Friday, August 1, 2014

Stocks to Watch: Five Years Later

July 21, 2014 marked five years since my original Stocks to Watch list was created. These were stocks that I liked* at the time -- and mostly continue to like to varying degrees -- at the right price for my own portfolio.

Six of the stocks were originally mentioned on April 9, 2009 (as part of the Six Stock Portfolio then later added to Stocks to Watch). Earlier this year I provided a five year update on just these six stocks.

Well, here's how the total returns look updated through July 21, 2014 for all the stocks on the list:

For the original six, the total return was 214 percent compared to 156 percent for the SPDR S&P 500 (SPY) over the same time frame.

For the stocks first mentioned on July 21, 2009, the total return was 150 percent compared to 129 for the SPDR S&P 500 over the same time frame.

It's not quite five years yet for the stocks later added on December 17, 2009. To date, those two stocks had a total return of 105 percent compared to 97 percent for the SPDR S&P 500 over the same time frame.
(Naturally, dividends are included in that total return calculation for all the above stocks and for the S&P 500 so it is an apples-to-apples comparison.)

Combined, these stocks are up roughly 159 percent since being first mentioned in those three separate posts a few years back.

Most of these stocks had their per share intrinsic value increase nicely over five years or so, but not nearly as much as the market returns would imply. These returns reflect intrinsic value increases plus a closing of the discount to value gap. These businesses certainly did NOT increase per share value 159 percent. Most of the return comes down to what was a temporary mispricing. They were just very undervalued at the time and the recent market returns reflect a "catching up". It's inevitable that the forward rate of return will be much more modest.

Clearly, unless we have another bubble (let's hope not), there's just no way the forward returns will be anything like the recent past.

In fact, it'd be better in the long run if these stocks came down in price somewhat. That way buybacks can have a greater long-term per share effect for each dollar allocated.

The performance of these stocks relative to the S&P 500 is finally starting to, if only barely, become more meaningful.
(In previous posts I've noted that the time frame was still too short to gauge relative performance.)

Keep in mind this list was established with an eye toward minimal trading and very long-term ownership.
(If nothing else a recurring theme on this site.)

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 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. Sound investments should separate themselves from the pack during the tougher economic environments.

These returns also naturally need be looked at in the context of risks (not beta...more qualitative).

I've liked these stocks (if bought at or below the maximum prices noted in prior posts) for the very long haul because my view has been that -- if bought at the once reasonable market prices -- attractive returns could be accomplished at lower risk. I may naturally be very wrong about this.

The substantial moves higher in many of these stocks just makes it harder to accumulate more shares (or for the companies to implement buybacks) below intrinsic value. So there's little reason to be thrilled about these mostly now too-high-to-purchase-with-sufficient-margin-of-safety prices.

That doesn't mean I'll be selling what I do own. I'm mostly not. It does mean I won't be buying more of these shares unless price versus value becomes more favorable.

Since these were first mentioned there were plenty of chances to buy at a nice discount to per share intrinsic business value.

Not now.

Naturally, my objective was to always buy these significantly below intrinsic value when the opportunity presented itself. The prices that were made available by the financial crisis (and the aftermath) allowed this to be largely accomplished.

As always, my intent is to hold long-term unless 1) the economic moat is damaged, 2) prospects were misjudged, 3) valuation gets extreme, and 4) occasionally when a substantial mispricing of another asset presents itself and the capital is needed for it.

Some things to consider:
- These stocks are intended to remain very stable over time with few additions or deletions. I think of it differently than the Six Stock Portfolio. Unlike that portfolio, I use Stocks to Watch as a list of quality businesses to monitor and, over a longer period of time, buy 5 to 10 of the stocks based upon what becomes available at the biggest discount to intrinsic value in the market. After that, the intent is to hold these indefinitely as long-term investments.

