve lost 10 pounds since making that choice. I fell a bit off the rails on Thanksgiving when I ate a significant amount of pie, but what the hell? That’s what Thanksgiving is for. I haven’t eaten any sugar since.
  • I started watching “The Man in High Castle” and have really been enjoying it. It makes me really appreciate the sacrifices made by the Greatest Generation. If it weren’t for their efforts, the horrific world featured in that series would be a reality.
  • I was saddened to hear about the loss of George H.W. Bush. Looking back on him, whether you disagreed with him or not, he was an exceptional human being who treated the opposition with respect. He was the last President of the World War II generation, and that’s why I think his Presidency feels like a distant, bygone era. That generation had a better perspective on life. That’s why their passing brings a real sense of loss. I think their perspective comes from seeing a World War and living through a Depression. These were experiences so intense, so palpable that Boomers, Gen Xers, and Millennials can’t relate to these experiences on any level. Our worries are trivial compared to worrying about the Nazis winning World War II, or starving to death in the Depression. After going through times like a Depression and World War, they didn’t sweat the small stuff the way that we do. They realized that the stakes weren’t so high and you didn’t need to vilify people because you disagree with them about minor things like taxes, budgets, whatever. I really believe that things were better with that generation in power. People who vehemently disagreed with each other, like Tip O’Neal and Ronald Reagan, could hang out after work and still get along. I wish things were like that now. We weren’t entrenched into competing camps convinced that the other side was evil or bent out to destroy the country because they happen to disagree. I wish that’s a perspective that we could bring back. I wish I could have that kind of perspective. I worry that’s not possible, because it’s a perspective you can only earn from going through the sort of horrible times that they went through in their youth.
  • I’ve been listening to a lot of a synth band called Electric Youth. They sound straight out of 1984, and I love it.

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 2018 Update

Q3 Performance

Overall

Another quarter, more underperformance.

Value investing continues to underperform, and I continue to make mistakes. Regarding value’s underperformance, YTD to the 50 cheapest stocks in the S&P 500 has returned 3.62%. The 50 most expensive have delivered a 17.95% YTD return, outperforming the S&P 500.

I believe this will end, but I have no idea of when or how this will happen. The current cycle has looked like 1999 to me for nearly three years. I always suspect we’re close to that magical March 2000 moment, but it never seems to happen and expensive stocks continue to rip.

It looks like we’re late in the bull market to me, but no one really knows. There are no clocks on the walls, and everyone is flying blind, despite their assertive declarations to the contrary.

The only thing that I can do is continue to pursue my strategy: cheap stocks, good balance sheets, high probability of mean revision.

As for my mistakes, the biggest one appears to be abandoning my strategy a year ago for 20% of my portfolio and buying a bunch of international indexes that wound up vaporizing my money. The meltdown in Turkey caused me to wise up (or capitulate, depending on your perspective) and get back to the basics – buying individual value-oriented U.S. stocks.

Trades

This quarter, I sold all of my international indexes and bought specific U.S. stocks that I thought were undervalued. I was also paid out for my shares of the net-cash situation Pendrell. I reached a one year birthday on my position in Foot Locker and re-evaluated the position. The stock has been fantastic to me, and I’ve taken many of my gains off the table as it ran up over the last year. Evaluating the position on its birthday, it looked much more expensive than when I bought it a year ago, so I exited the position. I still think it’s a reliable company, but it is too rich for my tastes.

With the money from these sales and portfolio events, I purchased the below positions. Each position is linked to a blog post in which I outlined my reasons for buying it.

  1. Sanderson Farms
  2. Thor Industries
  3. United Therapeutics
  4. Reinsurance Group of America
  5. Micron
  6. MetLife

Of these buys, I am most excited about Micron, which strikes me as absurdly cheap. It is, in fact, the cheapest stock on an EV/EBIT basis in the entire S&P 500.

Overall, I still think Argan is the most compelling bargain in my portfolio, and the thesis continues to pan out.

Goodbye, Cruel World

I initially pursued my international strategy for two reasons: (1) In Q4 2017, about 60% of the cheap stocks I was screening were in the retail sector, and I didn’t want to have that level of concentration in one industry. (2) The US valuations look terrifying to me, so I thought an excellent way to diversify would be to buy cheaper foreign markets.

So what happened?

Many of the cheap retail stocks I didn’t buy went on to perform magnificently. Here are a few picks I didn’t invest in because I had 20% of my portfolio devoted to international indexes:

Williams & Sonoma (up 32% YTD)
Best Buy (up 16%)
DSW (up 31.26%)

I ignored my thesis about the retail sector (that the popular “Amazon eats the world” hypothesis was wrong, and retail valuations were unusually cheap) and pursued another strategy that wound up falling apart.

Experience the carnage:

international indexes

Nearly every one of them declined, due to a combination of weakness in those markets and strength in the US dollar. I lost $1,090.30 overall on the experiment, which is 2% of my portfolio. Meanwhile, the stocks that I otherwise would have invested in did better.

I abandoned my strategy and underperformed as a result.

With all of this said, I still think that low CAPE ratio international indexing is a viable option that will outperform in the future. I also know it’s not for me. I need to understand my investments. I don’t know anything about the monetary policy or political situation of Turkey or Russia. I don’t know anything about foreign currency speculation. In short, I don’t know enough about the positions to stick with them when times get tough, as they are right now.

I also bought these indexes for all of the wrong reasons. Mainly, I am freaked out by the valuations of US stocks and thought this would be a way to diversify away from the risk of US overvaluation. The truth is, with the US comprising over 50% of the global market cap, when the US pukes, everything else is going to go down with it. There won’t be a place to hide, even among cheap international markets. And that’s what I’m terrified of — I’m not concerned about a gradual underperformance of the U.S. versus the world, I’m worried about the markets puking in a 2008 style event. Aside from hedging strategies, there isn’t much way to avoid this inevitable pain.

Should I just shut up and buy the damn screen?

I tweeted this back in April, and I think it’s true:

tweet

For my stock selection, I need to understand the companies to remain invested in them. I know if a sell-off is related to an actual problem (i.e., the woes of my sold Francesca position) or if it’s pure market noise (i.e., volatility in Argan). My understanding of the companies helps me stick with the strategy. Research helps me behaviorally.

Behavioral folly is also the reason I don’t go full quant even though I am very quantitative in my approach. I start with a screen of cheap stocks, research the output of the filter, and try to identify the opportunities which I think are best.

This approach has flaws due to the “broken leg” problem. One of the best examples of this is Joel Greenblatt’s brokerage service that was designed to help people implement the magic formula strategy. Greenblatt established a brokerage firm that would automatically invest in the magic formula for clients. Some clients automated the magic formula stock selection, while others chose from the list. The clients who picked their stocks from the magic formula list underperformed. Those who purchased the screen outperformed the market. Joel Greenblatt explains it here.

Why did this happen? In short, investors avoided the scariest looking stocks, which were the ones that provided the best returns. I don’t think this phenomenon only applies to amateur investors. I think it’s the main reason that many value investors underperform simple quantitative “cheap” strategies. You’ll often hear of exceptional value investors outperforming the stock market, but they often underperform the lowest deciles of cheap. They underperform simple metrics of cheap because, to avoid value traps, they often pass over the best opportunities in the market because of how terrifying they appear.

The evidence indeed suggests that I should go “full quant” and buy the damn screen. The reason I don’t do this is that I don’t feel that I would be able to stick with a “full quant” strategy. I want to understand what I invest in so I can stick with the plan through thick and thin.

The low CAPE strategy is a quant strategy as is merely buying cheap stocks. I recognize the compelling logic of a full quant approach, but I can’t fully embrace it because I want to understand the companies themselves. It might worsen my results over the long run, but at least I’ll be able to stick with it.

I set out on this blog to pick stocks within the low P/E, low debt/equity 1970s Graham framework. That’s what I’m going to stick to despite the temptations to abandon it. I am not knocking the low CAPE index approach, the magic formula, or the Acquirer’s multiple strategies. I just don’t think I’d be able to stick with a purely quantitative approach if it ever turned against me.

Random

This is hilarious. “He just wanted to spend time with his family . . . and his robot. Like a normal guy.”

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.

PCOA (Pendrell)

I was paid out for my lone share of Pendrell @ $689.19, which I bought in December because it was trading at net cash. This isn’t a “trade” as much as it is a portfolio event. There was a reverse stock split and tiny shareholders like me were paid out in cash.

This brings my cash balance up to $1,093.81. I am not sure how I am going to deploy it. I may rebalance my country indexes around 9/30 (they were mostly purchased in October 2017) and include this cash in the new positions that I purchase with those proceeds instead of buying something right now. I’ll also have owned Foot Locker for a year on 9/25 (a position that has been very good to me) and may sell that.

This would get me on a cycle of quarterly activity with a big rebalance in December (the blog started in December 2016, when I purchased the original 20 positions). My intention is to hold positions for at least a year unless they increase significantly or the fundamentals deteriorate.

I’m itching to sell Turkey. I clearly made a mistake with that one and should probably adhere to stricter quality criteria for international indexes.

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 2018 Performance

quarterlyperformance

My streak of underperformance continues. I have no idea when it will end. All I know is: you can’t time this stuff. You just have to stick to it. Over time, markets reward disciplined rules-based value-oriented approaches. I think Cliff Assness put it best when he said in a recent interview that you should “find something you believe in and stick to it like grim death”. I believe in this stuff. It’s logical, time-tested, battle-tested. I’m not going to abandon it because of underperformance.

Value tends to do best coming out of a recession. If I had to guess, I won’t really see any outperformance until we see another recession and the recovery from it. That’s going to take anywhere from 5 to 10 years. Of course, that’s not how things worked out in 2000. The outperformance of value actually started before the recession. There simply isn’t any way to know or time it. I just have to stick to it.

This is my key advantage as a small investor. A professional enduring my underperformance would be in serious trouble with their investors. In an effort to keep their job, they would start to buy more popular positions. They would start to hug the indexes. They wouldn’t be able to ride something like this out and be cool with it. This is why most professionals underperform.

