Tuesday, January 3, 2012

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.

Intrinsic Value: The Six Stock Portfolio

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  |  44.4%
 DEO   | 110.5%
 PM     |  135.6%
 PEP    |  38.5%
 LOW  |  31.6%
 AXP   | 162.5%

The total return for the six stocks combined is 87.2% (including dividends) since April 9, 2009. By comparison, the S&P 500 SPDR ETF (SPY) is up 54.0% (also including dividends) over that same time frame.

While the S&P 500 is down since I last updated this portfolio, the six stocks as a group continued to build on their gains. As a result, the portfolio's performance advantage expanded further. That certainly won't be the case in every period considering the concentration.

Unfortunately, none of these are selling at the kind of discount to intrinsic value I'd require to buy more shares.

Hopefully that will change.

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 Shareholder 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 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

My view is that 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 this approach to investing 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 speech to the Foundation Financial Officers Group

We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter

Clearly, many investors need to diversify holdings a bit more. As always, one of the most important things is to always stay well within one's own limits as an investor. Depending on background and experience, low expense index funds may make more sense for some than buying individual stocks. Yet, keeping trading and other frictional costs to a minimum is almost always wise.

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 an absolute basis, especially when risk-adjusted, relative to the market as a whole over a period of 10 years+.

It's worth noting the unusual allocation of this portfolio.

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.

Consumer staples were, of course, thought to be too defensive (lately, unfortunately, they've become a bit too popular...the substantial discounts to value that were available for many stocks in this sector have quickly disappeared) while many financial and housing stocks were in rough shape and in many ways continue to be so.

In part true, certainly, but you don't get bargains on good businesses when the outlook is sunny. Also, I consider the idea that one needs to jump in and out of stocks (or ETFs) based upon what the hot sector is to outperform is, to be kind, not a very good one (more a recipe to make mistakes and generate unnecessary fees and commissions).

Most readers of this blog will know the one thing I've said consistently is that the Coca-Cola's (KO), Pepsi's, and Philip Morris International's of the world are not defensive in the long-run.
(Okay, this has received more than its fair share of coverage on this blog but the fact is many consumer staple businesses, though each has a unique set of risks, often do not get enough respect as long-term offense while instead getting overplayed as short-term defense.)

Stocks in the consumer staples sector are, especially when bought well, often a lower risk way to outperform. For most of the time I have been making this point they've been priced from between extremely cheap to attractive. While not necessarily expensive now, most of these are no longer extremely cheap, either. So there are some great stocks in this sector to own for the long haul but the price paid still matters and the bargains, among consumer staples, have all but disappeared.

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 or better price. We'll see how the portfolio continues to perform.

In any case, this simple example is designed so it's easy for anyone to check the results over time. 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 bought with a margin of safety 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 still don't consider a little less than three years a meaningfully long enough time frame to measure performance.

Adam

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

* Total return is calculated using the closing price on December 31, 2011 compared to the closing price on April 9, 2011 (the date these stocks were first mentioned) plus dividends. I've used the closing price on April 9, 2011 (instead of something like average intraday price) even though it reduces the calculated total return slightly. The benefit is that it makes the calculation simpler and easier to confirm. In other words, better market prices were available intraday April 9, 2011 (and in subsequent days) so total returns could have been improved with some careful share accumulation. In any case, as always the comparison with the S&P 500 is apples to apples.
** 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 to cheap 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 six. The point is to get a handful of them at a fair price and then let the businesses and time work.
------------
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.
 
Site Meter