On A More Energetic Approach

Last year I wrote about how an effective strategy for compounding long-term value in a stock portfolio would simply be to find attractive businesses with understandable business models run by competent managers. I made mention of 13 businesses which seemed to fit the bill, in alphabetical order they were ADP, Alphabet, Analog Devices, Apple, Booking, Costco, Meta, Microsoft, Moody’s, Paychex, Texas Instruments, the Tractor Supply Company, and TJX.

That list did reasonably well in 2024 (+29%), as did the S&P (+25%), and happily so did the portfolio (+30%). The portfolio’s gains were even higher in the summer months, when a couple of what might be referred to (perhaps generously) as ‘special situations’ seemed to be working out, and by which point my largest holding (Plus500) had gained over 60%. By the end of August the portfolio was up 48% and it all felt like things were going well… which is often when things start to go not so well.

In this case the two ‘special situations’ started to become even more special, and not in the way that investors like. They weren’t especially large positions (albeit that is in the context of a portfolio that rarely exceeds eight positions). As at the year-end they are now reasonably large positions, at 18% for Vistry and 13% for Close Brothers.

Vistry is a stock I have owned on and off for a while now. In essence it is becoming the story of a charismatic CEO out to prove a business model that can deliver more homes, to more people, at a better price, faster, and with much higher returns on capital for shareholders, than the classic homebuilder business model.

To say the ‘jury is out’ would be to put it politely – the stock is in the doghouse after a blundered first year of execution, dropped mid-term targets and three consecutive profit warnings. With 2024 potentially helping to catalyse change in the group and with the CEO and his long-term backers still involved, there is a lot to do to prove the strategy out. However, should returns rise to above 20% in the next few years, the price to book of 0.55x at present is likely to have been a great entry level.

Close Brothers presents something of a binary outcome, with the judgement of the Supreme Court – no less – likely to strongly influence sentiment and future profits when it returns verdicts on three test cases in the spring. Not being a lawyer, this idea started on the (admittedly perhaps too simple) premise that a potential loss of ~£100m didn’t really fit with a market cap fall of ~£750m. By August this was looking like a good bet, with the shares around 80% above the price I had paid for them, but then in October the potential ~£100m loss looked more like ~£300m and the shares slumped back to new lows.

Of the eight current stocks in the portfolio, four are UK listed and four are US listed. The UK stocks held trade on an average of 6x earnings, whilst the US stocks held trade on an average of 26x. This reflects a broad dichotomy across the two markets. It is hard to find inexpensive stocks in the US, but easy to find high quality listed businesses. Meanwhile, it is easy to find inexpensive stocks in the UK, but hard to find high quality listed businesses. 2024 certainly taught the (admittedly rather enduring) lesson that owning shares in quality businesses is hard to beat. Seemingly, though, I can’t help myself but try.

On A Better Year

As could probably be expected from any review of the S&P’s calendar year returns, the -18% of 2022 was followed with a positive return for 2023. That it was as high as 26% (with dividends included) can be attributed to the change in expectations for the path of future interest rates. Pessimism and worry over persistent inflation at the end of 2022 had given way to optimism and the hope that inflation is under control by the end of 2023. Somehow it feels like inflation has yet to be fully tamed, though, so a fluctuating market may be the story for some time to come.

Just as a rising tide lifts all ships, the returns in portfolio-land were more positive in 2023 than in most of the past few years, at 19%. Rather annoyingly that return would have been 28% had I taken no action all year, i.e. taking the holdings at the end of 2022 and looking at their subsequent returns across 2023. Even more annoyingly the average return on the five stocks I held at the end of 2022 was 62% for the year. Portfolio weightings (a loose proxy for my confidence in these ideas after accounting for risk) were amusingly and annoyingly directly inversely correlated with subsequent returns.

The year was not helped by a poorly executed attempt to profit from the volatility in March associated with the collapse of Silicon Valley and First Republic Banks. With the benefit of hindsight, a low risk play through this period would have been to buy shares in UBS, who were handed Credit Suisse by the Swiss Authorities for a fraction of its solvent business value (as opposed to both its market value and its ongoing business value). A lesson here is that certain business models (banks most especially, perhaps) rely on trust in the business to remain in business at all.