What’s my edge? I don’t have an informational edge. The only edge that I have is behavioral, which is something most professional investors can’t afford to have. I can handle the stench and dive into the dumpster. I can ride out the underperformance. If I can’t, then I might as well put this IRA into an index fund.

In short, I have to stick to it like grim death.

Sells

After staying put for the first quarter, I did much more trading this quarter. You can read a list of all of the trades here. I’m trying to stick to some concrete, easily identified sell rules. Those rules are:

  1. I can sell on an operational slip. For me, that is an operational loss. When I’m buying a stock on the basis of EV/EBIT, what is the position worth if EBIT begins to fall apart?
  2. I can sell if I held the stock for at least a year.
  3. I can sell as part of an annual rebalancing or a price increase of more than 50%.

For the operational slip rule, this was a result of the lessons I learned from my positions in IDT, Manning & Napier, and Cato Corp in 2017. All gave me early warning signs of a problem in the form of a decline in operating income and I ignored it.

Selling is one of the hardest elements of deep value investing. You can go with a very simplistic system such as Greenblatt’s magic formula, in which he recommended holding a stock for a year and then selling it unless it was still undervalued. Graham recommended selling after a 50% gain or after holding for two years.

My method is a combination of the two along with an element of downside protection by getting out of positions in businesses that post operating losses.

A deep value portfolio is going to be a high turnover portfolio. I am not buying stocks of companies with deep moats and high returns on invested capital. These are companies with problems that are causing an undervaluation. My goal is to buy when sentiment is poor and sell when sentiment has improved. I also sell when the fundamentals deteriorate. This is a major reason that the account I decided to track on this blog was the IRA, so I wouldn’t have to worry about tax considerations.

My sell rules aren’t perfect. My sale of Francesca’s, for instance, is looking like a mistake. Even though it will result in mistakes, I think sticking to it will help to cut off the bleeding in the worst positions. I will probably add to the rules over time as my experience grows.

Many investors hate rules. I love them. Rules keep me honest. Rules keep me out of trouble. There are thousands of investment ideas. It’s important to have strict guidelines or it will be easier to do dumb stuff. Guidelines and rules keep me honest. They keep me from straying from a tried and true path.

Buys

After selling for various reasons (price pops, operational slips, etc.), I bought a number of positions in the past quarter. They are all listed below. I also included links to my brief write-ups on each position, explaining why I found the idea attractive.

They check all of my boxes: (1) statistically cheap, (2) clean balance sheet, (3) poor sentiment, (4) potential for improvement.

  1. Ultra Clean Holdings
  2. Big Lots
  3. Jet Blue
  4. Aaron’s 
  5. Unum Group
  6. Argan

Macro

I’m fully invested, which makes me nervous when U.S. stocks are as expensive as they are. I’m trying as hard as possible to ignore macro stuff and stick to buying undervalued stocks.

Now I’ll proceed to look at it anyway.

allocation

For US stocks, the average investor allocation to equities stood at 42.82% at the end of Q1 based on the latest data. That’s a slight improvement from 43.63% at the end of Q4 2017. This suggests a 3.2% rate of return from US stocks over the next 10 years. This is the same as than the 10-year treasury yield (3.2%) but much less than the current yield on AAA corporate bonds (4%).

Bottom line, the market is expensive. That should be news to no one. That doesn’t mean it’s going to crash. That doesn’t mean we’re going into another Depression. It means they’re expensive and returns are going to be fairly low over the next ten years. The road to those returns is unknowable.

Expensive markets don’t crash just because they’re expensive. Usually, there is an event that triggers the sell-off. Usually, the event is a recession. I think about rich valuations in the sense of “the bigger they are, the harder they fall”. To fall, you still need something to push you.

The most common cause of a recession is the Fed tightening too much, which is why the yield curve is a useful indicator. The 2 year vs 10-year yield curve still hasn’t inverted, implying that a recession is not imminent. We’re likely entering a very juicy stage of the business cycle (think 1969, 1989, 1999, 2006).

yield

There also hasn’t been an uptick in unemployment, another indicator that a recession is about to begin. Unemployment continues to drop. With a tight labor market, some employers are experiencing inflationary pressures (Eric Cinnamond mentioned others on “the investor’s podcast”). This suggests to me that the Fed won’t stop tightening and at some point, they’re going to push the yield curve into an inversion and trigger a recession.

unemployment

Nonetheless, the fact that I don’t expect a recession in the next year makes me comfortable with the fact that I’m fully invested and have positions in some deeply cyclical industries. The market could easily crash 20%, but I don’t think we’re going to see a really nasty recession that would trigger a 50% drawdown in the next year.

Random

1. I saw “Solo” and didn’t understand the criticism of it. It was fun and it checked off on all the fan boxes: we saw how Han met Chewie, how Han obtained the Millennium Falcon, etc. We even saw the Kessel Run! It was certainly better than “The Last Jedi”. My suggestion is to not listen to the haters and see it.

2. I hope Gamestop gets bought out. This has been one of my long-suffering positions and there are signs on the horizon that the situation is improving.

3. Argan is the position I am most excited about. It certainly seems like a “no-brainer” at this valuation and considering the quality of the company. Still, I’m trying to keep an equally weighted 20 stock portfolio and I am not taking a position that is too concentrated. We’ll see if I come to regret that.

5. My day job has been pretty hectic this quarter but it seems to all be working out. I work in operations for a bank. I was promoted last December to a section manager role and faced an internal audit and headcount exodus right after getting the job. I was able to hire new people who are working out well and I received news this week that I passed our internal audit, which was a relief. I hope the rest of the year is a smoother ride now that those hurdles are gone.

6. My personal highlight of the last quarter was taking a week off of work, going to the beach, and spending my time reading “Margin of Safety” by Seth Klarman. Good times.

7. I also caught a couple of really good under-the-radar movies. Thoroughbreds was a really twisted tale that you should check out. It was unlike anything I’ve ever seen before (American Psycho for rich entitled high schoolers?) Just don’t expect to feel good about human nature when it’s all over. I also really dug Lady Bird, a funny movie about a high school senior in 2002 plotting to get out of Sacramento and go to college. That was actually a feel-good movie. I recommend it!

8. Deutsche Bank really worries me. The bank looks like it is in a slow-motion collapse. It’s one of the biggest banks in the world and I don’t know how the global economy would handle it if the bank fell apart.

9. I’ve really been enjoying the Focused Compounding podcast with Geoff Gannon and Andrew Kuhn. They avoid a lot of the trendy topics that are geared towards big investors that seem to dominate the podcast landscape these days (sorry guys, I don’t care about venture capital or angel investing because I’ll never be able to do it and I think most of them are lucky gamblers anyway). They focus on individual stocks and situations that small investors can take advantage of. This one and “The Investor’s Podcast” are my go-to’s. I look forward to listening to them whenever they pop up in my feed.

10. Politics is nauseating and it is getting worse. When I was in my 20s, I loved politics. I was a news and political junkie. That hasn’t been the case for most of the last decade. It’s becoming increasingly impossible for people to empathize with the opinions of others. This is very apparent on Twitter and I follow people on both sides of the aisle. Everyone thinks the other side isn’t just wrong, they’re evil and need to be destroyed. All of this anger and vitriol isn’t good for people’s state of mind. Both sides have a mob mentality. I don’t know how we’re going to snap out of it. To paraphrase Charlie Munger, ideology is turning our brains into mush.

11. Last, but not least, Captain Kirk’s finest hour.

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 2018 Performance

Q1 Performance

q1 2018

For the first quarter of 2018, my portfolio declined by 3.46%, and the S&P 500 dropped by 1.22%. My strategy still isn’t delivering any outperformance from when I started. I’ve discussed the reasons on this blog. I think a bulk of it is due to value investing’s underperformance as a strategy and specific errors that I’ve made with stock selection.

I believe the outperformance will come, but there is no way to tell when it will happen. It’s not something that you can time. I just have to stick to it and be patient.

Sentiment Shift

With that said, it feels like the sentiment is starting to shift in a way that might benefit value stocks.

For years now, the market has been rewarding cool, growth-oriented companies with higher and higher valuations. You know their names: Facebook, Apple (although Apple is odd in that it sometimes trades at a dirt cheap valuation), Amazon, Google, Netflix, Tesla, Nvidia. I would even lump cryptocurrency’s run into this bucket as an example of the sentiment.

Cool things rarely reward investors. Nearly all growth companies eventually run into problems that investors can’t anticipate or imagine. The higher their valuations (i.e., the higher the expectations), the harder they do fall once they run into the problem, which is inevitable. It appears that the stars of this bull market are simultaneously hitting those problems.

Tesla, for example, has been a star of this bull market. Its rise is due to a cool product and a popular CEO. The rapid rise in Tesla stock to absurd valuations gave Elon the currency to issue new shares and debt to keep the company afloat. Meanwhile, the company has never been profitable or generated significant cash flow. That sentiment appears to be shifting.

A friend of mine owned a Tesla and took me out for a ride in it once. It’s an impressive vehicle. The iPad instead of a console, the quick and silent acceleration. All of it is super cool. With that said, auto innovation is quickly commoditized. Think about it: your bottom of the line economy car (think about a Nissan Versa or a Toyota Yaris) has all of the features that a luxury car had in the ’90s. I’ve never been a “car guy.” For me, every car does 80 mph (which is all you can get away with on a highway) and has all the features I need. Why spend any more money than I need to? Tesla’s innovations are fresh and exciting, but in 10-20 years it’s just going to be standard. The big automakers are going to copy and compete away Tesla’s innovations. In the long run, it’s probably road kill. In the short run, the stock is at absurd valuations.

