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2020 Portfolio Update

Performance Overview

For Q4 2020, the portfolio is up 13.21% and finished the year up 23.47%. The Q4 starting balance was $96,383.61, and finished the quarter at $113,027.88. Contributions to the portfolio during the quarter amount to $3,656. 

No stocks were bought or sold during this quarter. During October and November I owned some SPY puts as tail hedges, but I let that position run off in December. 

The current allocation of the portfolio is shown in the chart below. Currently, the portfolio  consists of discretionary value stocks, oil tankers, deep value, 401k stocks, precious metals, and cash. It can be seen that 66.7% of the portfolio is in stocks, while 33.3% is in cash and safe haven assets. I would prefer to deploy more of the cash to undervalued stocks, but I am remaining cautious despite the market ripping higher towards the end of the year.

During the quarter I received $427.04 total in dividends, which is broken down in the table below.

TickerQuarterly Dividend 
FF8.28
BBSI10.50
FRO81.50
STNG6.80
FE48.75
DHT43.00
RELL24.30
FRD7.06
RSKIA88.62
EMR42.93
COF5.50
SPG59.80
Total427.04

My Thoughts

2020 in Review

Going into 2020, my portfolio was a mess. Once upon a time, I was going for a multi-asset strategy. My portfolio consisted of value stocks, emerging markets, commodities, precious metals, money market, and tail hedge puts. In mid-2019 I sold my value stocks to buy a house, which created a gaping hole in my portfolio that remained early in 2020. As the market started to react to COVID, I quickly tried to get my portfolio in order. The primary focus was to reorient my portfolio to mostly focus on value stocks, and taking advantage of the market selloff to buy some quality companies at a discount.

One of the key factors that shaped this year’s performance was holding about $500 in SPY put options. The idea is that they would provide a buffer so that the portfolio could break even even if the market dropped by 20%. In late February these options were doing their job, so I sold them at a value of about $9,000. In hindsight I should have held onto them into March, but I can’t complain. The rest of the portfolio was primarily cash, plus stocks from my current 401k, and some precious metals.

The proceeds of this hedging was used to buy the first batch of quality companies. In March, I bought Capital One, Emerson Electric, and Simon Property Group. To my surprise, the market panic didn’t last long, so the deals quickly dried up. 

During April and May I jumped onto the oil tanker trade. While the thesis played out, these companies made a ton of money, the stock returns have been abysmal. I probably bought these stocks at the peak, but that’s the way it goes. 

The summer months saw me dip my toe into buying deep value stocks. These are stocks that traded at less than 5 times enterprise value over EBIT. Most of the companies I bought were microcaps, which have a market capitalization of less than $300 million. I didn’t know it at the time, but my timing in buying these stocks was great. The deep value universe got slaughtered during the March selloff, down around 50%. During the summer these stocks turned the corner and rallied all year so that they ended the year down only 7%. 

In August I bought some First Energy hoping their bribery scandal is overblown. Finally during the fall I started up the tail hedging strategy again in case of worsening COVID, no stimulus getting passed, and election drama. All of those things happened, but the market ripped higher on vaccine news, causing me a small loss on my SPY puts.

It felt like there was a lot of action in 2020, however I also tried to be measured in my capital allocation. Most of the year I carried a large cash balance, waiting for another chance to buy some undervalued stocks. In hindsight I should have gone all in, but I’d rather act conservatively and survive as an investor.     

Luck vs Skill

While I am proud of my performance this year, I am trying to reflect on my decision making. Many of my decisions, and outcomes, were the result of some part skill. However, I am aware I had some lucky tailwinds as well. Since I can be jealous sometimes, I also look at other investors and wonder how much of their results were based on luck or skill. 

The way I see it, there is a spectrum of complete luck (roulette wheel) to skill (chess), and most things fall in the middle. Everything in investing probably has some degree of luck involved. But there is a difference between making sound, well thought out decisions, and speculating without even being able to provide a thesis besides “stocks only go up” or “it’s different this time”. It is probably impossible to quantify luck vs skill in investing, but I’m going to ramble on a bit anyways. 

I’m not sure if it was luck or skill that I was hedged in February. The outcome of this hedging dramatically impacted this year’s performance. 