Following the above mistake of commission (owning some First Republic Bank shares for a brief period), the end of the year saw mistakes of omission. Having decided to take money out of stocks and put it into short-dated Gilts in July, by October I was patting myself on the back for having avoided some negative share price movements. However, that was also the point where equity markets started to move up on the hopes of rates having peaked. The subsequent rally lifted shares in many businesses, including 20%+ gains for multiple shares in my watchlist.

All the above points to a strategy that still needs work. However, it is important to not let perfection be the enemy of good. As at the end of the year the returns since inception in 2005 have averaged 17%, bringing in a total return of 1,878%. So, whilst not as good a year as might be hoped for, the returns were still reasonable. And said returns are certainly starting to add up as time passes.

Given the titles of my last two posts have been related to seeking out compounders and maintaining a consistent strategy, the above does remind me I really need to act on those intentions. Coming from a value (or ‘valuation’) type of background makes it hard to get excited about even great businesses when they trade on 30x or more multiples of earnings. Apple is most definitely a great business, but at almost $3tn for ~$100bn of profits, it is not clear to me that it will be a great investment from here. Costco is valued by the market at $300bn for ~$7bn of profits. Microsoft at $2.8tn for ~$80bn of profits and Moody’s has a market cap of $69bn for ~$1.8bn of profits.

A few others on my watchlist are at less inflated levels of market caps vs current profits. In retail, TJX (operators of the TJ and TK Maxx stores) trades on 23x forecasted profits; the Tractor Supply Company (which supplies more than just tractors, albeit to folks who often live close to tractors) is on 21x. In Tech, Alphabet (Google) and Meta (Facebook) are on 21x and 20x, respectively. In Semiconductors Analog Devices and Texas Instruments are on 26x. In travel, Booking is on 20x. In payments processing, ADP is on 25x and Paychex is on 24x.

Simple PE ratios aside, it seems completely rational to reduce a stock universe of all listed entities down to (a) those producing high and sustainable returns on invested capital, (b) those with understandable business models, and (c) those run by managers who think like owners. Such a slimmed down universe would make the task of finding solid investments a lot simpler than starting with a universe consisting of tens of thousands of global opportunities. If the list can be further narrowed to those trading at reasonable valuations, then the process of investing shouldn’t be excessively time consuming or require extraordinary insights or foresight.

Given that I have been aware that the above is a sensible way to build a portfolio of good investments for a while, and that such a portfolio should do well over time, I don’t really know why it is that I still get drawn to ‘special situations’. The short-term gains available in the likes of Green Brick Partners (a stock I no longer hold) during 2023 and recent returns in a small holding (also now sold) of a deeply discounted UK closed end fund called Riverstone Energy just seem to draw me in. These situations do rely on other investors to see what you see without always having the tailwind of a business that is building per share intrinsic value over time. Owning great businesses for the long-term does seem a more reliable route to compounding, even if it may not build wealth at quite the rate of a more energetic approach.

On Maintaining a Consistent Strategy

2022 was a year that many stock market participants may wish to forget. Having (effectively) predicted at the start of the year that deflationary forces would subdue any inflationary pressures that may arise, I found (along with many others), that this was not to be. Apparently a long period of easy money followed by a shorter period of even easier money (whilst outlets for spending were significantly curtailed!) combined with significant supply chain disruptions will trigger the sleeping forces of inflation.
 
In actual fact inflationary pressures from easy money have been putting upwards pressure on asset prices (and services for the well off, such as school fees) for many a year, but the price levels targeted by Central Banks (those of broadly used goods and services) hadn't seen any upwards pressure for such a long time that lending rates remained extremely low.
 
That period had to end at some point and it seems that 2022 was the year that it finally did end. The result was carnage across equities which really had no substantial earnings in the first place and were trading on multiples of projected profits that were more hoped for than truly expected. I got caught up in one of these 'story stocks', it seems, in the case of Naked Wines. Whilst it's annoying to look back on a poor investment decision it does highlight the need to maintain a consistent investment strategy, even if that strategy doesn't work for a long stretch.
 
My preference has generally been to find shares in businesses selling at high free cash flow yields. 14% is a level of yield which feels about right for a true bargain opportunity. However, as time has passed, the reality has sunk in that 'value investing' runs the risk of owning marginal businesses on the decline. More importantly it generally means missing out on what now feels to me like the real bargains available to stock market investors - owning compounders.
 