Facebook Is Bad For You

Facebook is running into problems as well. The problem which has been brewing for years is privacy concerns. Facebook presents its business model as a benevolent force aimed at “connecting humanity.” The reality is that it is an addictive product whose goal is to get people to turn over information about their lives, which Facebook then sells to advertisers. The perils of that business model came to a turning point in the recent scandal with Cambridge Analytica. I don’t know if the scandal will disrupt Facebook’s business model. As long as people continue to upload their life’s details to the site voluntarily, Facebook will have something that they can monetize. With that said, recent events do appear to be having an impact:

delete

I dropped my Facebook account a couple of years ago. Privacy was a part of it, but for the most part, I felt like Facebook was bad for me.

For me, I felt like Facebook was rotting my brain. That was the cost I was paying. The benefit was the connection with friends and family, but even that was entirely superficial. I also found myself wasting a lot of time on the app.

Regarding “brain rot,” a lot of it had to do with politics. The odd political opinions of my relatives and friends were making me dislike them. I thought to myself: did I become friends with these people because I agreed with their politics? Should a family member’s weird political opinions make me love them any less? The answer was, naturally, no.

Moreover, the bizarre beliefs I read on Facebook were hyperbole. The hyperbole on Facebook pollutes people’s outlook on the world. I also had to admit; the same thing was happening to me. I was confining myself to a shrinking bubble of information, and the increasing intensity of it all was polluting my mind. I found myself emotionally reacting to political posts instead of thinking critically about them.

The other odd thing I noticed was increased envy and jealousy. It’s unconscious, but it happens. No one posts their real life on Facebook. No one goes on Facebook and says “I had a huge fight with my husband today and I think he’s a jerk.” No one goes on Facebook and says “My children have so poorly behaved today that it makes me feel like I’m a bad parent.” No one goes on Facebook and says “My career feels like it hit a dead end and it makes me question my life choices.” However, these examples are all natural feelings that most people go through.

When you only see people post mostly “good” things about their lives, you start to think that your own life is inadequate, even though their life is probably as challenging and screwed up as your own. Think about it. Is life the happy pictures – the wedding albums, the graduation pictures, smiling families at events (the stuff that people put on Facebook) – or is it more nuanced than that? Every life has pain and disappointment. That’s not a bad thing – it’s just life.

People aren’t sharing their problems publicly on Facebook, but problems are still happening. We’re all human, and we all have issues. Social media makes us forget that and makes us feel inadequate.

I think more people are going to realize what I realized a couple of years ago. Facebook rots your brain and kills your self-esteem.

One of the most significant challenges in life is preventing your emotions from fooling you. Social media can make that an even more difficult task than it already is.

I digress. For growth stocks, the sentiment does appear to be shifting. We’ll see if it lasts.

Macro

Capture

The average investor allocation to equities

At the end of last year, the average investor allocation to equities in the United States was 43.787%. We are now beyond previous sentiment peaks, and current valuations had only been higher in 1998-2000. The 43.787% metric implies that in the next ten years we can expect returns of roughly 2.5%. The 10-year treasury yields 2.74%, so stocks no longer offer a premium over bonds.

The road to those returns is unknowable, but I think most investors are going to be disappointed in their returns over the next decade.

curve

The spread between the 10 year and 2-year treasury. When the 2 year has a higher yield than the 10 year (an inversion), it implies that monetary policy is too tight and will probably trigger a recession.

Concerning recession risk, the yield curve has not yet inverted, but it is in the process of flattening as the Fed raises rates. The lack of inversion means that a recession is unlikely over the next year. Eventually, however, the Fed’s tightening will cause a recession as it always does. The Fed is the cause and cure of every recession.

What this means for the short-term direction of equities is anyone’s guess. It does reduce the risk that equities will go down in a 2008-2009 style 50% drawdown. If the market does decline, it will probably be more like the 2000 decline. The economy was healthy, but valuations were absurd.

Of course, this bull run might just be getting started, and valuations may get even more insane. Over the short run, it is unpredictable, but we can infer from valuations that long-term returns will not meet investor’s expectations.

The Return of Volatility

After remaining dormant for a long time, volatility returned in force back in February. Volatility spiked, the market went down a little bit (10%), and everyone lost their minds. For people who were crazy enough to “short” volatility, they suffered a permanent loss of capital.

What’s funny about the whole ordeal was that the market decline was pretty tame and the rise in volatility was actually pretty normal in a historical context:

volatility

The return of volatility: angels and ministers of grace defend us

It was also really funny to me that so many tried to develop an explanation for the February decline. The reality is that there still isn’t agreement on what caused the crash of 1987! If we can’t fully understand what caused the crash of 1987, how can anyone say with authority what caused a 10% hiccup in February?

Everyone overreacted and lost their minds over a pretty normal event.

Volatility is your friend. Volatility is Mr. Market overreacting to events and losing his mind. You want to take advantage of Mr. Market, not be ruled by his mood swings. Too many investors fail to understand that the volatile nature of stocks is the reason that they offer opportunities to purchase mispriced assets.

If you can’t handle volatility – if you can’t handle very normal events like the one in February – then you don’t belong in the stock market. Bottom line, if you can’t afford to lose half of the money invested, it shouldn’t be in stocks.

Stocks are going to suffer a massive decline at some point. You can’t predict when that will happen, but I guarantee that in the next 10 years there will be multiple episodes when stocks suffer gut-wrenching declines. If you can’t handle them, then stay the hell away from the market.

It’s a good thing that most people can’t handle volatility and have no stomach for the gut punch that stocks frequently deliver. As long as most people are like this, Mr. Market will continue to offer attractive opportunities to people with the right emotional temperament.

My Portfolio

Below is a list of all of my open positions and the percentage change since I bought them:

list

Random musings:

  1. Retail: My retail stocks continue to weigh on my portfolio with the notable exceptions of Dick’s Sporting Goods and Foot Locker. Both companies delivered somewhat decent news, which was enough to deliver some solid gains. The two cheapest stocks in my portfolio (Francesca’s and Gamestop) continue to disappoint. Big Five isn’t doing quite as bad as those two, but it is still making me wince. Amusingly, Francesca and Gamestop are the two stocks that I am the most excited about. They are both priced for roadkill and any whiff of good news is going to send the stocks soaring (I hope).
  2. The international index ETFs I purchased for countries with low CAPE ratios are all doing very well and delivering solid performance. Russia and Singapore are doing the best, while Poland is the only one that is down.
  3. I didn’t do much this quarter. I did one trade, a small purchase in Argan. I had $1,000 in cash left from a distribution from Pendrell (odd lots were paid out when the company de-listed) along with some dividend payments. I decided to deploy it in Argan, which is an absurdly cheap stock with an enterprise value that is less than 1x its operating income. The timing was lucky, as the stock surged almost immediately after I bought it.
  4. Aflac was fairly volatile this quarter due to some lawsuits from former employees. The stock had a brief decline and then bounced back. It doesn’t seem to be a big deal and the stock continues to be one of the cheapest in the S&P 500.

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.

2017: A Year In Review

blaze-2178749_960_720 - Copy

My Performance

My performance was, in the words of Benjamin Graham, unsatisfactory. I lagged the S&P 500 substantially.

breakdown

The S&P 500 was a mighty opponent this year. It was like the Kurgan in Highlander, or perhaps the T-1000 in Terminator 2. It kicked my butt. The market steadily increased with minimum volatility and drawdowns. It was quite possibly the most perfect stock market rally in history.

The road to my return was also far rockier than the S&P’s. As recently as August, I was down 4.8%. My portfolio recovered 12.5% from those levels in the last few months. The S&P, in contrast, increased every month this year in a smooth and unstoppable fashion.

The S&P 500 was not to be trifled with this year.

Much of my underperformance is attributable to the underperformance of value investing as a strategy. This is to be expected. We’re in the late stage of a bull market. Value underperforms in the late stages of bull markets. In the late stages of a bull market, the stocks that shined the most during that bull market are going to be propelled forward by momentum while the laggards (i.e., beaten down value stocks) are going to be ignored or pushed down further.

Every AAII value stock screen underperformed the market this year. The lowest decile of EBIT/EV returned 8% this year, lagging the S&P 500 by 10%. The last time that EBIT/EV exhibited this level of underperformance was in 1999 when it lagged the index by 12%.

The parallel with 1999 could be an excellent thing. After 1999, from 2000-2003, value stocks went on to experience a substantial bull market while the indexes declined. The outperformance of value was significant during that time period:

cheap

Will value investors be as lucky as they were during the 2000-2003 period? I hope so. A more likely scenario would be that value will go down in the next bear market with everything else, then recover nicely. There is no way to know for sure, which is why I will simply stick to the discipline at all times.

While there are psychological underpinnings to the current environment, it is also driven by the perverse nature of indexing. Index funds pile more money into the best-performing stocks of the index. As a stock goes up, the index fund buys more of it. As a stock goes down, the index fund sells it.

When investors look at the recent returns for index funds, they pour money into them. The index funds then go out and buy based on market cap, giving momentum to the companies with the highest recent market cap gains. When money is pouring into index funds, it fuels momentum in the top performing large-cap stocks. This happened in the late ‘90s, and it is happening again.

The best performers of a bull market are rewarded even more because of the money being pumped into index funds. Companies like Amazon, Apple, Google, Netflix, and Tesla expand their market caps. In the ‘90s bull market, it was Microsoft, Oracle, Intel, Cisco and General Electric. They did well throughout the bull market and then experienced a manic frenzy at the very end.

The critical thing to realize about these moments is that they’re not caused by any change in the fundamentals. They are caused solely by money pouring into index funds, which rewards large market capitalization stocks with price momentum and punishes underperforming stocks further.

I have no idea when the current environment will end. I just know that it will end eventually. This might be 1999. It might also be 1996, and this thing might just be getting started.

What I try to do is take a long-term perspective: I am invested in stocks purchased at attractive valuations with safe balance sheets. It is unpredictable what years will deliver the returns, but I am confident that over the long run I should be able to beat the market if I stick to this approach.