I chalked it up more towards skill that I was buying in March when everyone was panic selling. On the flip side, if Great Depression 2.0 happened, I’d probably be complaining that I pulled the trigger too early. 

Perhaps I got on board with the oil tanker trade too late, my timing being bad luck, or maybe it was a lack of skill. 

The deep value universe was turning the corner right when I was buying in the summer. I’ll take this lucky timing since Paul Mueller Co, Barrett Business Solutions, Friedman Industries, and Spark Components have really helped me out. 

During the summer, Emerson was up 50%. It was tempting to sell it and get those quick gains. However I am trying to be more disciplined and hold my stocks longer, which worked out because now Emerson is up nearly 100%.

I think you can see there are arguments for luck and skill in many of my decisions. As I look around, I wonder about other investors (or speculators). Is betting on government stimulus, accommodative Federal Reserve, record vaccine development luck or skill? Is it luck or skill to buy cruise ships, airlines, Zoom, NIO and the like? Good for the people who made massive gains this year, but it would probably be wise to reflect on your decision making. 

One issue with the stock market is that many people focus on the short term. This short termism makes it easy to think the market is just a casino. Instead, I view owning stocks as owning a slice of a business. Holding a stock for the long term reduces the role of luck since the returns are more driven by business economics. I believe having a long time horizon, and taking advantage of behavioral psychology, allows an investor to make their own luck. 

Rationality and Wealth

It seemed like a lot of people lost their minds in 2020. I wish more people would think like Charlie Munger when he says “I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do”. Too many people fill their minds with toxic information, surround themselves with toxic people, and allow their cognitive biases to be exploited. An idea that I am developing is that you can’t build wealth (whether that is financial, or in mind/body/spirit) without rational thought. By rational, I mean thought based on first principles, facts, logic, reason, and removing your biases from the equation. You can get rich being irrational, but I think you will have a hard time building long term wealth without being rational. 

Discretionary Summary

Discretionary value is the label I’m giving to the positions that are fairly large (~5% of the portfolio) I believe are undervalued and may have the following characteristics: quality business, competitive advantage, misunderstood by the market, or a good company in a heavily sold off industry. The current discretionary value stocks I own consist of Capital One Financial (COF), Emerson Electric (EMR), Simon Property Group (SPG), and FirstEnergy (FE). The table below shows the cost basis, current value, and gains/losses for these positions.

Avg PriceCost BasisCurrent ValueCurrent Gain (Loss)
COF63.253,478.755,436.7556.28%
EMR41.003,485.006,831.4596.02%
SPG74.503,427.003,922.8814.47%
FE28.003,500.003,826.259.32%

There has not been a lot of news to report with these stocks. Simon Property Group announced the acquisition of Taubman Centers (TCO), which should close early in 2021. This deal was supposed to happen early in 2020, but it was called off due to COVID19. At least now SPG will pay $43 a share for Taubman instead of the original $52.50. 

FirstEnergy drama has deepened this quarter with the firing of their CEO and a couple other executives for misconduct. The company hasn’t disclosed yet what this misconduct was. While FE is looking a little more guilty at the moment than when I made my purchase, the stock has not sold off. I will continue to monitor this company, hopefully the bad news is overblown and the stock will revert back to its pre-scandal levels once the investigation progresses. 

Tanker Stocks

Tankers have continued to be disappointing, despite their great profitability this year. Oil tanker spot rates went from a massive peak to a massive trough. Luckily most these companies have used their abnormal profits to shore up their balance sheet. Now that the tankers have to pay less interest on their debt, the break even spot rate is much lower.  Recently steel prices have had a large increase, which hopefully means people will be scraping their old tankers soon. One dollar increase in steel prices increases the scrap value of a VLCC by $40k.  Plus, less supply of tankers equals higher spot rates to ship the oil. 