Back to Munger (as is so often the case): “A great business at a fair price is superior to a fair business at a great price.” As I can attest to the veracity of this through many an example by now, a high free cash flow yield does not always work out well as in investment/speculation. But owning great businesses usually does. There may be a short-term exceptions to this rule (short-term being somewhat meaningless in the attempt to compound capital over time), and that is when you own great businesses at high multiples of earnings, as was the case for many at the start of 2022.
 
Well, back to the portfolio. My top two holdings at the start of the year were Plus500 and Berkshire Hathaway. These made up more than 50% of the total holdings and both rose over the year (the latter due more to currency effects than the share price movement). The other four positions fared less well with Facebook (now Meta Platforms) and Naked Wines being the most injurious.
 
Energy won the year (assuming the market segments were in some sort of a competition); consumer staples made it through without too much pain; UK Homebuilders, Tech and Online Retail saw significant share price deflation as the cost of seemingly everything else rose over the year.
 
The portfolio fell, annoyingly, for the third year of the past 18. The result was -6.3% against +4.7% for the FTSE 100 and -18.1% for the S&P 500 (with dividends included). The first two of these are in pounds, so would be around 10% lower if measured in US dollars (making the portfolio's return only slightly better than the S&P).
 
Whilst disappointing - and even moreso as the three negative years were all within the past five - my hope is that I can be more consistent in my strategy in the future. The goal is to find compounders. This clearly needs work as I remain drawn to what may be broadly termed value, or special, situations. They're fun when they work but all too often they just do not work out as planned.
 
Holdings as at 20 January 2023: Plus500 33%, Berkshire Hathaway 26%, Admiral 18%, Vistry 11%, Green Brick Partners 8%, Meta Platforms 4%.

On Seeking Out Compounders

One of many useful investment aphorisms is that it is a 'market of stocks',  not a 'stock market'. A rational equity investor's goal may well be to seek total returns in excess of those available from passive index trackers. Unfortunately for that investor, the S&P turned in another extraordinary year in 2021. The index rose by 28.7%, with dividends included, following 31.4% and 18.4% total returns in 2019 and 2020, respectively. Extraordinary, to say the least. Meanwhile, yields on Treasurys, Gilts, JGBs, etc, remain at what could be described as 'confiscatory' levels given that current measures of inflation are running at multiples of such paltry returns.

The two above symptoms (a rising market value of the largest listed public companies, and desultory yields on risk-free assets) are very much linked. There may be some debate as to the underlying cause of such symptoms. In my view, four major forces all play a part, namely: (i) ageing populations in more developed countries; (ii) deflationary forces from a plentiful supply of new labour in emerging markets; (iii) deflationary forces from increasingly efficient supply chains; and (iv) Central Banks largesse in the form of major asset purchase programs providing a consistent source of price-agnostic demand for new government debt issuance.

The issue with trying to forecast what the overall stock market will do next based on changing macroeconomic forces, however, is that you need to be correct on three fronts to profit from any forecasts. First you need to be correct in your forecasts (note that many trained economists have been predicting that interest rates will rise for the past 10 years, and have been wrong for the same length of time as a result). Then you need to select the right instrument to translate your forecasts into an investment decision. Finally you need to be correct in your timing, as being right 'eventually' may lead to large interim losses or, more likely, even larger foregone profits from waiting for the predicted storm to arrive.

And so, whatever the stock market may do next (my prediction, as ever, is that it will fluctuate), the various markets of stocks should still provide decent risk-reward or price-value situations for the savvy investor to take up.

This brings to mind Buffett's excellent advice on seeking out fairly priced compounders, which is as follows: "Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, 10, and 20 years from now."

At present such trends as cloud computing and mainstream consumer tech adoption provide tailwinds to businesses that are market leaders in such areas - areas which mark a likely permanent shift in economic activity with related winners and losers. Microsoft and Apple come to mind as winners here. Not coincidentally they are the top two companies in the US by market capitalisation at present, with Apple briefly being valued at over $3tn and Microsoft at $2.6tn within the past week. The questions (for a potential investor to answer) here are twofold. Are their earnings expected to be materially higher five, 10 and 20 years from now and are current valuations what can be regarded as rational prices.