Value investing is pain. Value investors don’t earn their return when the strategy is working. They earn the return by enduring the pain when it isn’t working. The pain is how we make our return. If this were easy, everyone would do it, and these bargains would disappear. There isn’t a way to time it. We have to consistently maintain our discipline and buy with a margin of safety. We have to avoid fads. We have to stay away from what’s cool. We have to maintain the discipline. The concepts of value investing are simple. Sticking to those concepts through thick and thin is not. It’s simple, but it’s certainly not easy.

Mistakes & Goofs

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All of my underperformance isn’t attributable to the underperformance of value investing, though. I made specific mistakes and blunders this year which caused a good portion of my underperformance.

I made many mistakes in the last year. I think errors are fine, as long as you learn from them. Below are my biggest mistakes of the year. I learned the following lessons from all of them: (1) Do more homework, (2) Revisit the thesis when the company posts an operating loss, (3) Stay away from asset managers, (4) Don’t panic. Let Mr. Market do that.

Cato Corp (CATO)

CATO was a retail stock I purchased for an attractive valuation and dividend yield. I bought it for the same reason I bought my other retail stocks: I think sentiment against the industry is too negative. However, CATO was in a state of fundamental deterioration when I purchased it. The first time that the company posted an operating loss in January, I should have exited the position.

Lesson learned: when a company you own posts a loss in operating income, revisit the thesis. Going forward, if a company shows such apparent signs of a deterioration in the fundamentals, I think I should admit that I was wrong in my analysis and get out.

I lost 51% on my position in CATO.

Manning & Napier (MN)

Manning & Napier is a small asset manager. I bought it because the valuation was low and I thought that sentiment against asset managers was too negative.

I learned two lessons from this stock: (1) I should do more homework and (2) I shouldn’t mess around with asset managers because they are difficult to value.

If I did more homework, I would have seen that their assets under management were in a state of decline even when things were rosy for other asset managers and that their strategies underperformed all of their respective benchmarks.

I lost 51.56% on Manning & Napier.

United Insurance Holdings (UIHC) & Federated National Holdings (FNHC)

These weren’t mistakes because I bought them, they were mistakes because of the circumstances that I sold them. I purchased both Florida-based insurance companies because they were cheap in the wake of Hurricane Matthew and were well run.

I reacted emotionally when Hurricane Irma was barrelling towards Florida and sold both in a panic. If I just stayed put, it would have worked out fine. While they plunged substantially more after I sold them, they later recovered quickly from the depths of the decline and are now higher than when I sold them.

Lesson learned: don’t panic. Also, don’t buy more than 1 insurance company in Florida!

I lost 3.8% on UIHC and 23.36% on FNHC.

IDT Corp (IDT)

IDT was purchased because of the low P/E and low financial debt. Like CATO, IDT gave me an obvious warning sign that I was about to lose money: it posted an operating loss in the spring. I should have paid closer attention to the deterioration in fundamentals and exited the position.

My sale of IDT was pure luck. I exited on December 1st to begin my rebalance and was lucky enough to get out at one of the more attractive prices this year after the spring meltdown. I managed to exit losing 21.44%. A few days later, the stock plunged another 32%.

Lesson learned (same as CATO): when a company that you own posts an operating loss then it’s time to revisit the thesis.

US Market Valuations

We’re currently at a CAPE ratio of 32.56. Japan was around a similar valuation in 1985 when the Plaza accords were signed. Returns a decade out were predictably low, but that didn’t stop the Japanese market from stampeding to a CAPE of 100 by the end of the ‘80s. The same thing could happen to the US market. There is no way of knowing.

I don’t pretend to know what will happen in the upcoming year, but I do look at macro indicators to identify what we can expect over the long term (10 years from now) in the United States. I hope to earn a premium over the market return, but the market return will act as the force of gravity on my own gains. For that reason, I pay close attention to it.

My favorite metric of market valuation is the average investor allocation to equities. With the most recent data, that figure currently stands at 42.82%. Plugging this into my formula (Expected 10-year rate of return = (-.8 * Average Equity Allocation)+37.5), I get an expected 10-year return of 3.24%.

investorallocation

3.24% isn’t particularly exciting, but it’s not the end of the world either. It is a premium to the current 10-year yield, which is currently at 2.41%. The road to those returns is unknowable, but if history is any guide, it will not be 3.24% in a straight and orderly line. Within the next 10 years, there are going to be both screaming bull markets and savage bear markets. Through it all, a 3-4% return is the likely outcome.

Market returns are going to be low over the next decade, but not negative. Investors are likely to be disappointed in their future profits. With that said, it’s also not a Mad Max end of Western civilization scenario.

Recession Risk

As for the US economy, the current risk of a recession is low. If the market turns in 2018, I don’t think it will be driven by a recession or a problem brewing from within the economy. It may be caused by valuations just coming back to normal. In 2000, high flying stocks didn’t come back down to Earth because of a recession. People just realized that the prices were nuts. It just happened. Oddly, the decline in stocks likely caused the recession of 2001. Most of the time, this happens the other way around. Macro trouble brings stocks back down to Earth.

I think recession risk is low because the Federal Reserve is still accommodative and the balance sheets of households and businesses are still in good shape. Of course, wild things could happen like a war against North Korea or oil spiking to an insane level due to a revolution in Saudi Arabia. With that said, a recession is unlikely to occur naturally.

The Federal Reserve is both the cause and cure of nearly every U.S. recession, whether we like it or not. As they tighten monetary policy, they restrict cash flows for households and businesses. Ultimately, this causes households and businesses to limit spending, causing a recession. The Fed then loosens monetary policy until businesses and households begin borrowing and spending again. Cycle repeats.

A useful metric of the current household cash flow situation is household debt service payments as a percentage of disposable income.  Currently, this remains at a very low level of 9.91%. This implies that households are not going to restrict cash flows as a result of Fed tightening. Fed tightening isn’t having much of an impact (yet) because rates are low and most households cleaned up their balance sheets after the financial crisis. The same is true of the debt/equity ratio for the S&P 500. Firms haven’t gotten crazy with leverage in the current cycle after getting burned so badly last time.

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Households aren’t stretched

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Corporate leverage also looks healthy

The yield curve is another excellent indicator of the current state of monetary policy. The best metric to measure this is the difference between the 10 and 2-year treasury yield. It’s still positive, implying that the Fed still has more room to tighten rates without triggering a recession. In other words, monetary policy is still accommodative.

yieldcurve

The yield curve has not yet inverted. Monetary policy is still accommodative.

With households and company cash flows in good shape (because of low leverage) and an accommodative monetary policy, the risk of a recession is very low.

My US macro view: (1) Returns are going to be low over the next 10 years because stocks are expensive, but equities will still return a premium over bonds. However, a 3.24% rate of return is significantly below the expectations of most investors.  (2) The risk of a recession is low because the current round of Fed tightening isn’t restrictive enough to cause businesses and firms to restrict their spending.

The 2018 Portfolio

For analysis of each company stock that I own, you can read my analysis here. A breakdown of my portfolio is below.

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I currently own (1) a small piece of a net-net (Pendrell), (2) a spin-off at an attractive enterprise multiple (MSGN), (3) multiple companies in assorted industries with low valuations and safe balance sheets, (4) multiple retail stocks with low P/E’s and debt/equity ratios and (5) two very cheap airlines (Alaska & Hawaiian Air).

I also set aside 20% of my portfolio to put into country indexes with low Shiller P/E’s. I did this because it allowed for some international diversification in a manner consistent with a value framework and it reduces my exposure to retail. If I were to fill my portfolio with all the cheap stocks in the United States right now, my portfolio would be 60-80% in retail stocks. I decided to cap this at 30%. Currently, 28% of my portfolio is invested in the retail sector.

If these retail stocks are cut in half, I will lose 14% of my portfolio. That is a loss that I can deal with. If I were 60-80% in the retail sector, then a 50% drawdown in retail would take my portfolio down by 30-40%. That is a more difficult event to recover from.

In a value-oriented portfolio, you have to go where the bargains are. For the last couple of years that has been the retail sector and everyone knows why: Amazon. I think the retail sector is undervalued and that the current narrative is overblown. In 2018, we’ll see how that works out.

My concentration in the retail sector is not merely for the bargains, but also my belief that a recession is unlikely in the upcoming year. The economy is strong even though our markets are expensive and poised for disappointing gains in the future. If the yield curve were inverted and consumers looked stretched, I would have a different outlook.

My outlook for the US economy is also why I am comfortable investing in Kelly Services, a staffing company with low valuation metrics that will benefit from the tight labor market.

The full portfolio breakdown is below:

portfolio

Of course, all of this is speculation. That is why the margin of safety is the paramount concern when I make a purchase. Even if I’m wrong, I at least purchased at an attractive valuation. I buy stocks that post multiple low valuation metrics: low P/E’s, low enterprise multiples, low price/sales. I also like stocks with little debt as measured by debt/equity and debt/EBITDA. This is very similar to the strategy outlined by Benjamin Graham in the 1970s. Even if I’m wrong about the US economy, I am systematically buying cheap stocks with clean balance sheets, which should perform well over the long run.

Investing vs. Speculation

Bull markets dull the senses. Years of high returns with few drawdowns make people forget what the pain of losing money is like. They become more confident. They become more greedy.

As value investors, one of our key responsibilities is to not get swept up in the mania. We have to keep our wits about us. One of the key things to keep in mind is the difference between investing and speculation.

Graham defined the difference as follows: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

In other words, an investment is something for which you can calculate a margin of safety. Your margin of safety might be wrong. There are undoubtedly many ways to determine if you have a margin of safety. There are value investors who focus on assets. There are some who look at earnings based ratios. There are others who perform discounted cash flow analysis. Some take a relative valuation standpoint. Others try to purchase growth at a reasonable price.

“Value investing” is a big tent and there isn’t one right approach or one true faith, but the important concept is: value investors are trying to figure out what something is worth and they are trying to pay less for it. They might be wrong in their analysis, but at least there is logic to it.