- In contrast, I established the Six Stock Portfolio in April 2009 as an example of some quality stocks that could be bought relatively quickly (at prevailing market prices back then) and held long-term. No trading required unless one of the conditions noted above warrants a sale. Otherwise, this concentrated portfolio exists to reject the idea that trading rapidly in and out of different securities is necessary to create above average returns. Basically, owning shares of quality businesses -- those with durable economics that increase intrinsically in value at an attractive rate over time -- bought initially at the right price trumps excessive trading.

- A term used frequently by analysts is a "price target". I never have one. To me, investor returns should be driven by the core economics of the businesses they own compounding in value, ideally over a very long time, not some unique talent to jump in and out of the stock at the right moment/price. The ownership period of shares in a sound business can be indefinite when bought at a fair price. Again, my sell behavior is influenced by the conditions noted above.
(i.e. Permanent damage to the economic moat, misjudgments, extreme mispricings, opportunity costs etc.)

The bottom line is that these are all intended to be long-term investments. A ten year horizon or longer. No trades here.

All of the stocks on this current list were part of the original Stocks to Watch unless otherwise noted.

Stock|Price @ 1st Mention|Recent Price|Total Return (incl. dividends)**
WFC |      19.61          |   51.05      | 187% - 1st mention 4/09/09
PM    |    37.71           |   85.57      |  181% - 1st mention 04/09/09
PEP   |    52.10           |   89.91      |  102% - 1st mention 04/09/09
LOW |    20.32           |   47.58      |  159% - 1st mention 04/09/09
AXP  |    18.83           |   92.88       | 435% - 1st mention 04/09/09
DEO   |    45.54           |  123.82     | 217% - 1st mention 04/09/09
MDLZ|    17.90          |   38.27      | 142% -  Was KFT, cost basis adj. for spin-off 
KO    |    25.18            |    42.40       |  95% - Split 2-1 on 08/13/12
COP  |     33.53           |   84.53       |  215% - Cost basis adj. for spin-off
JNJ   |    59.49           |  101.27      |101%
PG     |    55.49           |   80.28       |  71%
ADP  |    35.72           |   80.98      | 162%
USB  |     18.27           |   42.12       | 153%
MHK|     38.62           |  131.35     | 240%
BRKb|    59.50           | 128.58      | 116%
MO     |    17.33           |  42.01       | 223%
MNST|   14.58            |  64.74      | 344% - Split 2-1 on 02/16/12
PKX   |   93.63            |  74.03       | -14%
RMCF|    8.29             |  13.00       |  92%
NSC  |     52.06           | 105.63      | 129% - 1st mention 12/17/09
MCD |    61.92            |  97.55       |  82% - 1st mention 12/17/09
(Splits, spinoffs, and similar actions inevitably will occur going forward. Will adjust as necessary to make meaningful comparisons.)

Spin-offs
KRFT: total return 121%
PSX: total return 320%

For simplification purposes, both of the above spin-offs will not be considered Stocks to Watch going forward. These aren't necessarily bad businesses, but this list is already plenty long enough and I like many of the others much more.

After five years it's inevitable that some housekeeping will be in order.

Beyond those two, there are three other stocks that are, mostly due to valuation, quite a long way from making sense for a stocks to watch list. Some of this also comes down to the aforementioned simplification preference, but it primarily comes down to market valuation and, to an extent, my current judgment of their prospects compared to more attractive and understandable alternatives.

MNST
MDLZ
RMCF

These three may do just fine (in terms of per share intrinsic value increases) going forward but, unlike when this list was created, they're now far from cheap and, as a result, have become less than an ideal fit for Stocks to Watch. In other words, these stocks are still worth tracking to see how they perform over the long run but hardly represent bargains now. To me, other alternatives offer a better mix of risk and reward. It's tough to understand lots of different businesses and attempting to understand too many can easily lead to being spread too thin. Trying to reliably guess near-term price action is a fool's game; trying to judge price versus value, within limits and with discipline, is not. Sometimes, what's already expensive often goes on to just get more expensive. I'll let others try to play that game. Other times, those that appear expensive now will go on to more than justify what is a seemingly high current valuation. Well, at least they will someday. That doesn't mean the future returns, considering the risks, is more favorable than better understood alternatives.