Avg PriceCost BasisCurrent ValueCurrent Gain (Loss)
DHT8.171,755.901,124.45-35.07%
FRO10.661,738.291,013.86-41.67%
STNG26.631,742.67760.92-56.34%
TNK23.861,765.88814.74-53.86%

Deep Value

Deep value is a sub-strategy I’m employing in my portfolio. This a quantitative strategy that buys a basket of statistically cheap stocks. The metric I use is EV/EBIT, based on the wonderful book The Acquirers Multiple. Historically, this strategy has provided excellent returns, although it has not kept up with the S&P 500 the past few years. Additionally, I am making an effort to apply this strategy to microcap companies. Microcaps are classified as having a market capitalization between $50M-300M. These small companies are more volatile, but have the potential for attractive returns.

My position sizing is smaller than the discretionary side of my portfolio because I want to own a basket of about 20 stocks. Since this is a quantitative strategy, I do not spend much time analyzing these businesses. The main idea is that these companies are trading at very cheap valuations, and the winners will (hopefully) outnumber the losers. 

Avg PriceCost BasisCurrent ValueCurrent Gain (Loss)
BBSI50.501,767.502,387.3535.07%
FF13.001,794.001,752.60-2.31%
FRD5.101,800.102,421.5834.52%
HXL36.801,803.202,376.0131.77%
MUEL26.001,768.002,257.6027.69%
RELL4.451,802.251,907.555.84%
RSKIA8.251,740.752,126.8822.18%
SPRS1.311,819.303,074.7069.00%

401k and Precious Metals

My 401k is through my current employer and actively receives contributions. The 401k consists of a Blackrock Target Date Fund (which is no longer being funded), and the Oakmark Fund. The Oakmark Fund is a large cap value fund. Since I am actively contributing to my 401k, it will naturally have a growing influence on my portfolio. 

I also have a decent allocation to precious metals that are used as a bond substitute, recession and inflation hedge. The table below shows the YTD performance for the precious metals and 401k, which includes the effects of contributions.

12/31/1912/31/20YTD Gain (Loss)YTD Contributions
Precious Metals$7,861.00$9,964.0030.52%
401k$12,871.20$32,252.4314.59%$14,108.00

Tail Hedging

During October and November I implemented the hedging strategy that I had on early in the year. My initial position in October was buying $495 worth of SPY puts. In November, I sold the first batch of puts for $50, and bought another batch for $487. This second batch was sold in December for $175, and I haven’t bought any more since then. The net loss for this hedging was $757, or about 0.67% of the portfolio.

Books I’m Reading

The main book I read this quarter was The Philosophy Book: Big Ideas Simply Explained. Prior to this book, the only other philosophy work I have read was the classic Stoicism work “Meditations” by Marcus Aurelius. Whenever I would venture to Wikipedia to read about a philosophy concept, I would get bogged down by all the jargon. This book finally built the foundation for me to understand the high points of philosophy. In fact, I wish I would have read something like this a long time ago because I found the material extremely interesting. Not only does reading about philosophy feed my natural curiosity, but it applies to investing as well (maybe not the weird metaphysical concepts). Understanding why people do the things they do is very important to navigating the investment world. Maybe soon I’ll dig into a specific philosophical work like “On Liberty” by John Stuart Mills… 

Cable Cowboy: John Malone and the Rise of the Modern Cable Business is a book I received for Christmas and read within a few days. This book is about John Malone, and his career building TCI and Liberty Media. I was not familiar with Malone, but I knew he was renowned as a great capital allocator so I was looking forward to learning more about him. Malone took over as CEO of TCI in the early 70’s, and transformed the nearly bankrupt company to a cable giant. Once he sold off TCI, Malone has focused on Liberty Media, which he still controls today. Malone’s capital allocation is different from Buffett’s, he utilized debt and focused on cash flows over GAAP earnings. Reading this book makes me want to dig more into cable and media companies in the future. 

For more value investing content check out:

How Berkshire Acquired National Indemnity

Book Review: Buffettology

Intro to DCF Analysis Part 1

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How Berkshire Acquired National Indemnity

This post contains affiliate links. If you use these links to buy something I may earn a commission. Thanks for your support.