Speculation, in contrast, is when you can’t calculate a margin of safety and buy it anyway. Speculation is looking at a chart. Speculation is looking at recent price action and getting excited about it. Speculation is listening to a hot stock tip and buying it without doing any homework on your own. Speculation is buying something for which you can’t calculate a margin of safety and don’t understand.

With that said, you can’t be a speculator and a value investor at the same time. A value investor is a person for whom the margin of safety is the paramount concern in investing. Value investing isn’t a series of techniques and statistical abstractions: it is a way of thinking about the world.

The 21st-century term for speculation is FOMO. Fear of missing out. For a value investor, that’s the emotion that we need to continually keep in check and resist. Resisting FOMO may keep us out of “multi-baggers,” “compounders.” Investing is methodical and boring. Speculation is exciting. It may make us describe our returns in percentages and not “x.” It will also keep us from suffering permanent losses of capital. You can’t compound from zero.

 

One of the peculiar things about value investing is that the secret has been out since Benjamin Graham wrote “Security Analysis” in 1934. You would think that value investing would have been arbitraged away by now. You would think that it would be in the dustbin of history. The reason that hasn’t happened is because value investing goes against human nature. Most people are speculators. They are enticed by price action, they feel FOMO. People are never going to change, and that’s why Benjamin Graham’s lessons are timeless.

Only a select few are immune to this impulse. They’re the kind of people who look at a mania and think “this is BS.” They’re the kind of people who get excited when they buy a $50 pair of shoes for $25. They’re people who don’t look at value investing as some kind of statistical trick or academic exercise: it’s in their blood. It’s a way of thinking about the world. It’s a way of thinking that runs contrary to much of human nature. That’s why it continues to endure.

Before you make a purchase, think about it through this lens. Am I buying something for which I can calculate a margin of safety? Do I have a margin of safety? If the answer to both questions is “no” then you’re speculating, not investing.

There are certainly wealthy speculators, but they’re the exception. Speculation doesn’t work out too well for most of us. Speculation is buying something based on a chart, based on hype, based on a story. Success in investing requires us to avoid these impulses entirely.

Value investing isn’t low P/E, low price/sales, the magic formula, net current asset value, or low EV/EBIT. Value investing is a way of looking at the world rationally and not allowing ourselves to be swept up in the emotional impulse to speculate. This is an important thing to keep in mind in these frothy, speculative times.

The Blog

The year wasn’t entirely filled with folly. Concerning achievements, I’m most proud that I finally took the plunge and started this blog.

I’ve struggled with the itch to pursue active value investing for most of my adult life and lacked either the money or the courage to do so. The blog has been a real-time chronicle of my journey as a value investor. It also helps me stay accountable.

This year, I think my biggest achievement was finally pulling the trigger and doing this after thinking about it for so long.

Looking back at my posts, I am happy I did this. It is nice to look back and see my views in real time. It’s fun to share what I’m reading and thinking with others.

The blog is useful. It’s comfortable with the benefit of hindsight to look back and try to frame what I thought in the past. Putting down my thoughts on a blog makes it impossible to do that. It makes me more accountable for my decisions. I can look back and see why I did something and what my thought process was at the time. Hopefully, I can stick to it. I think it will help me become a better investor. I encourage others to do the same thing. Even if you don’t do it publicly, keep a journal and keep track of your decisions. Revisiting those decisions and your process will help improve your skills as an investor in the future.

I appreciate all of the feedback and am somewhat surprised that I actually have readers! Hopefully, you can all learn from my mistakes and goofs. Keep reading: you can learn about the markets on my dime!

To all of you, have a very happy, healthy and prosperous New Year!

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.

Winter is Coming: The December Rebalance

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The December Rebalance

December is for the holidays. Warm fires, quality time with family, generosity, cookies, gift giving and . . . Rebalancing my portfolio and buying hated assets!

Why do I want to rebalance in December?

  1. Give cheap stocks a chance – I want to give my investments at least a year to work out.
  2. Time is not on my side – I buy stocks of the “deep value” variety. These are companies that are in trouble. I believe if there is not a problem with a stock, then there can’t really be any value. I think that cheap stocks without any hair on them are about as rare as unicorns. These are not Warren Buffett value stocks that are long-term compounders with a moat and high returns on capital that I can stay invested in for decades. I’m not “picking winners,” I’m buying mispriced stocks and selling when they reach their intrinsic value. As a result, time is not on my side. As Warren Buffett says, time is the friend of the good business and the enemy of the bad business. I have to continuously move into and out of cheap stocks as their valuations change.
  3. Momentum – Once a cheap stock gathers some momentum, I want to ride it as long as it lasts. Quarterly rebalancing can cut off momentum as soon as the situation gets fun. Quarterly rebalancing also increases transaction costs, which I’m trying to minimize as they’re already high.
  4. The December Effect – I am shamelessly taking advantage of what academics call the January effect. Academics notice that stocks tend to do very well in January. They assert that this is due to investors selling their losers in December for tax purposes and then piling back in come January. I prefer to call it the “December Effect” because it is a time of the year that momentum takes over. Cheap stocks get cheaper and hot stocks get more expensive. This creates opportunities for value investors. There is the tax loss effect, but there is more to it than that. In one of Peter Lynch’s books (I don’t have it handy, but I believe it’s in One Up on Wall Street), he explained that December is a time of year that portfolio managers do significant clean up going into year end. A professional portfolio manager doesn’t want to go to his boss, consultants and investors with a bunch of “garbage” in his portfolio (i.e., the kind of stocks that I like to buy). They want to buy cool stuff that will get their superiors and investors excited — i.e., whatever has gone up this year (FANG, Tesla, maybe a dash of cryptocurrency for dramatic effect). This tends to make value stocks even cheaper in December, creating a great opportunity to buy them.
  5. Will this just get arbed away? – The December/January effect will probably get arbitraged away eventually. Then again, it was identified in the 1980s, and it still works to this day. Even if it stops working, I still need to rebalance annually, and I might as well pick the time of the year that has been historically most advantageous to do that. December it is.

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Die Hard: The Finest Christmas Movie

The Candidates

With the bull market now raging for nearly a decade, the number of cheap stocks is rapidly decreasing.  Most of the value in this market is concentrated in retail.  While I am okay with taking a huge (i.e., 30-40%) position in one industry that is struggling and hated, I am not going to invest 60-80% of my portfolio in it.  That is far too much for my taste.  If I were to buy all the statistically cheap stocks out there, most of my portfolio would be in the retail sector.

To prevent this, I moved 20% of my portfolio into international indexes at attractive valuations.  The purpose of this was to diminish my concentration in retail stocks and reduce my exposure to a heated US market.  If the US market falls next year and increases the value opportunity, I’ll sell these indexes and buy more US companies at attractive valuations in a diversified group of industries.

Here are the candidates I am considering:

Current positions I will likely keep and expand:

Cooper Tire & Rubber (CTB)

Gamestop (GME)

Foot Locker (FL)

New Retail Positions:

Big 5 Sporting Goods Company (BGFV)

Francesca’s Holding Corp (FRAN)

Hibbett Sports (HIBB)

Dick’s Sporting Goods (DKS)

Chico’s (CHS)

Gap (GPS)

New Insurance Positions:

Genworth Financial (GNW)

American Equity Investment (AEL)

New Assorted Positions:

Interdigital (IDCC) – Tech

United Therapeutics (UTHR) – Biotech

Tredegar (TG) – Chemicals

Reliance Steel & Aluminum (RS) – Materials

Pendrell Corp (PCO) – Sub-liquidation value and net cash

Tennis Shoes

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I am considering more concentration into 10-15 stocks instead of 20.

Most people will say this is a terrible idea. Graham recommended 20-30 stocks. That’s also what Greenblatt recommends in The Little Book that Beats the Market. The academics also seem to agree that 20-30 is the ideal portfolio size.

I recently read Concentrated Investinga series of excellent stories about famous investors (Buffett, John Maynard Keynes, Lou Simpson, Charlie Munger) who ran very concentrated portfolios. One funny story from the book involves a conversation with Arthur Ross, who explained the secret to his success as “tennis shoes.” This was a misinterpretation: he actually said “ten issues.” He owned only ten stocks at any given time. Most of the investors featured in the book had great success with this kind of concentration.

Joel Greenblatt was also successful with concentrated investing in the 1980s and 1990s when he maintained a portfolio with as few as 8 names.

Concentration is a great tool to increase returns. Alternatively, it should also increase losses and drawdowns. It increases the volatility of the portfolio. Of course, as a value investor, I don’t consider volatility to be a risk.

In fact, looking at my dismal performance over the last year, I think a lot of it had to do with the fact that I filled my portfolio with additional stocks for the sole reason of hitting a 20-stock goal. The general underperformance of value hurt my performance, but I think that diluting my best ideas also played a big role.

Here is a comparison of my high confidence ideas vs. my low confidence ones:

 

10 highest confidence ideas:

Kelly Services (KELYA) Up 25.35% YTD

Gamestop (GME) Down 35.43% YTD

United Insurance Holdings (UIHC) Up 3.5%

Cato Corp (CATO) Down 45.64%

First American Financial (FAF) Up 48.68%

Sanderson Farms (SAFM) Up 72.27%

Cooper Tire & Rubber (CTB) Down 1.5%

MSG Networks (MSGN) Down 19.53%

Greenbrier (GBX) Up 13.12%

American Eagle (AEO) Down 1.58%

Net Result = 5.92% Gain

 

10 Lowest Confidence Ideas:

TopBuild (BLD) Up 79.78%

IDT (IDT) Down 27.78%

Manning and Napier (MN) Down 49.01%

Dillard’s (DDS) Down 11.34%

NHTC (NHTC) Down 25.71%

Steelcase (SCS) Down 19.27%

Supreme Industries (STS) Up 31.38% (bought out)

Federated National Holding (FNHC) Down 26.97%

IESC (IESC) Up 35.35%

Valero (VLO) Up 21.31%

Net Result = .77% Gain

 

Even with the big assists in my “low confidence” portfolio from TopBuild and Supreme Industries, my best 10 ideas outperformed my worst. This is even with some highly prominent duds in my top 10 stocks, with CATO being the biggest. For this reason, I think it might make sense to concentrate on my top 10 ideas.

