Simplifying the Portfolio

Two posts in a row with a link to Jason Zweig. I think he’s that good! This post is about knowing when to sell. One way I do that is to limit my position count so that I am always thinking relatively about whether what I own still offers good value relative to what else is out there (in my case, against my watch list of ~120 potential investments and cash or T-bills).

How to Keep Your Cool When Markets Are Sizzling – Intelligent Investor Column, April 23, 2021

I have been evolved in how I have managed my investments over this Covid-19 pandemic period. I mentioned in an earlier post how I have let myself get sucked into some back investments due to the soaring markets in some speculative assets and too much free time to check my investments too often.

I have gone from very little of my family’s capital being passively indexed to a larger proportion under a 90/10 scheme.

I am still actively managing a substantial percentage but I have changed the way I think about this portfolio. In an effort for simplification I am working from a modified “punch card” approach. Warren Buffett has long used a punch card analogy except his is in reference to 20 “punches” over a lifetime of investing. I am not prepared to restrict myself to that extent but I do like the idea of setting some artificial structure around how many holdings am willing to have at a time.

Here is how I am thinking about it:

  • No more than 20 holdings at 5% each.
  • High conviction holdings can have a double allocation (take up two punches). This can be done upfront or if a single punch declines in value and becomes more attractive.
  • The active portfolio overall has a notional value so that each new punch is for $X (5 or 15% of this notional value). Often the portfolio is above this notional value due to dividends or capital gains. Upon a position sale the excess returns are shifted into the passive portfolio.
  • No obligation to fill all 20 slots and cash can be held at my discretion.

I like this framework because it restricts me from having no more than 20 positions and no fewer than 10. It also enforces some discipline about the relative potential of new positions coming in and that I must have a reasonable expectation that they will outperform what is already there. Also, because I have the passive accounts which are larger than this active portfolio I am more willing to overweight an industry or sector if I think it has potential (as I am today with energy).

Here is the “punchcard” as of today:

Currently this portfolio is about 19,8% above it’s notional value due to capital gains and cash dividend accumulation.

-Charlie

The LT3000 Blog: Unravelling value’s decade-long underperformance (and imminent resurgence)

As a liquidity driven boom roles on year after year, investors become increasingly skeptical about the role of valuation, for the simple reason that valuation has proven to be a poor predictor of share prices in recent history. Stocks that looked expensive just kept going up (due to liquidity, which is why they were expensive in the first place), so investors – many of which lack decades of experience – come to believe that focusing too much on valuation is a bad idea. Investors will also point to a handful of big secular winners like CSCO and MSFT (in the 1990s) and AMZN this cycle and note they were ‘always expensive’ and that it was a mistake to pass them up simply because they didn’t trade on low multiples. They will then use this logic to justify paying almost any price for companies of vastly inferior quality, ignoring how unique and uncommon companies like AMZN are, so long as stock prices keep going up and validate the narrative. They are right that valuation is not a good predictor of share prices, but are wrong about why. They think it is because it is growth and business quality driving returns, when in fact it is simply liquidity. Nifty-50 investors learned this the hard way when the same high quality businesses with the same high quality and defensive operating results they had always had fell 80% in the 1970s.
— Read on lt3000.blogspot.com/2020/11/unravelling-values-decade-long.html

-Charlie

The LT3000 Blog: Crypto-mania is back: Crypto vs. Fiat, and why newer isn’t always better

Say for instance I were to build a hydroelectric dam. Billions of dollars worth of human effort would go into building it, from detailed engineering, to direct materials production such as concrete and steel, to complex engineered products like turbines and all their components, as well as considerable amounts of physical construction labour. Deriving further up the chain, effort has gone into discovering and digging raw materials out of the ground, like iron ore, and processing and refining those inputs into finished intermediate products like steel.

All of this takes tremendous human effort – what we often call “work” – and the outcome is a hydro dam that can produce useable electricity very efficiently, which can be used to increase human welfare/productivity, and better meet our needs and wants. This represents accumulated value, or “installed capital”. It is a store of value because replacing all that effort entails a real cost, and the installed capital generates real value/utility to human beings from low-cost electricity generation. Furthermore, it is highly predictable that that utility will exist in the future (so long as humans want and need electricity).

