Monday, April 14, 2014

Six Stock Portfolio Performance: Five Years Later

It has now been five years since I first mentioned the Six Stock Portfolio. At that time, I considered those stocks attractive long-term investments, if bought at the then-prevailing price levels, for my own portfolio.*

Back then I felt that 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                                 Price                      Price                         Total
                                        |Apr. 9, 2009     |Apr. 9, 2014        |Return**
Wells Fargo (WFC)               19.61                    49.10                  174%
Diageo (DEO)                         45.54                  126.89                 225%
Philip Morris (PM)                37.71                   83.88                 173%
Pepsi (PEP)                              52.10                    83.91                  87%
Lowe's (LOW)                         20.32                   47.40                 157%
AmEx (AXP)                            18.83                   88.72                410%

Since April of 2009, the combined total return is 204 percent (incl. dividends) for these six stocks while the SPDR S&P 500 (SPY) returned 141 percent (also incl. dividends).

Though intrinsic value has increased meaningfully since five years ago, the market returns were far greater than that increase. The optimistic view is that the market returns reflected intrinsic value changes plus a closing of the discount to value gap. In other words, they were just very undervalued at the time and the market returns so far reflect a "catching up". It's inevitable that forward returns will be much more modest.
(Though, over many years, per share intrinsic value should increase at a solid rate and might even do just fine on a relative basis.)

A less optimistic way of looking at it is that it's tough to buy these now with a sufficient margin of safety.

In any case, those five year returns are certainly not an indication of how much per share intrinsic value has increased.

So these six stocks now have a nice performance advantage achieved over the five years with no portfolio turnover and little, if any, trading abilities required (well, actually none). The process always demands paying a price that's comfortably below my best estimate of intrinsic value (necessarily more of a range of values than a precise number, of course).

The fact that shares of good businesses like these were that inexpensive back in April of 2009 still seems amazing. Decisive action required an awareness of that valuation disconnect, an ability to ignore most of the many scary headlines, along with some discipline and patience.

What Daily Journal (DJCO) was able to accomplish this past decade or so is as good an example of this as any that I know (no doubt other good examples exist). The company's portfolio remained 100% in cash and U.S. Treasuries in the years that preceded the financial crisis. Then, beginning in early 2009 at the height of the financial crisis, they decisively moved much of those funds into a concentrated portfolio of what, at the time, were heavily discounted marketable securities (mostly common stocks). Some follow on common stock purchases were also made in fiscal 2011 and 2012. The portfolio remains mostly in common stocks at least based upon what's been disclosed. A great example of discipline and patience followed by decisive action when the opportunity emerges.
(The specifics of their purchases were not disclosed until much later. In fact, they didn't provide specific common stock names until earlier this year. Based upon their latest filing, it appears they've pretty much remained in these same marketable securities since they were first purchased.)

Of course, it's not like buying an S&P 500 index fund back then would have worked out too badly. In other words, many things were rather cheap back in early 2009.

The real test of relative and absolute performance will come when some future crisis leads to a big drop in the market or, at the very least, after a couple more business cycles.

Since none of the six stocks are particularly cheap (nor are they outrageously expensive) 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 cheaper.

I have said before that, on rare occasions, I might 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 very much cheaper.
(Something that is just plainly a superior investment alternative. I mean, it has to be very obvious to 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 six stocks 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 per share intrinsic value will still increase over the long haul at an attractive rate.)

I don't necessarily expect most to adopt this way of thinking (and, more importantly, 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 rather 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. In other words, the emphasis is on sound principles and process; it is not on attempting to predict future outcomes.

Returns will be driven by the core economics of each business and always buying with a margin of safety, not some unusual talent for trading. A modest multiple of, conservatively estimated, future per share normalized earning power -- at least 7-10 years down the road and, ideally, even much longer -- should be all that's required, considering risks and alternatives, for a nice overall investment result.

So the price paid now compared to a modest multiple of those future earnings should yield a good result. Otherwise, find something else to invest in.

"If you don't feel comfortable making a rough estimate of the asset's future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn't necessary; you only need to understand the actions you undertake." - Warren Buffett in his latest letter

Inevitably, unexpected things will happen; things that can't be foreseen. That's where margin of safety comes in.

Trying to guess what those things might be and when they'll occur is futile.

There'll no doubt be both good and bad surprises ahead.

Expect as much.

None of that can be controlled.

All one can hope to do is improve the likelihood of good results over the long haul with a thoughtful approach.

