Monday, October 8, 2012

Six Stock Portfolio Performance

It has now been roughly 3 and a 1/2 years since I first mentioned the Six Stock Portfolio. At that time, I considered those stocks attractive long-term investments, at the then-prevailing price levels, for my own portfolio.*

Back then, I felt the share price of each represented a very nice discount to likely intrinsic value a few years out (and beyond) and said as much. No estimate of value can be perfect, of course, but each seemed oddly cheap back then compared to even the most conservative estimate of their intrinsic worth.

None are now selling at much, if any, discount to my judgment of their value. To me, at the very least, the margin of safety is now insufficient.

As a group, the six stocks have obviously done just fine since they were first mentioned.

Stock                                                | Total Return**
Wells Fargo (WFC)                                    91%
Diageo (DEO)                                           187%
Philip Morris (PM)                                 189%
Pepsi (PEP)                                                 52%
Lowe's (LOW)                                             67%
AmEx (AXP)                                             230%

Since April of 2009, the combined total return is 136 percent (including dividends) for these six stocks while the SPDR S&P 500 (SPY) returned 82 percent (also including dividends).

So that's a ~54% performance gap achieved in 3 and a 1/2 years with no portfolio turnover and little, if any, trading abilities required (well, actually none). It's always a focus on paying a price that's comfortably below my best estimate of intrinsic value (necessarily more of a range of values than a precise number).

The fact that shares of good businesses like these were that inexpensive back in April of 2009 still seems amazing.

Since none are particularly cheap at this point, some might ask why not switch from these somewhat expensive stocks (or, at least, a whole lot less cheap) into something a bit less expensive.

On rare occasions, I'll consider a switch if: valuation becomes extreme on the high side, I've lost confidence in/significantly misjudged the long-term prospects of the business, or I understand an equal or better quality alternative investment pretty much as well that is clearly much cheaper.
(Something that is just plainly a superior investment alternative. I mean, it generally has to be just screaming at me.)

Otherwise, I'm just not that smart. Each move is just another chance to make a mistake. Buying and selling isn't just a chance to improve results, it's a chance to hinder them. It's all too easy to overweight the likelihood that a move will improve portfolio performance while not considering the possibility it might do just the opposite. It's an illusion of control. Of course, each move also creates unnecessary frictional costs.

I own these because my judgment is that they have durable advantages that support attractive business economics and it was, at one time, possible to buy the shares comfortably below my conservative estimate of intrinsic value. Once I own shares of a good business at the right price (at least those that I understand), my bias is to not sell for a very long time. That means sometimes holding onto shares of a business I like even if, due to increased market prices, the stock might temporarily no longer be a bargain relative to current estimated per share intrinsic value.
(As long as my expectation is that intrinsic value will still increase over the long haul at an attractive rate.)

I don't expect most to adopt this way of thinking and apply it in their own way but it's, if nothing else, a recognition of my own limits. We'll see how these six perform over many years compared to the S&P 500. If I'm an idiot it will clear over time.

The blog is here to make sure of that.

This concentrated portfolio is meant to be an example of how attractive results can be accomplished with minimal to no trading. I'd imagine it takes a fair amount of energy to learn trading techniques and become proficient (though I don't plan to find out). My interests lie elsewhere. Instead, my energy and focus has always been on judging business quality and value, being disciplined about buying shares at a substantial discount to that value, and minimizing frictional costs of all kinds.

Returns are driven by the economics of each business and always buying with a margin of safety, not some unusual talent for trading.

Of course, many investors -- depending on the circumstances -- will want or need to own more than six stocks but portfolio concentration can make sense.***

At least for me, it's not possible to get a good understanding of 50-100 businesses.

Some may be able to do just that, but I can't.

I suspect there are a few who are kidding themselves that they understand so many businesses well enough to risk their capital.

So I think attractive results can be achieved without some unusual acuity for trading but, instead, via paying the right price per share (buying with a nice margin of safety) for good businesses with sound economics and owning them for a very long time.

At some point each of these businesses (and maybe their stocks) will almost certainly not perform well for a period of time. Yet, considering both the quality of the businesses and the price that shares could be purchased for in April 2009, I'd expect this portfolio's overall results to be just fine over the very long haul.

Of course, as noted above, if my view of future prospects were to change action might be necessary. For example, if the economic moat of one of these businesses became materially impaired (or if capital allocation decision-making by management became a serious concern), I will certainly consider switching one of these out.

It's probably obvious for those who've read some of my previous posts that I don't view it as a good thing this portfolio has doubled in value so quickly. Right now, I am comfortable with these six stocks long-term but, at current prices, neither I nor these companies can buy shares at an extreme discount to value.

In the long run, as Buffett pointed out using the IBM example in the most recent Berkshire letter, that will reduce returns for long-term owners. So it makes no sense to be happy the stocks have run up this much.

It does, in fact, actually hurt relative and absolute long-term performance.

The gap in performance more recently shouldn't be sustainable. If it does continue, then price action will certainly outrun increases to intrinsic value. Not a good thing. At the end of 2011, these six stocks combined, since April 9th, 2009, had a ~33% performance advantage over the S&P 500. Less than a year later, it is now already up to a ~54% advantage. It seems improbable these stocks will continue expanding the gap over the S&P 500 at such a rate over the longer haul.

These are good businesses, in my view, but their capacity to increase per-share intrinsic value is far more modest than that.

In other words, it seems likely some underperformance is overdue for maybe even an extended period of time.

I certainly hope so.

So, while I'm not surprised that these six are doing well compared to a broad-based index (and might look very solid over a 10-20 year and longer horizon), the extent of the more recent outperformance continuing simply is not likely at all.

Still, if they do produce nice risk-adjusted returns over the very long haul, it will because these six enterprises continued to have sound core business economics and were bought at a discount to per share value in the first place.

Finally, I'd add that 3 and a 1/2 years is still not really long enough to make a meaningful judgment on relative performance.

Adam

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

* 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.
** Includes dividends and based upon closing price on April 9th, 2009 compared to this past Friday.
*** It comes down to reliably judging business economics. Index funds will be, of course, the more logical alternative for many investors. Portfolio concentration is a disaster waiting to happen for anyone not able to reliably judge business economics. As always, awareness of individual limits is key.
 
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