My primary concern with a portfolio isn’t volatility, it’s maximum drawdowns. I did a bit of backtesting and research to determine the kind of maximum drawdowns I could expect from a concentrated portfolio.

I performed a backtest on the lowest EV/EBIT names. A portfolio of 10 stocks had a max drawdown of 62.48%. A portfolio of 20 only lowered it slightly to 62.04%. More stocks didn’t bring much to the party.

I also took a look at Validea’s value investment screen.  Their 10-stock screen has delivered a 12.6% rate of return since 2003 with a 2008 drawdown of 27.2%. The 20-stock variation achieved a 9.2% rate of return with a 2008 drawdown of 31.5%. In other words, the portfolio with more stocks decreased returns and increased drawdowns.

The results are similar for their price to sales screen. The 20 stock screen delivered a return of 8.9% with a 2008 drawdown of 39.4%. The 10 stock variation returned 9.8% with a 25.1% drawdown in 2008. Same result: more stocks increased the bear market drawdown and lowered overall returns.

Stockopedia has a handy chart showing the number of stocks and volatility versus the index. Once you get up to 10 stocks, most of the volatility is meaningfully reduced. To get the major benefits of diversification after owning 10 stocks, you have to get up to 50 stocks. At that point – why are you even bothering owning individual stocks? You might as well buy a fund or ETF with a style that you agree with.

I see a similar pattern with Alpha Architect’s backtest of the simple Ben Graham screen (low P/E, low debt/equity, which is very similar to my own strategy). In 2008, the 15 stock portfolio went down 27.78%, 20 stocks went down 29.38%, 25 stocks went down 30.88%. More stocks did nothing to reduce the severity of the drawdown. The results were similar for other big drawdowns in value stocks: 1990, 1998, 1974. All of the portfolios held up roughly the same in each drawdown, with the 15 stock variation usually holding up better.

Theoretically, a bigger portfolio should reduce returns, but also reduce the severity of drawdowns. That doesn’t seem to happen in practice.

A big portfolio does little more than reduce volatility while increasing drawdowns and lowering returns. It’s almost as if more stocks only provides the illusion of safety. The risk that I actually care about, lowering drawdowns, doesn’t seem to be impacted at all by the number of stocks held in a portfolio.

This is a point Greenblatt makes in his earlier book, You Can Be a Stock Market Genius. He points out that most of the benefits of diversification can be achieved by owning only 10 stocks. He makes the following point:

“Statistics say the chance of any year’s return [for the entire market] falling between -8% and +28% are about two out of three . . . these statistics hold for portfolios containing 50 to 500 different companies . . .What do statistics say you can expect, though, if your portfolio is limited to only five securities? The range of expected returns in any one year really must be immense . . . The answer is that there is an approximately two-out-of-three chance that your portfolio will fall in a range of -11 percent to +31 percent. The expected return of the portfolio still remains 10 percent. If there are eight stocks in your portfolio, the range narrows a little further, to -10 percent to +30 percent. Not a significant difference from owning 500 stocks.”

Joel further elaborates:

“The fact that this highly selective process may leave you with only a handful of positions that fit your strict criteria shouldn’t be a problem. The penalty you pay for having a focused portfolio – a slight increase in potential annual volatility – should be far outweighed by your increased long term returns.”

Style Considerations

A concentrated portfolio is unusual for a deep value investor. Graham owned lots of stocks. I believe he held over 100 net-nets at one point. Walter Schloss also owned a high number of stocks.

The investors who ran concentrated portfolios successfully (Buffett, Munger, Lou Simpson) were those who emphasized quality businesses and long-term positions. It’s one thing to put 10% of your portfolio into Coca-Cola. It’s entirely different to do it with a money-losing, terrifying net current asset value stock, for instance.

It’s highly unusual for a deep value investor to take such a focused approach. You’re dealing with businesses going through difficult times, and it can be somewhat frightening to some investors to have a concentrated, often volatile, position in these stocks.

In any case, if I do pursue more concentration, it would be a highly unusual move for someone with my outlook. If I do it, I’m going to have to make sure I do significantly more homework. I’m also going to have to make sure that I am diversified across different industries. I’m not going to buy 10 retail stocks, for instance (as tempting as that is right now).

Summary

  • My portfolio will be rebalanced every December. Annual rebalancing is my preference and December is the best time to do that due to tax loss selling and professionals “cleaning up” their portfolio for cosmetic reasons.
  • I noticed that my 10 best ideas outperformed my 10 worst.
  • Due to this, I’m considering concentrating my stock portfolio on only 10-15 stocks.
  • Looking at quant value screens, additional stocks only reduce volatility, but they don’t reduce max drawdowns which is what I actually care about.
  • Concentration is unusual for deep value investors.
  • If I do concentrate on 10 names, I need to make sure that they are diversified across different industries.

Disclaimers

To reiterate — I am not a professional. I am just a guy with a brokerage account and a blog. I’m taking risks that many smart people say I shouldn’t be taking.

This blog may go down in internet history as “crazy man proves that you should shut up and give your money to an index fund.”

It would break my heart if someone out there took my stock suggestions and lost money. So, please, do not emulate what I’m doing here. The purpose of this blog is to force me to record what I’m thinking (something that we often forget with the benefit of hindsight), to keep me honest (i.e., I hope you all send me scathing comments and emails if I do something whacky like buy Tesla stock or a cryptocurrency). Do your own homework, do your own analysis, get plenty of advice, and choose an investment approach that’s right for you.

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.

International Index Investing: A Metric to Measure Quality

themazeA recap of my thinking

Recapping the last few blog posts: I think valuations are too high in the United States. Choose your poison: CAPE ratios, market cap to GDP, or the average investor allocation to equities. All suggest low returns in the coming decade.

At the same time, I know that attempting to time the US market using valuation is a fruitless effort. Markets can stay expensive for a long time. Since 2000, the US market has only gone to its “average” historical valuation once, in the depths of the 2009 financial crisis. Avoiding the market for a long time in a low return asset like cash or t-bills ultimately hurts future returns. It can even result in negative real returns if inflation picks up. If interest rates stay this low, then the market can certainly remain expensive. The direction of interest rates is the key question when determining future valuations.

For value investors, timing based on the valuation of the broader market is particularly tricky because there is often value in individual securities even if the broader market is overvalued. For instance, in the early 2000s, value stocks had a nice bull market while the broader market melted down. In Japan, while the broader market was crushed, Joel Greenblatt’s magic formula returned an amazing 18% annual rate of return from 1993-2006.

So, I think that a portfolio of 20-30 cheap stocks over the next 10 years will handily beat the S&P 500.

The caveats to this:

(1) Value doesn’t usually experience a bull market while everything else goes down. The only time this happened was the early 2000s. Value stocks normally go down with everything else. I suspect the current disconnect between value and growth stocks will see value triumphant, but we likely won’t see that happen until a decline happens in the broader market.

I suspect the current cycle will be more like the 1970s when value stocks went down with the broader market in 1973 and 1974 and then staged a very nice bull market after ’74.

The current cycle has much more in common with the early ’70s than it does with the late 1990s. The high flying stocks of the early ’70s weren’t crazy speculative companies like they were in the late ’90s. The hot stocks of the ’70s weren’t garbage like Pets.com, they were quality companies like McDonalds and Xerox. It’s the same thing today. The high valuations aren’t in junky speculative companies, they are in quality names like Facebook and Amazon.

The decline of 1973-74 wasn’t driven by a bubble popping like 2000, it was caused by a macro event (the oil crisis), which brought down the richly valued companies by bigger drawdowns than everything else. I think the same thing will probably happen to the US market this time around. What event will cause this is unpredictable (a war with North Korea, inflation causing a hike in interest rates?), but I think something is likely to come along that will cause a major drawdown.

A smart guy like Nassim Taleb would call this a “black swan” or “tail risk” event. I prefer a simpler way to express this: shit happens.

(2) Trying to time the US market with CAPE ratios is ineffective. The alternatives (cash, T-bills) do not yield enough to justify moving in and out of the US market. Tobias Carlisle did some great research on this here.

(3) Even value stocks are expensive in this market. For instance, a stock screen I like to comb through is the number of stocks trading at an EV/EBIT of less than 5. Out of the entire Russell 3000, I can only find 16 of them outside of the financial sector. Of these, half of them are in the retail sector.

At the beginning of 1999, there were 38 of these opportunities in a diversified group of industries. After the manic tech euphoria of 1999 where money flowed from “boring” stocks into tech, the number grew to 70 at the start of 2000. This group of stocks returned 20% in 2000, while the S&P 500 went down by 10.50%.

Expensive Value Stocks

The value opportunity set in the United States is currently limited.

Much of what fueled the early 2000s bull market in value stocks was the wide availability of cheap stocks in diverse industries. This simply isn’t the case today, as the small number of value opportunities in the U.S. is concentrated in one industry: retail.

I currently have 30% of my portfolio invested in the retail sector, which I’m comfortable with. If I were to buy all the cheap stocks in the United States, over 60% of my portfolio would be invested in retail. While I think retail stocks will ultimately stage a resurgence, I’m not certain of it. A 60-80% concentration in one industry is too risky. The sector could easily be cut in half again. 30% is the maximum extent that I am willing to commit to an individual industry. If retail were cut in half, my potential loss if 15% of my portfolio. If I expanded that to 60% or 80%, I could lose 30-40% of my entire portfolio. That’s a much more difficult event to recover from.

I could achieve more diversification by taking a relative valuation mindset to the current market, but I think this is dangerous. I prefer absolute measures of valuation — like a P/Sales of less than 1, the price is below tangible book, EV/EBIT of less than 5, 66% of net current asset value, earnings yields that double corporate bonds, etc.