At a system level, *that* is how value is stored, and wealth accumulates. Paper money or crypto currency that merely represent 1s and 0s on distributed computers, in and of themselves store nothing. It is the *real world stock of accumulated capital* that backs financial claims that legitimately store value. Without them, both fiat and crypto currencies are utterly worthless, and no value is stored aside from the inter-temporal exchange value discussed in the prior section of this article (intermediating between goods X and Z). Large scale storage of value, at a system level, therefore must derive from real world things that have a predictable ability to generate real world value for human beings in the future. 
— Read on lt3000.blogspot.com/2021/04/crypto-mania-is-back-crypto-vs-fiat-and.html

-Charlie

Most Ridiculous Investing Ideas

I first came across the name Jason Zweig when reading the commentary in the revised edition of the Intelligent Investor by Benjamin Graham. I read this book over a long period a few pages at a time while in high school but I remember really enjoying his commentary that helped break down and “modernize” some of what Graham was saying.

I forgot about him for many years, to be honest, until I subscribed to the Wall Street Journal and came across his Intelligent Investor columns. I have been an eager reader ever since! It’s also been really nice to be able to get on the email list so that now his commentary and links to top reads for the week hit my mailbox every Tuesday or Wednesday.

Last week he asked the question “What’s the most ridiculous investing idea you’ve come across lately — or ever?” and I knew exactly where I wanted to go with this one so I went ahead and responded.

In this week’s column/post I was excited to see my answer show up!

Venture-capital firms, private-equity firms and many small start-ups appear to be in business for a quick payday of M&A, getting swallowed by a FANG, or overleveraging themselves for near-term dividends — as opposed to solving problems for consumers…. At the end of this period I think a lot of “owners” (small investors, pensions, endowments, etc.) are going to realize significant value has been destroyed through this short-term decision-making.

Charlie Groover, Houston, Texas

(Yes, I just quoted myself in my own blog/journal…) Here is the full post. There are some other really good answers like NFTs and triple-levers ETFs as well.

April 20, 2021 Intelligent Investor Newsletter

My comments were cut down a bit as I probably ran too long in my response (and I’ll give it a shot here too!). The general point is that I get the sense that less people are out to build businesses around wowing their customers in some way. Or businesses that are financial fortresses. Or intergenerational businesses with the goal of owning and operating them for 100 years!

Sure these exist still. Berkshire Hathaway and Costco are the top two that come to mind for me. But that’s not the focus of most businesses managers and CEOs today. The goal for many is to strip value, take dividends, add debt if not already high enough (PE Model) or to create half baked businesses, fudge numbers (eyeballs, users, clicks) with a goal of flipping to a larger player like a FANG. Rinse and repeat.

And at the end of the day it’s worked in recent years. I can’t help but think it’s been pushed to extremes at this point and won’t work much further in the future. FANGs and other large tech companies are now a huge percentage of the S&P500. PE companies, or the boards of their acquisition targets, are starting to see court cases turn against them when a company defaults due to reckless levels of debt are added. And since 2008 these FANGs and PE fund (“alternative investments”) have become a larger and larger part of capital under management in endowments and pension funds.

What does this mean? Not necessary that the market crashes, USD loses its mantle, and society falls apart. But it may mean that we see a long period of sub-par returns in most investment classes. The juice has been squeezed and we’ve pulled forward from future potential through debt in both the corporate and government spheres. No telling how this plays out but deleveraging has to happen in some form, slow or fast, though repayment or devaluation.

My thoughts about the root causes and possible solutions to some of this. I attribute the issues to two things both of which are part of human nature. One is a natural preference for the here and now over delayed gratification (especially if the repayment is stretched far enough out that goes beyond one’s lifetime) and two, the principle-agent problem. If, as owners of capital, we outsource decision making to a CEO or fund manager then they are naturally going to do what nets themselves the greatest value. This can be value destructive “exits” (M&A), adding debt to juice the beta of the remaining equity (as D/E goes higher the E should see more movement when the business does well or poorly). As our funds get larger and larger it all becomes more unwieldy to enforce rigorous decision making on this small group of agents.

My solutions are not perfect but here they are though:

  • Control my capital to the extent possible. Make stock or fund selection directly so long as I am willing to put the time in to understand business characteristics such as cashflows, balance sheet, and management quality/governance.
  • Look for businesses with high executive ownership that aligns interests
  • Understand what I am buying when I buy an ETF. What’s in and what’s out. Percentages of largest holdings and in what regions of the world. What are the management costs. Finally try to understand on what basis/mechanism they will by making future additions/removals from the fund.
  • Get engaged. Vote my shares in annual proxies. Email Investor Relations teams when I am not happy with a decision. Do what I can to get my perspective on issues in to these principles in the company. (One example of this is that I almost always vote against the CEO being chairman of the board because I believe those roles should be segregated and that the board shouldn’t be lead by management. As an owner I want the board to work for me and direct management, not the other way around).

-Charlie

Last Man Standing · Collaborative Fund

Amazon in 2014 was a puzzle. It was big. It was growing. It had market share and mindshare. Competitors feared it as much as customers loved it. What it didn’t have was a good business. Profit margins wobbled between negligible and negative. That might be acceptable for a young startup, but Amazon was two decades old at the time. The whole thing was easy to mock and call a bubble. Jeff Bezos had a different view: Margins don’t matter. Dollars do. A huge business with low margins was preferable to the opposite. He explained in 2014: Margins are not one of the things we are seeking to optimize. It’s the absolute dollar free cash flow per share that you want to maximize. Free cash flow [is] something that investors can spend. Investors can’t spend percentage margins … What matters always is dollar margins: the actual dollar amount. Companies are valued not on their margins, but on how many dollars they actually make. There are parts to quibble with here, but I just liked Bezos’s simple logic: The business with the most dollars wins. Not the best margins or the highest quarterly growth. Just how many dollars you generate over the long run. Let me propose the equivalent for individual investors. It might push you away trying to earn the highest returns because returns, like margins, don’t matter; generating wealth does. Everything worthwhile in investing comes from compounding. Compounding is the whole secret sauce, the rocket fuel, that creates fortunes. And compounding is just returns leveraged with time. Earning a 20% return in one year is neat. Doing it for three years is cool. Earning 20% per year for 30 years creates something so extraordinary it’s hard to fathom. Time is the investing factor that separates, “Hey, nice work,” from “Wait, what? Are you serious?” The time component of compounding is why 99% of Warren Buffett’s net worth came after his 50th birthday, and 97% came after he turned 65. Yes, he’s a good investor. But a lot of people are good investors. Buffett’s secret is that he’s been a good investor for 80 years. His secret is time. Most investing secrets are. Once you accept that compounding is where the magic happens, and realize how critical time is to compounding, the most important question to answer as an investor is not, “How can I earn the highest returns?” It’s, “What are the best returns I can sustain for the longest period of time?” That’s how you maximize wealth. And the most important point is that the best returns you can earn for the longest period of time are rarely the highest returns in any given year, or even decade. Charlie Munger says “the first rule of compounding is to never interrupt it unnecessarily.” Interrupting it can happen in many ways. The most common is finding a strategy that produces high returns for a period of time then abandoning it when it inevitably has a few bad years. Investing in a strategy or sector that produces great returns for five years but shakes your faith to the point of abandonment after a collapse in year six will likely leave you worse off than a strategy that produces merely good returns but you can stick with for years six, seven, eight, 10, 20, etc. This is especially true if, after abandoning a strategy in its down year, you move on to whatever the new hot thing is only to repeat the process. Complexity is another door to interruption. It can produce higher returns. But the more knobs you have to fiddle with, the more levers you have to pull, the higher the odds that something, at some point, will cause you to second-guess yourself, or reveal a risk you hadn’t considered, or tempt your clients to leave – all of which stops the clock of compounding and can outweigh any return advantage you had when the strategy worked. None of that is intuitive in the moment, because the pursuit of the best returns at all times feels like the best way to maximize wealth. It’s not until you consider the time factor of compounding that you realize maximizing annual returns in a given year and maximizing long-term wealth are two different things. Carl Richards once made the point that a house might be the best investment most people ever make. It’s not that housing provides great returns – it does not. It’s not even the leverage. It’s that people are more likely to buy a house and sit on it without interruption for years or decades than any other asset. It’s the one asset people give compounding a fighting chance to work. Everyone’s different, with varying levels of confidence and tolerance for what they can put up with in investing. But the idea that endurance is more important than annual returns even if annual returns get all the attention is something virtually every investor should think more about. Airbnb CEO Brian Chesky once said, “If you’re trying to win in the next year, and I’m trying to win in the next five years, we both might win. But I’m ultimately going to win.” That’s the whole idea. Bezos’s goal isn’t to have the best business. It’s to make the most dollars. Likewise, investors’ goals shouldn’t be the best annual returns. It should be to maximize wealth. And you get that through endurance – not to be the best in any given year, but to be the last man standing. This kid has it all figured out:
— Read on www.collaborativefund.com/blog/standing/

Less Is More – Fasting and Boredom

This fits with a thread that less is often more in life. We are happier when we spend less than we have because it reduces financial stresses in our lives. Our investment portfolios often perform better when we tinker and trade less. I’m often the happiest and feel the most fulfilled with the simple things – a picnic or walk with the kids or making dinner at home with my wife as examples. I think this is another great example along this thread. I haven’t fasted often (I could use more of it physically and spiritually!) but when I have I am amazed at the clarity that comes along with a feeling of tightness in the stomach, for me about eighteen hours after my last meal. I’m not sure why I don’t do this more often other than that food is so prevalent and accessible in my life – and I recognize it’s a privilege to have this choice of whether to fast or not. In my life its always taken less effort or thought to fall-in-line and eat every 4-6 hours as I’ve done since first starting on solid foods.

Full post from Stray Reflections – Hunger is Divine Food

In Hinduism, fasting is known as Vrata, performed on certain days to honor the gods and goddesses. Buddhist monks consider fasting to be one of the dhutanga austerities, a group of thirteen ascetic practices to “shake up” or “invigorate” in a life-affirming way. As a Stoic, Seneca believed that by overloading the body with food you “strangle the soul and render it less active.” Gandhi showed us how our bodies can be turned into an instrument. He undertook 17 fasts during India’s freedom movement. It’s pure discipline and obedience, growing and nurturing willpower.

In a time of unprecedented conveniences, fasting is countercultural. Brett McKay writes about how it can unlock far more possibilities than can be read on a scale:

“In fasting, we have to face down our appetite for food, but this hunger stands in for all our other gnawing appetites. In overcoming what seems like an insatiable desire to eat, we come to realize that other desires that seemingly demand to be answered now, can in fact be postponed. We come to realize we can do without. We can control the things that seek to control us. The self-restraint built by fasting becomes an aid in keeping all our priorities straight, helping us get a better grip on the constant battle between short-term pleasures and long-term goals. It’s a concrete practice that helps develop that nebulous thing called character.”

Jawad Mian

A loosely related article along the less is more thread that I ready this morning as well. This is along the lines of boredom vs excitement. That boredom is necessary to truly appreciate the exciting and that most people are probably happier overall with a slower paced and more boring life. Chasing excitement and always needing higher highs to feel fulfilled can be draining and possibly not so fulfilling. This was a useful perspective for me to reflect on as a former adrenaline junkie turned dad and 9-5er.

Final thought – there are also some good notes in here about how we raise children related to boredom. Boredom brings out the imagination which can be so good for kids vs passive excitement through electronic devices. I know my wife and I are guilty of overusing iPads because they are amazing at keeping the kids quieter and the house cleaner for at least a little while – although we have shifted to setting time limits and significant cut back on games during the school week.

Brainpickings: Bertrand Russell and “Fruitful Monotony”

-Charlie

In Democrats’ paradise, borrowing is free, spending pays for itself, and interest rates never rise – The Washington Post

With their plans for trillions in stimulus relief packages, and push for a $15-an-hour minimum wage, Democrats are dismissing concerns about the rising national debt and inflationary pressures.
— Read on www.washingtonpost.com/business/2021/03/03/democrats-stimulus-spending-inflation/

Great end of career post that comes across as very balanced. Critical but fair. Wish more would write from a moderate perspective like this.

Old Sequoia Fund Letters

I came across these Sequoia letters covering 1974-1982 from a link posted by Jason Zweig in his weekly round-up and found them really interesting. Each one is short and very straightforward on how Bill Ruane and Rick Cuniff thought about investing and markets – most of time showing their intellectually honesty and saying they didn’t know what was next – but sticking to their investment principles. These letters also read like a condensed set of Berkshire Hathaway annual reports and you’ll even seen some of the same references and analogies.

Assuming Ruane and Cunniff placed their key tools of evaluation in order of importance then you can pull from these letters that their approach (and success) was driven by the following:

Sequoia Investment Criteria:

  1. A good company – by far the most subjective but from other parts of the letters the refer to future growth potential, pricing power, asset-light, brand value, and excess cashflows so that helps understand the nuance some.
  2. High rates of return on capital
  3. Strong balance sheet – many negative references to too many companies and governments being overleveraged.
  4. Low price-to-equity ratio

Also interesting to me is that Sequoia pretty consistently maintained a 85/15 ratio of equities to government bonds until the early 80s at which point it shifted closer to 65/35 due to high interest rates and falling inflation. Ruane and Cunniff are explicit that they made this shift because real rates of return on these bonds became more attractive than equity assets broadly. They also say they didn’t take the shift further because of concerns of reflation beyond 1982 (not that they expected it but they didn’t know how it would play out).