So the remaining list is plenty long enough even if nothing is truly cheap at this point. I'll remain disciplined about price -- and continue to work hard at better understanding these businesses over time -- in an attempt to produce at least respectable long-term results. There's plenty of work to do even when there's little to buy. I expect plenty of waiting until, once again, some of these sell at a nice discount to value.

Some will still be misjudged. Some will disappoint. I mean, even the best businesses run into unexpected and real difficulties from time to time. That's the nature of equity investing and where margin of safety comes into play.***

The price paid should be such that rather unspectacular business performance will still deliver, in terms of risk and reward, an attractive long-term investment result.

Of course, if some of them do surprisingly well, there'll be no complaints.

Five years or so is enough time that things like management decision-making, changes to the competitive landscape, technology, and other factors can alter how attractive a particular investment is. It's enough time for price versus value to shift dramatically. In some cases, the long-term prospects are now even better. Most are roughly the same.

Yet some, inevitably, have become less attractive.

It'd be safer and easier to invest right now if these stocks were selling at a discount to value. Not only does it allow the investor to accumulate more shares below intrinsic value, the company itself can use excess free cash flow to do the same.

"When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases." - Warren Buffett in 1984 Berkshire Hathaway Shareholder Letter

Many of the above stocks are up substantially. Of these stocks, 20 of 21 have produced positive returns while most have more than doubled and then some. The best of them, American Express (AXP), would have turned a hypothetical $ 10k investment into more than $ 50k in five years. Crucially, the increases are NOT the result of extreme speculative valuations. In fact, prices now simply more fully reflect, give or take, intrinsic value. So, while these are not necessarily overvalued, the margin of safety is generally insufficient (some more than others).

On the other end of the spectrum from American Express is Posco (PKX). It has been, by far, the worst performing stock. Today, the stock closed at $ 81.50 per share. The stock has rallied since July 21st yet, as I write this, it's still not quite break even (incl. dividends). Back in July of 2009, I wrote that I'd be willing to buy the stock if it went below $ 80 per share. It proceeded to rally up to around $ 140 per share in less than 6 months. (Certain traders surely didn't mind this.) So it ended up taking more than two years for the shares to even get cheap enough to buy again. Well, unfortunately, the company by that time had taken on lots of debt. In fact, a bit too much for my taste.

In addition, capital allocation has been at best questionable and some value no doubt was destroyed in the process. We'll see if the new CEO is more disciplined with capital. So, for this to be worth the trouble, capital allocation needs to be improved and the balance sheet needs to be strengthened somewhat. I still like the business but it's not exactly at the top of this list. For now, in small doses, I'll continue to own it. My current cost basis offers a nice margin of safety (against permanent capital losses NOT temporary paper losses). Unlike the others, if it becomes more fully valued, I'll likely sell all or most of it. In the meantime, capital allocation and the balance sheet will be closely monitored.

Essentially, it took a long time for Posco to even get cheap enough to buy and, by that time, it had become less attractive. The stock performance, in itself, is not a problem. A languishing stock is no bother -- in fact, it can be beneficial for long-term owners if the business still has good prospects and per share value is increasing at an attractive rate. The company still has enough cost and other advantages -- through technology and some operational factors -- to be just barely worth some trouble. The weak steel pricing environment doesn't bother me. I don't even begin to try and speculate on such things. Instead, I just figure over a long period of time there'll be both good and bad price environments. Businesses with truly durable advantages are built to handle all environments. I just don't like it when a capital intensive business, one with too little control over raw material costs and the price of its products, carries this much debt.

Ditto for poor capital allocation.