The book “Capital Allocation: The Financials of a New England Textile Mill” is a must read for anyone interested in the history of Berkshire Hathaway. One of the first big moves Buffett did once he took control of Berkshire was to acquire the property-casualty insurer National Indemnity. In this post I wanted to go back and review the details of this acquisition, trying to put things into context. Some of the things I was curious about were “how big of an acquisition was this relative to Berkshire?” and “how did Buffett pay for it?”. But first, we must travel back to the mid 1960’s… 

Berkshire in 1967

Before we get into the acquisition of National Indemnity, let’s get a picture of what Berkshire looked like in the mid/late 60’s. When Buffett took control of Berkshire in 1966, it was a struggling, capital intensive textile mill. One of Buffett’s first tasks was to optimize the company’s overhead expenses, capital expenditures, and working capital needs. This freed up cash that could be put to better use, like buying marketable securities. 

In 1966, the textile business made about $2.6 million in net income, while the investment portfolio produced about $166k in realized gains. The free cash flow for Berkshire in 1966 was about $5 million. For 1967, the textile business actually lost money, with a loss of about $1.3 million. The newly acquired insurance operations and the investment portfolio bailed out the company by allowing Berkshire to have a total net income of $1.1 million. Revenue for the textile operations fell by 24% from 1962 to 1969. Clearly the industry was challenged, so diversifying Berkshires income stream was a wise move by Buffett.

Assets

Berkshire’s investment portfolio ending in 1966 had a market value of $5.4 million, with approximately the same cost basis. A majority of the portfolio, 87%, was in bonds. The high ratio of bonds was probably due to Buffett holding some capital in reserve for an acquisition. Following the acquisition of National Indemnity, Berkshire’s investment portfolio was booked at a cost of $3.8 million. This portfolio had a market value of $6.8 million, a nifty 77.5% gain in one year. The investments were always recorded on the books at cost instead of market value. Berkshire reported a total of $38 million in assets in 1967. This figure would have increased by 7.9% if the securities were booked to market. 

Valuation

During this period, Berkshire often traded below book value, getting down to 57% of book value in 1967. The market cap for Berkshire ranged between $16.8 million, and $20.9 million ($167 adjusted for inflation) in the year that it purchased National Indemnity. Next we will take a look at National Indemnity’s business, and see how a $20 million company acquired the insurer for $8.6 million.

National Indemnity

National Indemnity was a property and casualty insurer founded by Jack Ringwalt in 1940. Another insurance company, National Fire & Marine Insurance Company was an affiliate to National Indemnity. Buffett purchased 99% of these two companies in March of 1967 for $8.6 million. For comparison, this equates to $67 million in 2020 dollars. 

NI’s Income

During this time, Berkshire was a capital intensive industrial company, which meant it had very low returns on equity. Buffett realized that a smart strategy would be to redeploy cash from the textile business into a business with a higher ROE that didn’t constantly require upgrading machinery. National Indemnity had a decent ROE that averaged about 11%. The insurer was also growing, having grown premiums at 21% and net income by 15% for the last decade. Average net income for NI was $437,000, while 1966 was an outlier with $1.4 million in profits. 

Float

When insurance companies receive premiums, they hold it as a reserve called float. This float can be invested to generate extra income for the company, which is another feature that attracted Buffett to the insurance business. Sometimes insurance companies will write policies that are underpriced, meaning that they end up paying out more for damages than what they received in premiums (they would also hope their investment returns bail them out in the scenario). This would indicate that the float has a negative cost. On the flip side, if the insurer wrote good policies, they would make money on the premiums. This effectively means the float will have no cost. The cost of float generated by National Indemnity was cost free for 6 of the last 10 years prior to the acquisition.

The value of the NI’s float at the time of Berkshire’s purchase was about $17.5 million. The investment portfolio of float was mostly made up of bonds. Additionally the company had a stock portfolio that was about the same size as the shareholders equity. From Buffett’s perspective, he is practically buying a portfolio of stocks and bonds that he could surely optimize for better returns. Just by increasing the investment income on the float by 1% would generate an additional $175k in net income for Berkshire.

While Buffett went on to buy other insurers, namely Geico, National Indemnity is where it all started. To put into context Berkshire’s achievement, in 1967 National Indemnity wrote $12.7 million in premiums. State Farm was the largest property-casualty insurer of the era, with premiums totaling $800 million. Fast forward to 2019, and State Farm is still number one in premiums. However Berkshire is right behind them in second place.      

