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.