So this will remain a small position and not nearly a favorite among the above stocks. It is in the "penalty box", but I'm not ready to sell it just yet. Compared to the others this stock is, and likely will continue to be, a bit of a wild ride.
(Note: The total return calculation for Posco is based upon a 07/21/09 closing price that was well above what I'd be willing to pay. My actual cost basis is quite a bit lower. Once again, I've done this for simplicity's sake. Essentially, so it's easier to track results over time. This is less than a perfect way to measure performance -- a bit on the tough side, actually, since I was not willing to pay that price -- but still meaningful enough overall, I think. If these are good businesses, bought at or near attractive valuations, this discrepancy shouldn't matter much in the long run. I don't want tracking these results to become more confusing than it needs to be.)

The idea is that good businesses should increase intrinsically in per share value at an attractive rate.

Again, some will disappoint in unforeseen and, sometimes, unforeseeable ways.

Mistakes will get made.

Yet, as a group, these should be able to do okay in terms of risk and reward over the longer haul.

For me, the right approach has been to buy a subset of these 21 based upon what became available at the most attractive market prices.

Some of these stocks really were just extraordinarily cheap when the list was created. Others weren't quite as cheap as I'd like back then, but all were selling at a discount to my own (possibly flawed) estimate of intrinsic value. As they get further away from July of 2009, increases to per share intrinsic value should be the dominant factor since, generally speaking, the mispricing gap on these stocks has been all but eliminated. If this list of stocks is any good, it shouldn't require trading brilliantly in and out of positions. The subset that were bought at attractive prices should do the heavy lifting, as far as generating returns, as they increase intrinsically in value. I definitely don't think attempting to own all 21 stocks is wise or likely to produce spectacular relative results (even if absolute results -- to a great extent due to the once very low market prices compared to intrinsic value -- certainly aren't too bad at all). I do think a subset of the 21 stocks, if bought reasonably well, should do just fine longer term (though, of course, not necessarily over shorter time horizons) with the Six Stock Portfolio being just one good example. As I've noted, it'd be better if these performed a little bit less well (the stock prices...not the businesses) in the near and even intermediate term. That can improve long-term results -- mostly because, even without incremental purchases, the buybacks and dividend reinvestments become more effective -- though it requires some patience and warranted conviction.

I'd add that the maximum price I was willing to pay (as noted in some prior Stocks to Watch posts) attempted to take into account an acceptable margin of safety.

That margin of safety differs for each company.

In other words, I believed these were intrinsically worth quite a bit more than the max price I was willing to pay. I also believe most of these companies generally have favorable long-term economics (i.e. the best of them have high and durable return on capital) and, as a result, intrinsic values will increase nicely over the long haul. The more capital intensive businesses on this list obviously have lower returns on capital but, in my view, are otherwise sound businesses. Of course, I may be misjudging the core economics and that margin of safety could provide insufficient protection against a loss.

Though I could easily be wrong, at the right price I consider these stocks appropriate for my own portfolio (i.e. not for someone else's) given my understanding of the downside risks and potential rewards.

So these don't necessarily make sense for others unless they do their own research and reach their own similar conclusions.

To me , these stocks are mostly just too expensive to buy meaningful amounts right now. There was, in contrast, no shortage of chances to buy these at a nice discount over the past five years or so. That was the time to act. The risk of missing the chance to own a well understood investment when a fair price is available -- an error of omission -- can be more costly than suffering a temporary paper loss (though, due to loss aversion, many focus much more on the latter).

Hopefully some of these stocks will get cheap again. Though I never try to predict such things, considering the current valuation environment, if these stocks do not perform well over the next several years it would be unsurprising.

In fact, if the market prices performed poorly, but otherwise core business characteristics remained in tact, that'd be a good thing.

Here are some thoughts on errors of omission by Warren Buffett from an article in The Motley Fool.

Also, from the 2008 Berkshire Hathaway shareholder letter:

"During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt... Furthermore, I made some errors of omission, sucking my thumb when new facts came in." - Warren Buffett

Choosing to not buy what's attractively valued to avoid short-term paper losses is far from a perfect solution with your best long-term investment ideas.