The Purchase

So how did Berkshire acquire a company that was nearly half its size? To fund the purchase, Buffett pulled capital out of the textile business, issued some long term debt, and liquidated some of the investment portfolio. For the textile operations, Buffett optimized the accounts receivables, accounts payable, inventory, and PP&E in order to pull out $4.6 million. Berkshire then issued $2.6 million in 20 year debt at 7.5% interest. Finally, the marketable securities portfolio was reduced by $1.6 million. To me, this is a little interesting that Buffett wasn’t afraid to issue a little debt. He is usually says he is against debt. Additionally, the way Warren pulled out that much capital from the textiles goes to show that he deeply understands the operations of a business.  

The book Capital Allocation also discusses a unique way to think of this transaction. When purchasing NI, Buffett was getting a company with a tangible net worth $6.7 million. These securities could then be deployed to marketable securities. Now Buffett was already holding a portfolio of marketable securities of around the same size. So in a sense, Warren is trading his portfolio for National Indemnities portfolio, plus chipping in an extra $1.9 million to get to the full purchase price. Using this mental accounting, National Indemnity operating business was bought for this $1.9 million premium. If we compare the subsequent profit generated by NI to this “purchase price”, we see some absolutely astonishing returns. 

Conclusion

Capital Allocation is probably my new favorite business history book since I love nerding out over early Berkshire’s financials. This book shed light on one of the seminal moments in Berkshire’s history. Buffett transitioned the company from a capital intensive textile mill to the giant it is today. The acquisition of National Indemnity set the stage for Berkshire to grow from a $20 million textile business that no one cared about, to the $500 billion behemoth it is now.

For more value investing content check out:

Q3 2020 Portfolio Update

Intro to DCF Analysis Part 1

Book Review: Buffettology

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Book Review: Buffettology

This post contains affiliate links. If you use these links to buy something I may earn a commission. Thanks for your support.

Woo! My first book review. A while back, I stopped in my local used book store and saw that they had the 1999 classic: Buffettology. This book was a quick and enjoyable read, much like the Warren Buffett and the Interpretation of Financial Statements from the same authors. As a hardcore Buffett fan, most of the concepts in this book were not new for me. However, I believe this book provides an excellent foundation for new investors or those who have only participated in the speculative side of the market. While the book has a lot of good information, in this Buffettology book review I wanted to highlight my two big takeaways: thinking about stocks as a business owner and owning quality businesses.

Business Mindset

One of the key takeaways from Buffettology is that stocks are a fractional share of a business. When you own a stock, you are a partial owner of that enterprise. For example, if a company had 1 million shares outstanding, and you owned 10,000 shares, then you would own 1% of that company.

Realizing that you are a business owner when you own stock helps create a long term mindset. This is opposed to the short term, constant buying and selling commonly associated with the stock market. With a business owner mindset, would you rather own a great business that compounds at 10% a year for decades or sell a stock after six months to make a 20% profit quickly?

Another aspect of thinking of stock as owning a business is that the share price by itself is meaningless. A stock trading at $1,500 a share may be cheap, while a stock trading at $2 a share could be expensive. That is because stock prices are more than just some numbers that fluctuate on a screen. A stock price is telling you what the market currently thinks the business is worth, but that is only useful when you compare it to the profits generated by the company.  The $1,500 a share company could have profits of $500 a year, while the $2 company might only generate a penny of earnings. The $2 company is not a bargain.

Since looking at giant corporations can be confusing, I like to think about this concept using a simple example. Imagine your friend is trying to sell you their ice cream stand. Probably before you even looked at the selling price, you would look at its financials. Is this ice cream stand profitable, by how much, and are the profits stable? If the ice cream stand makes $10,000 a year in profit, what would be a reasonable price to pay?

Buffettology explains that the price you pay for a business determines your rate of return. Let’s say you paid  $100,000 for this ice cream stand, which would generate a 10% return. Not bad. Alternatively, if you paid $1 million for this ice cream stand because they have this new flavor that is the best thing since Rocky Road, well, you would likely earn about 1% a year. When you can see how much earnings the business has, you can determine the price you are willing to pay for that stock by determining your desired rate of return (there is more to business valuation than this, but it’s a good basic concept).