Figuring out how price compares to per share intrinsic value is difficult enough to do consistently well. Attempts to correctly time individual stock price (or market) moves and carefully consider macro views, even if well-intentioned, likely just distracts and leads to mistakes that need not be made.

"Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important." - Warren Buffett in his latest letter

Buying a stock that leads to a permanent -- not temporary -- capital loss is a costly mistake. Well, not owning shares of an understandable business with good prospects that was once cheap -- but now isn't because it rallied instead -- is also a costly mistake.

That's a risk that's too often ignored.

Permanent losses are unacceptable.

Temporary paper losses are inevitable.
(Well, at least that's generally the case with common stocks.)

In other words, the attempt to both time things well and price things well can lead to this expensive outcome. For most of us, there are only so many things that can be understood well enough to be bought with conviction. The possibility of not owning (or not owning enough of) something, at a good price, that is otherwise perfectly sensible to own because it possibly hasn't quite bottomed just yet is a risk that can be underappreciated.

"Picking bottoms is not our game. Pricing is our game. And that's not so difficult. Picking bottoms is, I think, impossible." - From this interview with Warren Buffett

There is a real cost to not acting decisively when action is warranted.

There's a real cost to mistakes or errors of omission even if those costs are harder to measure.

The right price and right time to buy might often coincide, but, in my view, the focus needs to be on how price compares to value and never on timing. Inevitably, what was bought cheap will get even cheaper (and, with inherently emotional markets, the opposite plainly also occurs) but, if ultimately the investor has paid far less than per share intrinsic value, the weighing machine generally sorts at least most of this out down the road. In the short run psychology moves prices. In the long run core business economics becomes the dominant factor. Learning to ignore short and even intermediate term quoted prices isn't a bad habit to develop.

Price action will, at times, go the wrong way near-term but shouldn't matter much in the long run if value has been judged well and the right price was paid.

The emphasis should be whether the price paid today will sufficiently compensate the investor based upon a conservative estimate of likely per share intrinsic value many years from now.

A good investment outcome should never depend on getting a premium valuation. Good results should need no more than a more moderate valuation environment if and when it comes time to sell.

There'll be no complaints if premium prices happen to prevail.

Now it's certainly true that 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 just 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 for good businesses with sound economics and owning them for a very long time.

Considering both the quality of these businesses and their rather cheap stock prices back in April of 2009, I'd expect this portfolio's overall results to be just fine over the very long haul.

Yet, at some point, I won't be surprised if at least some of these businesses (and their stocks) do not perform well for a time. Even very good businesses eventually experience their fair share of challenges. To me, this means it's wise to expect that performance in any given one to three year stretch -- and maybe even somewhat longer -- will almost certainly be subpar. Those who judge investment performance over such short time frames are choosing what's measurable over what's meaningful.

I'd add that five years is just barely long enough to make a meaningful judgment on performance. So whether the relative performance of these six stocks against the S&P 500 means much, if anything, is a reasonable debate. In fact, I'm not convinced it means a whole lot. I'm just convinced that these six stocks made sense for my portfolio as prices got near the levels that they did back in April of 2009.

Of course, as noted above, if my view of future prospects were to materially change then 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. On the other hand, I would NOT consider selling if one of these runs into some kind of temporary but fixable problem.

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 increased in value so quickly. Right now, I am comfortable owning these six stocks long-term but, at current prices, neither I (nor these companies via buybacks) can acquire shares at a sufficient discount to value. For a business with durable advantages, it is the paying of meaningful discounts to value over time that improves the balance of risk versus reward.

In the long run, as Buffett pointed out using the IBM example in the 2011 Berkshire letter, the elevated prices will only reduce returns for long-term owners. So it makes no sense for an investor to be happy these stocks have run up this much.

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

The performance of the six stocks over these five years just isn't sustainable on an economic basis. If this were to continue, then price action is certain to significantly outrun increases to intrinsic value. Not a good thing for the investor (traders, of course, surely view this differently). It also seems rather improbable at best that these stocks will expand the performance gap over the S&P 500 at such a rate over the longer haul.

These are six good businesses, in my view, but their capacity to increase per-share intrinsic value is far more modest than what the above performance would otherwise suggest.