There is no inherent reason that Apple can't keep its earnings rising (from c.$95bn a year at present), but it will have to contend with a shift to the next major computing platform - whatever that may be - constant competition from hardware and software providers and other various business risks that will crop up over time. Microsoft, similarly, could go on compounding earnings (from c.$70bn at present), whilst contending with the deflationary forces that new entrants to cloud computing could bring to pricing models over time. Still, for now, both seem well positioned and arguable cheap (versus Treasuries!). At over 30x current earnings, however, there remains a risk that even if profits increase at a good clip, multiple compression could bring about a lower return than earnings growth over time.

Back to my own little portfolio and returns. 2021 brought a return to form, of sorts, with a 16.8% return following three low return prior years. This was well behind that of the S&P and even behind the FTSE 100's 18.0% total return for the year. I currently hold six stocks and whilst I think all have decent risk-reward or price-value relationships, I feel I can do better by digging a bit harder. I haven't yet succumbed to sitting on obvious compounders and accepting that 10% is a reasonable return (even though I know it is perfectly reasonable), as I still feel 20% is possible with a bit of work.

At the end of the year, the portfolio looked as below, with the following stocks and portfolio positions:

Stock.............Price Paid....Current Price....% Value

Plus500.............£8.10............£13.61................28%

Berkshire...........£160..............£221.................28%

Vistry.................£8.61............£11.84...............15%

Facebook...........£232..............£249.................12%

WPP..................£8.09............£11.20.................8%

Naked Wines.....£6.37.............£6.51..................8%

Here's hoping for a few new ideas to add compounder names that can be purchased at reasonable prices for the year ahead.

On Market Dislocations

The past calendar year was, to put it mildly, an interesting one for investors. The S&P started the year at 3,230 and ended it at 3,756, paying a dividend of around 59 points along the way. You would think that a return of something close to the indexes total return of 18% would have been easy to generate as a result. Yet the market low of 2,237 on 23 March 2020, reflecting the liquidation of risk assets in the face of the first global pandemic seen in 100 years, tested investor's nerves.

As pointed out previously, those who focus on time in the market vs timing the market can ride out such dislocations with relative ease. The dream scenario of selling before the market tanked in mid-February, to then buy back after the significant decline could have easily resulted in a 50%, or greater, gain from market timing alone. Anyone latching on to the relative strength of businesses in commercial cloud, online retail, or other lockdown beneficiaries may have been able to do significantly better.

However, the reality of the situation was that those invested in less attractive businesses probably saw their portfolios decline by of the order of 50% over that turbulent month. Many of these stocks, at the market's lows, presented excellent buying opportunities for those with the fortitude and short-term mindset to benefit from the ensuing 'value rally'. A portfolio of relatively low quality businesses could easily have returned as much as 100% from the market lows to the end of the year.

So much for hindsight. In the midst of the turmoil I managed one intelligent purchase and some very unintelligent sales. The sales mostly came in May, after the worst of the stock market's losses were over, but before there were clear signs (to me at least) that risks of any significant recession (or, indeed, depression) had been avoided.

Whatever the excuses may be, by trying to protect against market declines in late 2020, I held excess cash as markets rallied hard on vaccine approvals announced in November. At the time there were plenty of businesses with good prospects and pessimism baked into valuations to have been able to construct a well positioned portfolio. Knowing that market timing is futile is one thing - staying fully invested through thick and thin is another.

At least holding excess cash can have the benefit of avoiding stupid purchases. By consistently trying to not be stupid, and occasionally having a useful insight into a perceived price-value gap, returns should at least be adequate over time. If those insights are of a high quality and there are sufficiently many of them to create a portfolio of ideas with a margin of safety, then those returns should be more than adequate.

Many years now of observing the results of holding excellent businesses purchased at fair prices has embedded the belief that this really is a better way of consistently trying to not be stupid, and therefore generating adequate returns over time. The better the business and the lower the entry level, the more likely it is that the returns can be better than adequate.

A friend with a low turnover strategy (as trading is a hassle in his job) owns the likes of Facebook, Apple, Amazon, Google and Disney. All excellent businesses and all easily observable at times over the past few years as being available at sensible prices. This does beg the question over whether the time and energy of seeking out brilliant risk-reward situations that need to be replaced with new brilliant risk-reward situations every year or two is worth the time, energy and stress given the alternative of holding excellent businesses for the long-term.