Thinking about stocks as partial ownership in a business is a key aspect of my investing philosophy. One of my favorite Buffett quotes is, “Investing is most intelligent when it is most business like.” I think for someone new to investing, or someone who trades the market in a speculative manner, Buffettology does a good job introducing investing from a business owner perspective.

Quality Companies

Now that Buffettology has laid down the foundation for how Warren Buffett thinks about stocks, the book spends some time defining what a good business is. Most businesses are mediocre, or just plain bad. Searching for quality companies is like a process of elimination. It can make your life easier because you filter out all the mediocre businesses in order to focus on researching the gems.

The book introduces the concept of “consumer monopolies”. These are businesses that have a popular brand name, patents, or secret formula. Think of companies like Coke-Cola or Nike that have products that are “must have” for some people. Another example was when newspapers existed, a city with a single newspaper had a monopoly on all newspaper ad revenue.

A thought experiment described in Buffettology used to test if a company has a consumer monopoly is to think about what it would take to create a better competitor from scratch. If you had access to billions of dollars and top managers, could you overtake Coke? Probably not.

There are many benefits to consumer monopolies that attract Buffett’s interest. These businesses are typically very profitable. Even better, these profits are consistently increasing. Poor quality businesses have erratic earnings that make it difficult to predict your rate of return. Consumer monopolies are often low tech, and often have products that are easy to make. This differs from companies that must constantly invest in R&D or build complex factories to stay competitive. Finally, consumer monopolies typically have low debt, since they’re business grows just fine without it. Low debt is a major factor I look at when analyzing companies. It’s hard for a company to go bankrupt with no debt.

Warren Buffett often talks about business having a “wide moat” to defend itself from competitors. These moats are the consumer monopolies as described in Buffettology. For my discretionary stock picks like Capital One, or Emerson Electric, I am definitely thinking about whether these are quality companies with consumer monopoly.

Conclusion

Buffettology is now my go-to book recommendation for anyone who wants to be introduced to the value investing philosophy. As a value investing nerd, I have a few nit picks such as the valuation method used, and the implications of low interest rates (the book is talking about 5-7% rates!). Towards the back of the book, there is a list of companies the authors believed are consumer monopolies. One of these days I want to go through this list to see how these consumer monopolies did 20 years after the book was published! Hope you enjoyed my Buffettology book review

For more value investing content check out:

Q3 2020 Portfolio Update

Intro to DCF Analysis Part 1

The Many Flavors of Value Investing

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Valuation: Intel vs TSMC vs AMD

Recently, Intel announced the delay of its 7-nanometer integrated circuit process. Affected by the news of Intel’s delay, Intel stock moderately sold off. At the same time, Intel’s competitors AMD (Advanced Micro Devices) and Taiwan Semiconductor Manufacturing (TSMC) have seen their stock prices rise sharply. Given the recent hype in technology stocks, AMD and TSMC stocks have been very hot recently. I think Intel’s sell-off has been exaggerated, while the valuations of AMD and TSMC suggest unrealistic growth. The purpose of this article is to perform a fundamental DCF analysis of Intel and compare it with the valuations of AMD and TSMC.

Background

The narrative is that Intel’s latest chips will be delayed, their rival AMD will gain the lead by selling 7nm devices. AMD does not produce its chips. Instead, AMD signed a contract to produce its circuits with Taiwan Semiconductor Manufacturing Co (TSMC), the largest IC contract manufacturer. As another twist, Intel has stated that if they need a backup plan, they will have TSMC produce some of their chips. The market is interpreting this announcement as Intel is doomed and that AMD and TSMC will grow like crazy. This is reflected in the share price of these stocks, which is shown below. 

Both AMD and TSMC stock prices have gone parabolic lately. Part of this is from Intel’s news, while a lot of it is their gains are from the recent tech stock mania.

By doing a rough DCF valuation on these companies, I believe Intel is reasonably valued. As for AMD and TSMC, I believe the market is pricing in unrealistic growth. The narrative may be true, that Intel loses market share. Maybe Intel becomes the next IBM, being less relevant than its glory days. On the flip side, I believe overpaying for a stock is far riskier than scary headlines. Value investors look for times when negative news is overblown, and the stock can be bought at a discount.

