Strategy

strategy

My strategy is inspired by the ideas of Benjamin Graham. In particular, I am influenced by the rules outlined in Ben Graham’s Simple Way strategy from the 1970s. I am also heavily influenced by the work of Tobias Carlisle, which is outlined in his book, Deep Value.

I purchase common stocks that I believe are trading at a discount to their intrinsic value. I sell when I believe they are at or near their intrinsic value. I do not utilize leverage of any kind. I don’t sell short. As John Maynard Keynes put it, “Markets can stay irrational longer than you can remain solvent”.  With a long position that isn’t leveraged, I can wait out irrationality. That isn’t an option when an investor is short or using borrowed money to buy stocks.

My style is more influenced by Benjamin Graham than it is by Warren Buffett. I am not looking for moats. I am not trying to hold onto stocks for decades. I am not buying compounders. I am attempting to buy mispriced stocks and sell when they are fairly valued.

Stocks I Buy

  1. Statistically cheap. If it’s cool and people are excited about it, then I want no part of it. I prefer companies and industries that make people either yawn or recoil.  If most investors don’t ignore it, hate it, or are bored by it, then it’s unlikely to be mispriced. My goal is always to buy mispriced securities. I believe that the best place to find mispriced securities is among the cheapest deciles of the market. For that reason, I look for multiple metrics and valuation ratios which show that the stock is cheap relative to its history and its peers. I prefer stocks that have multiple measures of cheapness, as measured by valuation multiples. I don’t engage in complicated discounted cash flow analysis, because I think it’s simply a way to fool yourself into accepting your own biases about companies that you love with a false sense of precision. I’ve also noticed that while many value investors outperform, they often fail to outperform the most basic measures of statistical cheapness. The key metrics I look at are price/sales, earnings yield, and Enterprise Value/Operating Income. There is also plenty of outside research showing that equally weighted and statistically cheap portfolios outperform. A good example is this excellent paper from Tweedy Brown, What Has Worked in Investing. My own research shows that cheap portfolios outperform for nearly every valuation metric.
  2. Low debt with high financial quality. I look for companies that have a debt to equity ratio below 50%. For larger capitalization stocks, I will tolerate more leverage (around 100%). I also want to see a high degree of interest coverage, ensuring that the company can survive a serious deterioration in earnings and cash flow. As Peter Lynch put it: Companies that have no debt can’t go bankrupt.” If a company is utilizing significant leverage, they may be able to produce great results in the short run, but one mistake can kill the firm. I believe that the best way to minimize the risk of the portfolio is to focus on the balance sheets of the companies in the portfolio. Additionally, my research shows that combining balance sheet quality with statistical measures of cheapness leads to long-term outperformance. This approach dulls results during booms, but outperforms over the long run because it contains drawdowns during recessions. Other key measures of financial quality that I look at are Altman Z-Scores (bankruptcy risk), Piotroski F-Scores (overall financial quality), and the Beneish M-Scores (earnings manipulation).
  3. Below net current asset value. Sometimes, companies will trade at a significant discount to their liquidation value, or the net current asset value.  These stocks are typically only available in large numbers during recessions. During normal times, my focus is on earnings, cash flow, operating income, and sales. I will purchase more stocks below their net current asset value during recessions, which is typically the only time that they are available in bulk. Outside of recessions, I will sometimes purchase 1 or 2 of these situations when I am lucky enough to find them. Ben Graham referred to this as a “Foolproof Method of Systematic Investment.”
  4. US-based companies.  I shy away from international investments. I understand US accounting principles. I trust the SEC will limit most but not all accounting shenanigans. I generally have an optimistic view on the long-term economic prospects of the United States economy. We have our problems, but who doesn’t? I am sure that there are amazing value opportunities in other markets, but I stick to what I know, understand, and what have the time to research.
  5. Fear, Indifference, and Ignorance. I am looking for situations where the market has thrown the baby out with the bathwater. Generally, I am looking for situations where scary headlines are causing fear among investors. Outside of fear-driven trades, I am also looking for situations where I believe that the market is simply overlooking the company due to a small float or low market capitalization. The question I ask myself before buying a stock is: “Why is this a bargain? Is the market treating this situation rationally?”

Portfolio Management

I do not hold stocks for long periods of time. My approach is high turnover. Benjamin Graham had simple sell rules: sell after two years or when the stock is up 50%, whichever comes sooner. I have my own spin on this and my rules for portfolio management are outlined below.

1. 20-30 Stocks. I try to hold at least 20 stocks at any given time. The most I would ever own is 30. Benjamin Graham recommended 30 holdings. The academic research agrees with him on this point. My research agrees with this and shows that the ideal number of stocks to hold in a portfolio is 20-30 positions. This appears to be the sweet spot to eliminate significant portfolio blowups and minimize volatility, while still offering the opportunity for outperformance. Beyond 30 stocks, I don’t think there is much point to owning individual securities. At that point, it makes more sense to simply buy an ETF or mutual fund.

2. Sell rules. I sell positions for any of the below reasons. Typically, these reasons overlap.

a. The stock is at or near a 52-week high.

b. The valuation multiples imply that the stock is at or near its intrinsic value.

c. There has been a decline in the fundamentals of the company, proving that my thesis is likely wrong.

d. The position is over a year old.

e. More compelling bargains are available.

f. As part of a rebalance, which I usually do every December.

3. Industry concentration. I try to diversify among different industries, but still have outsized exposure to industries and sectors that I believe are currently out of favor. Usually, I try not to hold more than 30% of my portfolio in a single industry. I believe this will give me enough exposure to hated and out of favor industries to outperform, while at the same time limit the possibility of a portfolio blow up if I am wrong.

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

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

I am a value investor. My outlook is inspired by the ideas of Benjamin Graham. This site is a real time chronicle of my portfolio and an outlet to share my ideas. I hope you enjoy.

%d bloggers like this: