Tuesday, April 12, 2011

Six Stock Portfolio Update

Portfolio performance since mentioning on April 9, 2009 that I like these six stocks as long-term investments if bought near prevailing prices at that time (or lower, of course).

While I never make stock recommendations each of these, at the right price, are what I consider attractive long-term investments for my own capital.

The portfolio is made up of the following stocks: Wells Fargo (WFC), Diageo (DEO), Philip Morris International (PM, Pepsi (PEP), Lowe's (LOW), and American Express (AXP).

Stock |Total Return*
 WFC |  70.9%
 DEO  |  83.0%
 PM    |  90.2%
 PEP   |  33.4%
 LOW |  37.6%
 AXP  | 172.4%

Total return for the six stocks combined is 81.2% (including dividends) since April 9th, 2009 while the S&P 500 is up 63.2% (also including dividends) over that same time frame. This is a conservative calculation of returns based upon the average price of each security on the date mentioned. Better market prices were available in subsequent days so total returns could have been improved with some careful accumulation.

The above is a relatively low turnover and concentrated portfolio of high quality businesses. It is, in part, meant to be an example of Newton's 4th Law at work (or, alternatively, a way to avoid being tripped by the invisible foot).

Adam Smith felt that all noncollusive acts in a free market were guided by an invisible hand that led an economy to maximum progress; our view is that casino-type markets and hair-trigger investment management act as an invisible foot that trips up and slows down a forward-moving economy. - Warren Buffett in the 1983 Berkshire Hathaway Annual (BRKaShareholder Letter

The approach rejects the idea that trading rapidly in and out of different securities is necessary to create above average returns. Instead, build a stable/concentrated portfolio of high quality businesses that can outperform over the long-haul.

Buying shares at a discount to value (conservatively calculated), low "frictional costs", and the intrinsic value created by the businesses themselves becomes the driver of total returns not some special aptitude for trading or timing the market. In short, the outperformance, if it continues, will come from owning shares of good businesses bought with an appropriate margin of safety combined with little in the way of unnecessary fees, commissions, and related costs.

Buffett on Helpers and "Frictional" Costs

Many equity investors would get improved long-term returns, at lower risk, if they: 1) bought (at fair or better prices) shares in 5-10 great businesses, 2) avoided the hyperactive trading ethos that is so popular these days to minimize mistakes & frictional costs, and 3) sold shares in these businesses only if the core long-term economics become impaired or opportunity costs are extremely high.

This six stock portfolio is clearly very concentrated by most standards but the Buffett/Munger approach rejects the idea that vast diversification is needed.

I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken.

In the United States, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations is securely rich. And why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices. - Charlie Munger in this 1998 speech to the Foundation Financial Officers Group

Clearly some, depending on background and experience, may need to diversify holdings a bit more. For others, low expense index funds may make more sense than buying individual stocks. Yet, keeping trading and other frictional costs to a minimum is almost always wise.

As always, one of the most important things is to always stay well within one's own limits as an investor.

Though I could surely be wrong, I consider these six stocks appropriate for my own portfolio (not someone else's) given my understanding of the downside risks and potential rewards. It doesn't make sense for others unless they do their own research and reach similar conclusions.

The above concentrated portfolio of six stocks obviously won't outperform in every period. In the long run, it has a reasonable probability of doing well compared to the S&P 500 due to lower frictional costs and the durable high return qualities of the businesses. While unlikely to outperform the very best portfolio managers**, it's likely to perform well on a risk-adjusted basis relative to the market as a whole over a period of 10 years+.

It's also worth noting the unusual allocation of this portfolio. First of all, there is not/has not been exposure to the hot sectors (commodities these days and surely something else down the road) and no attempt to do so. When I put this together, I intentionally allocated one half the portfolio to consumer staples (DEO, PEP, PM), a third in financials (WFC, AXP), and a housing stock (LOW). At the time, none of these were exactly the hot trade of the moment. Staples too defensive. Financials and housing a mess. All partly true but shares of a good businesses usually aren't cheap when the macro environment looks great.

Not to beat a dead horse but most readers of this blog will know the one thing I've said consistently is that the Coca-Cola's, Pepsi's, and Philip Morris International's of the world are not defensive in the long-run. They are often a lower risk way to outperform.
(Okay, maybe I've beaten this one dead but the best consumer staple businesses, while each having a unique set of risks, often do not get enough respect as long-term offense instead getting overplayed as short-term defense.)

The point is I wanted this portfolio to be made up of businesses that, once shares were bought at the right price, could be, for the most part, left alone to compound in value across multiple business cycles. Some may want exposure to other sectors not represented here which is fine if quality can be had at a fair price. We'll see how it continues to perform.

In any case, this simple example is designed so it's easy for anyone to check the results over time using this blog. If this six stock portfolio*** isn't performing well against the S&P 500 it will be obvious. The idea that a concentrated portfolio of quality businesses can perform well while avoiding the hassle and risks of trading should, at least, be of some interest. Producing results via the increasingly popular hyperactive buying and selling of securities seems inspired by Sisyphus by comparison to me.

Finally, an opportunity may come along where the capital from one of these stocks is needed. My view is under such a scenario the threshold for making changes needs to be high. That hypothetical new investment must have clearly superior economics and relative price.

In addition, if something appears to fundamentally threaten the moat (ie. the effect of the internet on the newspaper biz) of one of these businesses a change may also be warranted.

So I may rarely add or switch some of the stocks in this portfolio but I will only make a change if the situation described above exists (ie. if the core long-term economics of one of these stocks become impaired or opportunity costs of not making a change is extremely high).

Keep in mind that even though the stocks I chose have done well versus the S&P 500 I don't consider a mere couple of years as a meaningfully long enough time frame to measure performance.

Adam

Long position in DEO, AXP, PEP, PM, WFC, and LOW

* As of 4/11/11.
** There's no shortage of evidence that many actively managed equity mutual funds underperform the S&P 500. 

"Of the 355 equity funds in 1970, fully 233 of those funds--almost two thirds--have gone out of business. Only 24 outpaced the market by more than one percentage point a year--one out of every 14. Let's face it: These are terrible odds!." - John Bogle


Also, DALBAR's Quantitative Analysis of Investor Behavior (QAIB) study released in March 2009 revealed that over the past 20 years investors in stock mutual funds have underperformed the S&P 500 by 6.5% a year (8.35% vs. 1.87%). Beyond the performance of the funds themselves, it shows that much of these poor returns come down to investor behavior. The tendency of investors to buy the hot mutual fund that has been going up while selling when the market is going down out of panic or fear. 

*** I don't think these are necessarily the six best businesses in the world, but I believe they are all very good businesses that were selling at reasonable prices on April 9th, 2009. At any moment, there is always something better to own in theory but I don't think you can invest that way (as if stocks are baseball cards) and have consistent success. So there are certainly quite a few other shares in businesses that would be good alternatives to these 6. The point is to get a handful of them at a fair price and then let time work.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
 
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