The portfolio generated a return of 0.7% against a decline of 10.6% in the FTSE 100 and a gain of 18.4% in the S&P 500 during the course of 2020. It remains a concentrated set of interesting risk-reward ideas and the goal remains a 20% rate of compounding over time. It is, however, tempting to accept a more subdued (but still excellent) 10% rate of compounding with both less effort and with a lower risk of seeing returns fall far short of the targeted growth rate both in any given year, and also over longer periods of time.

On Speculation vs Investment

The past year, moreover the past decade, has been a wonderful period for investors. It has been less kind to those of a speculative nature (as is, perhaps, the case for all decades!). The total return of the S&P 500 in 2019 was a whopping 31.5%; even the lower quality FTSE 100 achieved a total return of 17.2% for the year. Over the past 10 years the annualised figures are 13.5% and 7.4% for the S&P 500 and the FTSE 100, respectively (measured in local currencies).

And what of the portfolio. Well, 2019 was a year to forget… to put it mildly. Essentially the question of whether putting capital into what I can now admit were highly speculative enterprises was an investment or a speculation has been rather abruptly answered. They were a speculation. Unfortunately, the early gains had the perhaps predictable effect of making them appear lower risk than any rational person could easily have appraised them to be. The opportunity to exit them with significant gains locked in was taken to an almost complete extent during 2018 then, sadly, undone during 2019. Very sadly, the significant gains within the largest holding were all but reversed in 2019 to leave nothing but coal in the place of the 2017 carbuncle stones.

Whilst this speculative episode can have nothing but deleterious effects on any hopes of creating a strong investment track record, in terms of attracting institutional funds, the entire track record was – to some extent – spoiled by the initial foray away from solid investment assets and into the realms of the highly speculative early-stage biotechnology nano-cap universe. With the benefit of hindsight, any straying from sound investment principles was an invitation to the risk of a permanent loss of capital. But the allure of easy gains proved a temptation hard to resist at the time. Perhaps the reasons were partly related to working in a somewhat speculative environment. Perhaps with external capital and the promise of sticking to sound investment principles the initial investments would never have happened. But they did, and the results show the dangers of straying from a sound investment approach.

So, 2019 in portfolio-land was a poor -6.5% return. By way of mitigation, this was after larger losses part-way through the year with August YTD losses of -17% followed by a gain of +12% since the end of August (when the strategy was finally return to one of high-FCF yield investments in unloved enterprises with a long history and some degree of predictability to future cashflows). In a slightly stronger form of mitigation, results for the decade were an annualised gain of 23.6% and a total return of 732%.

Clearly 2019 would have been a lot more profitable and a lot less stressful had I simply followed the sound advice to hold index trackers. The noted cash holdings were a drag on returns (vs the broad indices) at first, and then far worse when transferred into speculative holdings. But what of the decade ahead?

The S&P 500 began the 2010s at a price of 1115 and ended it at 3231; the FTSE 100 began the decade at a price of 5412 and ended it at 7542. Whilst it is impossible to say what the next decade will hold, a repeat of the multiple expansion seen over the past 10 years in the world’s most followed (and possibly most important) index is highly improbable. In the absence of multiple expansion, with a dividend yield of 1.8%, to match the past decade’s returns the index would require earnings growth of over 11% and an absence of multiple contraction to counter-act these positive sources of returns.

11% annualised earnings growth may be possible, but this is partly due to the fact that some potential future market participants such as Uber ($60bn market cap; $6bn in losses over the last 12 months) and Tesla ($87bn market cap; $800m in losses over the last 12 months) will either grow earnings significantly over the next decade or not join the index. Large market constituents such as Apple and Microsoft (with a combined $2.6tn price tag, or 9% of the index’s $30tn total capitalisation) appear to be growing per-share earnings at double-digit rates, but the outlook for these behemoths will need to be at least as good by the end of 2029 as it is today for their earnings multiples (22x and 28x, respectively) to remain in tact.