If an investment is initially bought at a fair price, and is likely to increase substantially in value over 20 years or so, it makes no sense to be bothered by a temporary paper loss. Of course, make a misjudgment on the quality of a business and that paper loss becomes a real one (error of commission).

There is no perfect answer to this problem. When highly confident that a great business is available at a fair price it's important to accumulate enough while the window of opportunity exists.

Sometimes accepting the risk of short-term losses is necessary to make sure a meaningful stake is acquired.

In any case, the record has been plain to see since I first mentioned the above stocks on this blog. If it turns out I've made dumb decisions it will be obvious over the long haul.

The objective will continue to be good long-term results, at lower risk, accomplished with minimal trading.

For me, performance during a down market and tough economy matters a whole lot. That'd be business performance not stock performance. The truly good businesses are strengthened by the tougher economic environments. Some of the above stocks actually had terrible price action during the financial crisis but actually came out stronger and more valuable as a result of it.

So investment performance shouldn't be measured by the near-term price action. It should, instead, be measured by changes to per share intrinsic business value once the economic environment stabilizes. Sometimes price action reveals something about the business itself; other times that's just not the case.

Market prices eventually at least roughly track intrinsic values even if, in the shorter run, prices can fluctuate rather wildly.

Overall, I'd expect the above stocks to temporarily drop their fair share in a bear market. Yet I'd also expect them to perform just fine on a relative basis once that tough environment is far enough in the rear-view mirror.

Again, the emphasis here is on long run business performance -- and changes to per share intrinsic value -- not short-term stock performance.

I am also never tempted to trade from "defensive" to "cyclical" stocks (or anything similar to that approach) depending on the market environment. Too much trading leads to unnecessary mistakes. This is about part ownership of businesses. I'll let others play the trading game as I believe this approach will do just fine in the long run (even if it offers a little less excitement).

Some may think it's time to add some new Stocks To Watch. Well, the above list, even after the deletions, offers plenty of alternatives for me to consider. Keeping the list short allows one to really get to know what they own or might want to own some day. Some patience and discipline is required. In fact, if anything, I'd still like to have fewer on the list.

In any case, I'm certainly not expecting all that many will find this way of thinking about investment to be of much interest. It's just an approach that happens to be in my comfort zone.

As I mentioned above, these are simply the stocks I like for my own portfolio. In other words, I have no opinion whatsoever as to which stocks others should own.

It's worth considering that, unlike several years back when lots of stocks had a nice margin of safety, errors of commission are much more likely to occur these days.

Market prices would have to adjust downward significantly for some future updated Stocks to Watch list to become relevant and useful again. There's just not much to buy these days with a sufficient margin of safety. While it's impossible to know when this will change, these interludes are a good chance to get more familiar with current and/or potential investments.

The right preparation should make it possible for decisive action the next time others are fearful and market prices once again become attractive.

Adam

* 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 remain long the above stocks (at least those that at some point became cheap enough to buy) unless market prices become significantly higher than intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** The total return includes dividends and is based upon the closing prices on the date first mentioned compared to the 07/21/14 closing price. 1st mention of each stock was 07/21/09 unless otherwise noted. Removed from the list a while back was BNI; a stock I liked up to $ 80/share. It was bought out by Berkshire Hathaway for $ 100/share in late 2009. Deal closed in early 2010. BNI's stock price when 1st mentioned was $ 74.80. So it ended up being a ~34% return in a relatively short amount of time which was easily greater than the S&P 500.
*** The required margin of safety is naturally larger for a bank than for something like KO. When I make a mistake and substantially misjudge a company's economics, the margin of safety may still not be sufficient. Judging the durability of the economics correctly matters most. If the economics remain intact but the stock goes down -- as was the case for most of these during the financial crisis -- that is a very good thing in the long run.
 
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