I enjoy going back and reading things like this because it gives perspective on peoples concerns or fears at that time in history. Inflation was rampant, debt held by foreign countries was showing cracks, and these guys felt debt was being used to extensively. Its fascinating in the context of today where our institutions are actively trying to create inflation and debt is miles higher that it was at the time of these letters. When inflation does return there is going to be a lot of investment dollars severely hurting due to the purchase of bonds at negative nominal rates and tiny real rates of return.

-Charlie

Jekyll and Hyde: A Look Back at My COVID Era Investing

Since the March 2020 market crash related to COVID concerns and shutdowns of the economy I have been pulled in two different directions. I have invested based on principles I’ve learned and honed since I first picked up The Intelligent Investor as a teenager but, for a variety of reasons (boredom, WFH, FOMO, etc.) I have also made a lot of speculative investment decisions. Almost entirely, investments under my traditional value investing style and investment principles (see below) have worked out great while my more speculative trades have blown up in my face.

Fortunately the good and bad have about washed each other out and I haven’t taken any serious loss across the portfolio as a whole – however – and this is a big however – it makes me sick to my stomach to see how much my porfolio would have appreciated if I’d had the discipline to stick to my investment principles.

The good – I initiated new positions or averaged down near the low points for several investments in 2020. These included SLB, HP, EPD, XOM, BAC, WFC, C, LUMN, OSK and BRK.B. Not only were these viable businesses being severely under priced but they also increased the dividend yield of the portfolio significantly.

If only I had stopped there…

The bad – I am naturally contrarian and I let this get ahold of me to the point I knew TSLA was increasing too much and it had to fall. One repetitive them this year is that I do not do a good job on position sizing. When I “know” I am right or am emotionally charged on a company I tend to oversize the position and introduce more risk than is appropriate. This was true for Tesla as I chased the price upward and added long-dated puts at higher and higher strike prices. I did the same to a much smaller extend with NKLA but after its major fall had already occurred. I also failed to appreciate the impact of time decay which made waiting for my thesis to play out very painful when it was all said and done. The puts on these two companies was about 50% of my losses in the bad trades category.

The other half of the value destruction of my bad trades come from FOMO more than anything. I know nothing momentum trading and proved that to myself in an expensive way (ironically the TSLA and NKLA trades were both anti-momentum and I am not good at that either!). I jumped in late to GBTC and after early success I increased my position size right as momentum broke.

And then the final nail in this stock operators coffin was doing something similar in GME. I followed early success by increasing position size, ultimately buying a large position (by my standards) @$131. Within hours the stock fell into the $60s and I learned the true distinction between “Diamond hands” and “paper hands” and no doubt found myself to be the latter (if you don’t believe in the underlying asset then it’s much harder to have conviction – this was true for me for both GME and GBTC). I sold these shares at $69 as I thought the stock was cracking and crashing back to reality (only to watch it move to a high near $500 in past day or two). At the end of the day, how high it went should be irrelevant to me because I never should have bought the stock in the first place.

Below are my investment principles that I have developed over time through a combination of direct experiences and the learnings/writings of others. I broke every single one of these in the process of my bad trades and remained true to them in just about all cases with my good investments over the past year.

Investment Principles:

  • No Options or Shorting
  • No Margin
  • Target 10% cash or cash equivalents
  • Sleep on it before adding any new positions. If I feel urgency to buy it today then it’s probably a speculative urge and not aligned with my objectives.
  • Prioritize quality and value. Things like cashflow, balance sheet strength, and ROIC.
  • Minimize position count but alternately watch for over concentration.

I was vert fortunate to have had the balancing effect of the good investments and bad trades allowing my portfolio to stay broadly in line with the S&P500 index because things could have turned out worse. It leaves me thinking about the old tennis saying “In sports, the main difference between amateurs and pros is that amateurs focus on avoiding mistakes while pros play to win” in the sense that I need to do more sitting on my hands and focus on avoiding costly mistakes more than playing to win (swinging for the fences – another sports metaphor) to give myself the best chance to succeed through long-term compounding.

-Charlie