Perhaps passive index tracking is, indeed, the best solution; it certainly appears to be for the vast bulk of investors. Much of the portfolio’s returns during the 2010s was from a sweet spot in the first half of the decade where earnings grew strongly, and multiples expanded markedly – especially for smaller companies. With multiples now at elevated levels for quality businesses and with the economy towards the tail-end of an expansionary phase, growth in asset prices will be harder to come by. But the fun of trying, and the challenge of doing so, means it is likely I’ll keep plugging away. Compounding capital at over 20% annually for a decade may be a tough challenge, but challenges are there to be met and it is heartening to know that the portfolio managing this elusive goal over the past decade, albeit with some significant fluctuations along the way!

On Market Timing

Whilst I mused on the difference between investment and speculation in January of last year, the reality of what constitutes market risk hit many full in the face from October to December of 2018. Fears of ‘trade wars’ hitting economic growth, combined with other reasons provided by the commentariat led to sell orders, fund redemptions (requiring more sell orders to meet year end redemption notices) and broadly a preference for cash over shares as the calendar year rolled over.

For those who held their nerve (or more accurately their stocks) through this period, I suspect many will be nursing significant losses where their holdings were either unconventional (or simply bad) investment ideas. As for differentiating between the two, I am increasingly of a mind that for something to work truly spectacularly, it is likely to be seen by the majority as unconventional (or simply bad), as investment ideas go.

In the world of the fully invested quality investor, however, it does not seem to me that much has really changed through what is being termed by many as recent market turbulence. The broad indices are close to (around 10% off) their all time highs. Interest rates are still low, which should keep risk assets priced at high levels vs their expected future cashflows.

It is a near certainty that a significant rise in interest rates would mean lower share prices in a general sense. With government bonds yielding historic lows, the temptation is to assume mean-reversion and expect a poor stock market performance. But over what time-frame is the question. And, more importantly, what else is there to do with your capital over that period?

One remedy for the dilemma of trying to time markets, as I have previously noted, is simply not to do it. Just hold good businesses and when bargains are few and far between, accept that the quoted value of your portfolio may ‘suffer’ from higher discount rates or lower expected future cashflows. Over time, however, the benefits of being a holder of equities should fully compensate the mental anguish that may (or may not) be caused by swings in quoted values.

Another path, and the one that I chose to select in late 2018 as my more speculative holdings were hit harder than the broad market, is to move to cash. And cash, whilst yielding next to nothing at present, at least has the advantage of not going down in a market decline. It offers optionality to the holder over possibly lower future share prices. And yet... it could simply be a form of market timing to say that cash is more attractive than holding shares at any given time.

The dilemma is solved, to some extent, by revisiting what exactly are your investment goals. If you are in the protection-of-capital-with-slightly-better-than-the-broad-market-growth-camp game, then being underinvested for even short periods can harm performance over a long period (witness the January 2019 market bounce). If you are in the significant-outperformance-and-high-compound-rate-of-growth game, then avoiding drawdowns and protecting capital by seeking out favourable risk-reward situations with limited expected downside and good upside potential may require periods of holding cash. Is this market timing? Possibly. Is it speculative? Probably. But at least by returning to the core of what it is that you are trying to achieve with your portfolio - and thinking through the strategies with which you wish to achieve your goals - can lead to periods of holding cash in some instances.

As for the portfolio’s performance itself, 2018 brought huge growth on top of the 2018 high performance... until the summer came... and then it all went into reverse. The total return for 2018 was positive in cash terms, but brought my first negative return (-1%) in money-weighted terms. I held cash into the end of the year as I cared (somewhat ridiculously) about the -1% figure and didn’t want it to get worse. To then view various businesses I had recently owned (and liked at current levels) bounce by 10-20% in January, was a lesson in the ill potential of trying to time markets vs just sitting through the potential turbulence in quoted prices.

In any case, if the goal is a 20% compound rate of returns over a long period of time, a few months of performance is unlikely to affect the broad outcome. But taking that goal, and trying to achieve it with cash for any extended period is unlikely to work particularly well. Owning solid, sensible, large-cap businesses is also unlikely to meet the above goal (unless the starting point is a more subdued price environment than exists in early 2019). And so, it’s a case of keeping the gun loaded, looking for targets, and waiting to pull the trigger when prices are at attractive levels. A more speculative approach than the conservative investor would hope to employ, but one which can at least benefit from market dislocations should they come about again... and they do have a tendency to come around from time to time.