Intel DCF

First, let’s estimate the value of Intel using a discounted cash flow model. Intel’s free cash flows for the last few years, plus trailing-twelve-month, are shown in the table below. I’ll use the average of these FCF figures in my model by using $15B as the input. Over the last five years, Intel has grown revenue at 7% a year. I will handicap this a bit by using a 5% growth rate for the next ten years. For the growth rate beyond year 10, I will use a value of 2%. The last input to the model is the discount rate, which I will set to 10%. These values estimate the value of Intel at $51.20 a share. Currently, Intel is trading for around $50 a share.

201720182019TTM
10.33B14.24B16.93B21.9B
Intel Free Cash Flow

Based on this analysis, Intel appears to be fairly valued. It may not be a screaming bargain, but it is trading at a reasonable business valuation. I believe the market’s narrative is exaggerating Intel’s troubles. It is quite possible that you could buy Intel, and the business produces a 10% average return. As we will see, I do not believe that is the case with AMD or TSMC.

TSMC DCF

Next, we will perform the same calculation on TSMC. The table below shows TSMC’s recent free cash flow figures. An average free cash flow value of $7.3B seems reasonable, so that will be input into the model. In the last five years, the income growth rate is 8%, so we assume that the cash flow in the next ten years can grow at this rate. The terminal growth rate and discount rate are the same as the Intel example. These DCF inputs yield an estimated value of $27.25, while TSMC currently trades around $79 a share.

201720182019TTM
8.56B8.41B5.16B5.16B
TSMC Free Cash Flow

As you can see, there is a significant discrepancy between my estimate of what TSMC’s business is worth compared to what the market thinks. Perhaps I underrated TSMC’s growth rate since the narrative is that it will gain market share on Intel. Let’s try redoing the calculation by using a 15% free cash flow growth rate instead of 8%. This produces a value of $42.80 per share. Ok, how about we try an even more optimistic growth rate of 20%. The DCF outputs a value of $59.15 per share for TSMC, still significantly below what it currently trades at.

Another technique I like using when looking at stocks is performing a reverse DCF. This is done by specifying the current cash flow, discount rate, and current stock price. Then address the growth rate instead of the business value. This can help investors understand what kind of growth the market is pricing in stocks. Through this exercise, based on TSMC’s current prices, the market estimates a ten-year growth rate of 25%.

I believe a 25% growth rate for TSMC is rather optimistic. Many companies can grow at high rates for short bursts, but it is difficult to sustain greater than 20% growth for ten years. It is possible TSMC could pull it off, but I assign a pretty low probability to this.

AMD DCF

Finally, in our Intel 3-way show off, we will calculate the value of AMD. The recent cash flows are shown below, and we can see 2017 and 2018 cash flows are negative. The 2019 FCF figure is slightly positive, and the TTM number is the highest in this series of data. To be generous, we use the round number of $600M. In this example, I will use a 7% growth rate, which is why AMD’s revenue has been growing in the last five years. With these inputs, the DCF produces a whopping $9.70 for AMD’s shares…AMD currently trades at $78.

201720182019TTM
-101M-129M276M611M
AMD Free Cash Flow

To give AMD the benefit of the doubt, let’s recalculate its value using higher growth rates. Using a 15% growth rate produces a value of $15.95, while a 20% growth rate yields $21.90 a share. Both of these are well below what AMD currently trades at.

Using the reverse DCF, we can see how much growth the market is pricing in. This technique shows that AMD would have to grow at 40% per year for ten years straight to justify its value. This growth rate is completely unrealistic. Sure, the stock price of AMD has skyrocketed lately, but the business hardly makes any money. The price of AMD makes no sense when looking at it as a business. Instead, the market is valuing AMD based on its narratives, making increased profits from AI, self-driving cars, cryptocurrency mining, and, most recently, gaining market share from Intel. These could all come true, but an investor must pay a reasonable price for growth.