In other words, though I never have a view as to how price action might play out, it seems likely more modest performance should at least be expected and for maybe even an extended period of time. I certainly hope so. In fact, a nice drop in prices would be a welcome development.
(Those looking to profit from price action must necessarily think differently than those investing long-term in a business they like and understand. Those in it for the long haul should logically want prices to not run well ahead of intrinsic values; they should hope for the return of big discounts to value. It's only when it comes time to sell that one should hope prices at least fully reflect value.)

It's difficult enough to find a good understandable business that can be bought well. If shares of that business become materially overvalued then it begs for an alternative to be found. That may work out well, but also opens up the possibility that an unnecessary error is made. The long-term investor is hurt, in terms of the balance between risk and reward, when the discount to value disappears or, worse yet, prices get ahead of per share intrinsic value.
(Naturally, those selling soon will welcome that premium to value. In addition, if a stock sells at a huge premium to value while something else understood well stays very cheap eventually a move is warranted. It's just wise to not try and trade around more modest valuation discrepancies once something attractive has been bought at a good price.)

So, while I'm not surprised that these six stocks are doing well compared to a broad-based index (and might even look very solid over a 10-20 year and longer horizon), continued performance similar to these past years simply is not likely at all. In fact, I'd expect that a less ebullient market than the current one -- or, better yet, significant broad-based caution to return -- would improve on relative performance.

If these stocks 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.

It's all too easy to look back at what else could have been purchased ("woulda, coulda, shoulda") that would have performed even better; it's easy to compare what actually happened to theoretical alternative outcomes. It's much more difficult to act decisively beforehand in way that the investor actually benefits from the mispricing. Well, in order to act decisively beforehand, lots of warranted conviction is required. The only way I know of to acquire that kind of conviction starts with buying only what is truly well understood (necessarily unique for each investor); where, through careful evaluation, the investor concludes something possesses attractive long-term prospects.
(This is one of the reasons why I think it never makes sense for an investor to invest in something that someone else happens to like.)

Lacking that kind of conviction means that the "noise" -- possibly including lots of fear inducing headlines and stories -- will likely have too much influence on investment decision-making. Buy what someone else likes and the conviction needed isn't likely to be there when it counts.

By building the necessary conviction during the years that preceded the financial crisis, decisive action on the six stocks above was possible when the mispricings emerged. It was the preparation beforehand, over a number of years in fact so patience certainly was required, that made it less difficult to act decisively when needed than it otherwise would be.

Preparing in the coming years in order that similar decisive action (even if not necessarily the same marketable stocks) can be taken if/when another such opportunity arises likely isn't a bad idea.

Some might reasonably wonder what can be bought now that has a similar risk and reward profile to those six stocks in early 2009.

Well, if there is something with that kind of profile -- and there just might be -- it's irrelevant since I surely don't understand it.

Nothing today strikes me as being even close to the mispricings back then. A big part of the investment process comes down to figuring out at what price it makes sense to buy something -- building the necessary level of justified conviction -- then waiting until the opportunity to buy at the right price arises.

This generally involves much reading and thinking over many years and, well, sometimes the wait for the right price will require many years. This takes patience, discipline and, yes, maybe quite a lot of work.

What it doesn't necessarily require is brilliance.

Things like sound business judgment, persistence, discipline, patience, and knowing limits matters more.

Now, though there are surely flaws, I'm comfortable with this particular approach for my own investments compared to alternatives. It's built on solid set of principles, yet remains flexible enough to respond to uncertain world.

Still, improvements will always be sought.

An investor doesn't controls what ultimately happens, but does control the approach.

The most one can hope for is to improve the likelihood that good things happen down the road.

Finally, it's worth closing with the thought that time and energy spent seeking evidence that I'm wrong about an investment beats time and energy spent confirming I'm right.

"To kill an error is as good a service as, and sometimes even better than, the establishing of a new truth or fact." - Charles Darwin

My guess is this habit alone helps me to eliminate unnecessary errors as much as anything else. Darwin may not have asserted the above in the context of investing, but it certainly applies.

"...Warren and I are better at tuning out the standard stupidities. We've left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error." - Charlie Munger in Stanford Lawyer

While some market participants are busy trying to discover beforehand what's going to be the next big thing, they're missing the chance to improve results simply through the elimination of error.

Adam

Long positions in WFC, DEO, PM, PEP, LOW, and AXP established at very much lower than recent market prices. No position in DJCO.

* 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.
** Total return includes dividends and based upon closing price on April 9th, 2009 compared to the April 9th, 2014 closing price. 
*** 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 or buys what they don't really understand. As always, awareness of individual limits is key.
 
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