A major reason I prefer absolute measures of valuation is that I think high valuation ratios in the cheapest decile of a market is a sign that the valuation metric is losing its effectiveness. A good example of this is price/book.

Price/book worked marvelously prior to the 1990s, but its effectiveness has been dramatically reduced since then. This is because Fama & French identified price/book as the best value factor. This made it respectable to buy low price/book stocks, while previously low price/book investors were regarded as oddballs (rich oddballs who consistently beat the market, like Walter Schloss!). Once Fama & French gave it their blessing, vast amounts of institutional money poured into low price/book strategies. Price/book became synonymous with value and this ruined the effectiveness of the factor.

If too much money chases low P/E, P/Sales, EV/EBIT stocks, then they will suffer the same fate as price/book. They will still work due to human nature (investors will always find ridiculously cheap stocks repulsive), but the effectiveness will be diminished. Institutional big money can ruin the factor. I think a good way to tell that this is happening is to focus on absolute metrics of valuation rather than relative valuation compared to the rest of the market. If too much money chases the value factor, then absolute measures of valuation will rise. By focusing on absolute levels of valuation, I can avoid this.

EV/EBIT is by far the best of all value factors, but if too much money chases it, the effectiveness will be reduced.

This is why I think focusing on absolute valuation is a way to prevent falling into this trap. Think about it through the prism of the real estate bubble: a house cheaper than the rest of the neighborhood was still a bad bet in 2006 because all real estate was in an inflated bubble. A single house might have been a good relative value and suffered less of a price decline than everything else, but it was still expensive. Focusing on an absolute level of valuation would have helped avoid this trap.

Going International

The beauty of the modern world is that I’m not limited to the United States. Previous generations of investors had a handful of options: cash, bonds, US stocks. Fortunately, I don’t have to sit on a pile of cash earning nothing while I wait for US markets to deliver me juicy opportunities, which is a bad strategy that can cause real inflation-adjusted losses the longer that the adjustment takes. I could wind up sitting on cash for a decade, absolutely decimating my real returns.

A great alternative to cash while the US market is expensive is investing internationally. While I don’t trust my ability to research foreign companies, I am comfortable investing in an index of a foreign country. While I think foreign stocks are more prone to fraud, I don’t think the financial results of an entire index can be fraudulent.

A few weeks ago, I did this in a very crude way. I invested 10% of my portfolio into a basket of the 5 cheapest country indexes on Earth.

If I’m going to do this in a bigger way, I need a better quality metric. It seems obvious to me that higher quality countries (like the United States) should command a higher valuation than a low-quality country. The definition of a bargain would also depend on the economic quality of that country. For instance, the US at a CAPE Ratio of 15 (where it was in 2009) is a screaming bargain, while Russia at a CAPE of 15 is probably a bit expensive in comparison to the risk. I’ll invest in a country of any quality – but I should demand a higher margin of safety if it is a low-quality country.

But how does one measure the “quality” of an entire country? This is a tough thing to quantify. Mainstream economists do this by splitting up the “developed” (i.e., already rich) parts of the world from “emerging” (trying to get rich) and “frontier” (poor). This doesn’t make sense to me to use as a quality metric. An emerging or frontier market may have better prospects than a developed, rich country.

What makes a country’s economy “quality”?

One of my favorite books about this subject is P.J. O’Rourke’s “Eat the Rich“.  P.J. has written some of my favorite books of all time (Parliament of Whores in particular).

eattherich

In the book, P.J. tries to define what makes countries “good” economically. His question is pretty simple: “Why do some places prosper and thrive, while others just suck?”

P.J. explains the conundrum in the following passage:

It’s not a matter of brains. No part of the earth (with the possible exception of Brentwood) is dumber than Beverly Hills, and the residents are wading in gravy. In Russia, meanwhile, where chess is a spectator sport, they’re boiling stones for soup. Nor can education be the reason. Fourth graders in the American school system know what a condom is but aren’t sure about 9 x 7. Natural resources aren’t the answer. Africa has diamonds, gold, uranium, you name it. Scandinavia has little and is frozen besides. Maybe culture is the key, but wealthy regions such as the local mall are famous for lacking it.

Perhaps the good life’s secret lies in civilization. The Chinese had an ancient and sophisticated civilization when my relatives were hunkering naked in trees. (Admittedly that was last week, but they’d been drinking.) In 1000 B.C., when Europeans were barely using metal to hit each other over the head, the Zhou dynasty Chinese were casting ornate wine vessels big enough to take a bath in–something else no contemporary European had done. Yet, today, China stinks.

Government does not cause affluence. Citizens of totalitarian countries have plenty of government and nothing of anything else. And absence of government doesn’t work, either. For a million years mankind had no government at all, and everyone’s relatives were naked in trees. Plain hard work is not the source of plenty. The poorer people are, the plainer and harder is the work that they do. The better-off play golf. And technology provides no guarantee of creature comforts. The most wretched locales in the world are well-supplied with complex and up-to-date technology–in the form of weapons.

You should read the whole book (it’s really funny), but the gist is pretty simple: what causes prosperity is economic freedom. Economic freedom doesn’t just mean “people can do whatever they want”, it is capitalism within a defined rule of law that is enforced.

The magic ingredient that can make a country rich is economic freedom, and it’s what turned the United States from a third world nation of farmers into the richest country on Earth that it is today over a relatively short span of history. The people of the United States weren’t more talented or better than anyone else. We were the first to wholeheartedly embrace capitalism while the rest of the world fiddled around with bad ideas like feudalism, mercantilism, socialism, and communism.

The secret to US success is now out.

Since the fall of the Berlin Wall in 1989, economic freedom has been advancing throughout the world (even though it has retreated in its birthplace, the United States). The worldwide spread of capitalism and economic freedom have been profoundly positive for humanity. In fact, the global rate of poverty has been cut in half since 1990. It’s not a coincidence that this decline began at the exact moment that the Soviet Union collapsed. As the world embraces capitalism, it is growing increasingly prosperous as a result.

If we acknowledge that economic freedom is the best measure of the “quality” of a country, how do we quantify that?

The Index of Economic Freedom

The Heritage Foundation has done the world a service by quantifying economic freedom in their index of economic freedom, which they update annually.

They define economic freedom in four key categories:

  1. Rule of law – property rights, judicial effectiveness, government integrity.
  2. Government size – tax burden, government spending, fiscal health.
  3. Regulatory efficiency – business freedom, labor freedom, monetary freedom.
  4. Market openness – Trade freedom, investment freedom, financial freedom, openness to foreign competition.

Each category is scored and the total is grouped in the following levels:

Free: 100-80 (Australia, Hong Kong, Singapore)

Mostly Free: 79.9-70 (The United States, Ireland, the UK, Sweden)

Moderately Free: 69.9-60 (Israel, Japan, Mexico, Turkey)

Mostly Unfree: 59.5-50 (Russia, Egypt, Iran, China)

Repressed: 49.9-40 (Venezuela, North Korea, Cuba, Afghanistan)

Going forward, I think I will buy “free” and “mostly free” countries (a score of 70-100) if their CAPE Ratio is below 15. By this metric, Singapore is the most attractive market in the world right now, with a CAPE ratio of 12.9 against an economic freedom score of 88.6.

If I’m going to buy countries that are “mostly unfree”, I should demand a higher margin of safety — i.e., it should be a compelling bargain, with a CAPE ratio below 10. Russia would be defined as “mostly unfree” (Russia currently has a score of 57.1). However, at Russia’s current CAPE ratio of 5.6, it would still meet my requirements and provide an adequate margin of safety.

The quick and dirty way I think about P/E ratios or CAPE ratios is in terms of earnings yield. Take the P/E or CAPE ratio and divide it with 1. For instance, Russia’s CAPE is 5.6, so its earnings yield (1/5.6) is an astounding 17.85%, well worth the heightened risk of owning that country’s stocks. The US, with a CAPE ratio of 30, would have an earnings yield of 3.33%. This means US investors can expect a total return of about 34% in the coming decade. In comparison, if Russia delivers a compounded return of 17.85%, it’s a return of 438%.

It’s also important to consider that the returns will be lumpy. Much of the return could be concentrated in a few years and there will likely be a large drawdown at some point. Stocks deliver high returns because of these drawdowns. The high returns of stocks are a compensation for this risk. The US returns aren’t terrible, especially when compared to bonds, but they’re nothing to get excited about.

Among the other two positions I chose, Poland and Turkey, they are in the murkier area of “moderately free”. I think I’ll buy these type of markets when they get below a CAPE ratio of 12.

Here is where my current positions stack up in terms of both CAPE ratio and standings in the index of economic freedom:

Capture

Using these guidelines, I made a good choice with both Singapore and Russia, but likely paid too much for Brazil and Poland. As I expand my position in international indexes while the US market is expensive, I will use the index of economic freedom as a rough quality metric when determining the appropriate price to pay for each country.

When I rebalance my portfolio in December, I am going to expand this segment of my portfolio. When the US market suffers a drawdown, I will reduce this segment of my portfolio and purchase more bargain stocks boasting low absolute valuation metrics.

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 2017 Performance Update

performancetable

I had a nice run this quarter after underperforming for most of the year. We will see if it lasts.

Interestingly, nearly all of the gains occurred in the last month. A month ago, I was down 2.72% for the quarter and the portfolio then staged a resurgence. Even after the resurgence, I still lag the S&P significantly by 8.8%

For most of the year, richly valued large-capitalization growth stocks dominated the market, and cheap stocks have lagged. This appears to have reversed in the last month, but we will see if the trend can be sustained.

As explained in a previous blog post, value stocks have lagged the market in the United States for the longest period of time since World War II. The trend will ultimately reverse itself, but there is no telling how that will take. I expect my portfolio to perform in a more exaggerated fashion to a standard value portfolio due to my concentration in 20 stocks. It should keep up with value as a group but it will be more volatile. This should lead to bigger gains in the long run with periods of pain and volatility.

STS, SAFM, BLD

While staying put for most of the year, I traded a bit this quarter. The sales are below.

sold

The first trade was in STS (Supreme Industries) on August 9th. A buyout was announced at $21 per share. I sold for $20.95, securing a 31% gain from my purchase price. Buyouts are one of the key drivers of performance in value stocks. I think once the buyout is announced, it makes sense to sell rather than capture a tiny gain. All that can happen after a deal is announced is the deal falling through or a bidding war. A bidding war didn’t seem likely in this situation.

The next trade was in Sanderson Farms (SAFM). I have a weird temperament: I get nervous when a stock goes up too much, and I don’t really care when it goes down. I got out of Sanderson Farms because the valuation simply got too high and I already secured a 59% gain. Nevertheless, the rally continued with the stock going up another 12.9%. I probably should have let the momentum continue.

I feel the same way about TopBuild (BLD) in which I am up 71%. To avoid a repeat of the Sanderson Farms situation, I am going to let that position continue to run. When it looks like the momentum has faded, I will sell. I will indeed sell at the end of the year when I do my complete portfolio rebalance.

This is the chief drawback of deep value investing. Time is not on your side. You’re buying businesses when they look dead (or they’re just so tiny that they’re being ignored) and selling when they’ve had a modest improvement in their outlook, which leads to a massive increase in price because the market was so downbeat in the first place.

Deep Value vs. Buy & Hold

I am not a “buy and hold” investor. Contrary to popular belief, neither was Benjamin Graham. Buy and hold forever was Phil Fisher’s idea, which Warren Buffett later picked up on. Phil Fisher recommended buying stock in excellent companies and then keeping them forever. This is advice that Warren Buffett then picked up when he shifted his investment philosophy from the purchase of undervalued cigar butts to investing for the long term in good companies

In contrast, Graham’s recommendation was to hold a stock for two years or after a 50% gain, then sell. In other words, buy undervalued stocks and sell them when they reach fair value. While most value investors moved on from this philosophy, Walter Schloss stuck to it and delivered impressive results throughout his career.

One of the drawbacks of a deep value approach (contrasted with the Warren Buffett approach) is that, as Warren Buffett likes to say, time is the friend of the good business and the enemy of the bad business. I am not buying the Coca-Cola’s of the world: I am buying ignored, hated, beaten up stocks in which a problem caused Wall Street to throw the baby out with the bathwater.

I like this approach for three reasons.

1) I’m not as smart as Warren Buffett and Charlie Munger to evaluate how “good” business is. Most of the people trying to emulate Warren and Charlie aren’t either, despite their claims to the contrary. Buffett and Munger have a genius at identifying companies with strong returns on capital that have an economic “moat” which allows them to sustain those high returns on capital. This looks easy in retrospect, but it ‘s hard to pull off in practice. Most of the Fortune 500 from 1950 is gone today. Most of those businesses thought they had a “moat” of some kind, but the relentless pressure of competition made it wither away.

Buffett’s 1987/1988 purchase of Coca-Cola looks like a slam dunk in retrospect, but hindsight is 20/20. Coca-Cola had just made some blunders. They were steadily losing market share to Pepsi in the early 1980s, which lead them to change the formula of Coca-Cola which caused an incredible public relations backlash. Buffett also bought Coke in the wake of the 1987 stock market crash, when many in the investing public suspected that the US may go through another Great Depression.

Buffett also had the insight to buy Coca-Cola at the right price. There is no such thing as a “good company at any price.” Coke made sense in its 1987/1988 price. It didn’t make sense at its 1998 price.

Once Wall Street and the investing public caught on to Coke’s greatness, Coke surged throughout the 1990s, reaching a peak P/E ratio of 50 in 1998. From there, it proceeded to plunge 44% in the bear market of 2000-2002. Coke didn’t change: it was still a great company, just as it was when Buffett first bought it. Since the 1998 peak, the stock price is only up about 9% (although it has consistently paid dividends over that time).

Not only did Buffett have the genius to recognize Coke’s natural moat and economic advantages: he had the talent to identify the right price to pay for Coke. That isn’t something that I can do.

The good news is: it’s not something I need the capacity to do because I’m not a billionaire. Buffett was forced into this style of investing when he became too big. Buffett’s best returns were actually when he was buying and selling cigar butts of the net-net and low P/E variety in the 1950s and 1960s. He had to stop doing that because he became too big. He was so big that he had to buy controlling interests in net-nets, which caused a lot of pain on his part. Trying to run bad businesses is not fun.

In fact, Buffett had this to say in 1999:

“If I were running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”

Now, I sure as hell can’t make 50% a year, but it seems absurd to me that most people try to invest like a billionaire when they don’t have to. An average person like me can operate in the small and micro-cap corners of the market and buy screaming bargains, then sell when they’ve had a modest improvement.

2) The other reason I prefer the deep value approach is because it is quantitative. I don’t have to visit management, I don’t have to have profound insights into the economy or future of the business, I don’t have to understand the “culture” of the firm, I don’t have to figure out if there is a moat.

It’s all right there in the annual reports and the quantitative signals from the stock. I look for a variety of signals: low P/E, cheap price/sales, bargain Enterprise multiples. I don’t need to have incredible insights into the operation and future of the business. I buy companies that are priced like they’re going to die and they are not for obvious reasons a) they don’t have a lot of debt and b) are still profitable.

Peter Lynch once pointed something out that is so obvious and so grounded in common sense that it eludes the smartest investors: “Companies that have no debt can’t go bankrupt.”

I think the leading “edges” that will exist in the future are behavioral. There is nothing more behaviorally challenging than deep value investing. You’re buying businesses with “stories” that make the stomach churn. You’re suffering short-term volatility and underperformance. Over the long run, however, the rewards will compound.

This is why I have an aversion to buying and holding great businesses, growth investing and momentum investing. It’s behaviorally easy. If it’s easy, it is eventually going to be arbitraged away. Buffett-style investing requires a stroke of genius that most people simply do not have.

Finally,

3) Every value investor is trying to be the next Warren Buffett. “Wonderful companies at good prices” is a crowded game that I’m not interested in playing because everyone else is playing it. Deep value, in contrast, is a niche. As long as it stays a niche, it should outperform over the long term.

Warren and Charlie make it look easy. It’s not.

Anyway, I’ve gone off on a tangent. Back to the portfolio!

UIHC & FNHC

It also appears that I made a mistake with these two stocks. They are both well run Florida insurance operations. I bought them last year in the wake of hurricane Matthew related losses. I figured that they were a great value and if Florida avoided a massive hurricane, they should do well.

When hurricane Irma was barrelling towards Florida, I got scared and sold both stocks. This looked like a smart move at the time, but both have recovered nicely.

One of the points that Tobias Carlisle makes is that models outperform humans in most fields.  In fact, simple models outperform experts when equipped with the model. The tweaks that the experts bring to the design usually create a drag on performance.

For instance, if you have a model indicating when someone will go to the bar for the evening, you should be able to override that model if the patron has a broken leg. The research suggests the opposite: you are better off going with the model.

I think I should have done this with UIHC & FNHC. I let my emotions make me frightened during the hurricane, and I sold both at a loss for the year. Both stocks completely recovered from the Irma sell-off and are back to where they were before.

I let my emotions get the best of me. Hopefully, I can control this a bit better in the future and let the statistical cheapness of the portfolio work over time.

Global Low CAPE Indexing

I wrote a blog post earlier in the month discussing the idea of buying indexes for countries with low CAPE ratios. I still haven’t decided to pull the trigger on this idea. I still hold a lot of cash, (about 17%). I deployed some of it this month in two incredibly cheap stocks: Foot Locker & Game Stop. I still haven’t decided on whether or not I want to pull the trigger on this idea.

FL & GME

I increased my bet on the physical retail space. I initiated a new position in Foot Locker and increased my position in Gamestop. Both are ridiculously cheap by all metrics. Foot Locker trades at a P/E of 8 and Gamestop trades at a P/E of 6. They are similarly cheap on an enterprise multiple and price to sales basis. They both have clean balance sheets: little financial debt relative to their assets and earnings.

Retail stocks have an inverse relationship with Amazon’s stock this year, which has been on fire. This is due to the ubiquitous narrative: physical retail is dead and Amazon is taking over the world.

I believe that investors have overreacted to Amazon’s success. They have bid up Amazon to an insane multiple (242 times earnings as of this writing). Amazon is a good company, but as I stated earlier in my Coca-Cola 1998 example, there is no such thing as a company so good that it is worth any price. Meanwhile, physical retail stocks have been hammered down to levels not seen since the Great Recession even though their financial situation is better than it was back then.

There is certainly some truth to the rise of Amazon, but I think investors are overreacting. This is why retail stocks now comprise 25% of my portfolio. If you want to outperform the market, you have to do things that are different than the market.

The popular perception is that most shopping will occur online, but the fact of the matter is that 91% of all retail sales still take place in a store. E-commerce has increased at a relatively steady pace since 2000, gaining a little less than 1% a year. This means that in 10 years, 80% of all retail sales will still occur in a store. The revenues spent on retail sales will also be higher than they are today through normal economic growth.

There will also be a peak to online shopping. There is only so far you can go with shipping products. There is only so much you can reduce prices and still maintain economies of scale. I don’t think e-commerce will eat into physical retail’s market share forever. At some point, the two will probably reach an equilibrium. Whether that’s 50-50 or 80-20 is yet to be seen.

Retail is a declining market and some operations will go out of business, but this is an opportunity for the physical retail stores that survive. As companies like Sears and K-Mart go out of business, their less indebted competitors should benefit from their demise. The goal is identifying the retail operations that will survive and whose stocks have been unduly punished in the current shake out.

All of the retail stocks that I own have common characteristics: they all are profitable, and they all have very little debt. I’m betting that they will survive the shake-up and the slightest glimmer of hope should cause their stocks to appreciate nicely.

Or maybe I’m just crazy. That is altogether possible!

In any case, we’ll see how this continues to shake out in Q4 2017. Hopefully, the value resurgence continues.

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.