Conclusion

As a value investor, I try to find situations where the market hates a stock or industry. Usually, these narratives are exaggerated, which creates opportunities. The market has also exaggerated potential growth, which has resulted in stock transactions that are much higher than actual growth rates. With this post, I tried to show that the market is pessimistic towards Intel. Still, it is trading at a decent business valuation. Intel’s competitors, however, are trading at values that imply unrealistic growth. AMD and TSMC may continue to do well in the short term, but valuations matter over the long term.

For more value investing content check out:

Q2 2020 Portfolio Update

Intro to DCF Analysis Part 1

Intro to DCF Analysis Part 2

The Many Flavors of Value Investing

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Q3 2020 Portfolio Update

This post contains affiliate links. If you use these links to buy something I may earn a commission. Thanks for your support.

Performance Overview

For Q3 2020, the portfolio is up 4.49% and is up 9% year to date. The Q3 starting balance was $89,241.80, and finished the quarter at $96,383.61. Contributions to the portfolio during the quarter amount to $3,135. 

No stocks were sold during this quarter, but nine new positions were added. The nine companies I have bought are Barrett Business Services (BBSI), Hexcel (HXL), Friedman Industries (FRD), George Risk Industries (RSKIA), Paul Mueller Co. (MUEL), Richardson Electronics (RELL), Surge Components (SPRS), FutureFuel (FF), and FirstEnergy (FE).

FirstEnergy is a sizable position, while the rest of the purchases were smaller allocations. FRD and RELL were net-nets (trading below net current asset value) at purchase. The rest of the smaller positions make up my foray into deep value investing, meaning they trade at very low EV/EBIT ratios. Many of these stocks are microcaps, meaning their market capitalization is below $300 million.

The current allocation of the portfolio is shown in the chart below. Currently, the portfolio  consists of discretionary value stocks, oil tankers, deep value, 401k stocks, precious metals, and cash. It can be seen that 69.8% of the portfolio is in stocks, while 30.2% is in cash and safe haven assets. I would prefer to deploy more of the cash to undervalued stocks, but I am remaining cautious despite the market surging during the third quarter.

During the quarter I received $318.08 total in dividends, which is broken down in the table below.

TickerQuarterly Dividend 
FF8.28
BBSI10.50
FRO81.50
STNG6.80
DHT103.20
EMR42.50
COF5.50
SPG59.80
Total318.08

My Thoughts

This quarter has been pretty drama free for my portfolio. The pandemic and economic difficulties have appeared to mellow out…but I wouldn’t be surprised if there is more trouble on the horizon. Despite my cautiousness, I did some buying this quarter. My goal of building out about 20 deep value positions started this quarter, with my purchase of eight companies. For the foreseeable future, I want to move towards an allocation of 70% stocks, 30% safe haven assets. I believe this will allow me to put some cash to work, while also having some ammo if the market corrects again. 

As for the market, it still appears irrational. Everyone and their plumber is making easy money in the market right now. Everything seems easy when the market keeps going up, but let’s not forget everyone freaking out in March. I strongly believe there is a difference between gambling speculation and investing (ok oil tankers are a speculation, but at least there’s a reasonable thesis behind it). I’m here trying to build wealth, not make quick gains. 

Also, the election is coming up, which I’m sure will be completely drama free…but if you think your portfolio is going to tank because the other guy won, well, you’re doing it wrong. As Buffett has said, don’t bet against America. Our businesses and country have been the place to be for 200 years. And if you’re that worried about a Great Depression 2.0, then you can always invest in a resiliant multi-asset portfolio.

Discretionary Summary

Discretionary value is the label I’m giving to the positions that are fairly large (~5% of the portfolio) I believe are undervalued and may have the following characteristics: quality business, competitive advantage, misunderstood by the market, or a good company in a heavily sold off industry. The current discretionary value stocks I own consist of Capital One Financial (COF), Emerson Electric (EMR), Simon Property Group (SPG), and FirstEnergy (FE). The table below shows the cost basis, current value, and gains/losses for these positions.

Avg PriceCost BasisCurrent ValueCurrent Gain (Loss)
COF63.253,478.753,952.313.61%
EMR41.003,485.005373.4559.93%
SPG74.503,427.002975.28-13.18%
FE28.003,500.003,588.752.54%

FirstEnergy

FirstEnergy (FE) is an Ohio based electric utility company. FE services Ohio, Pennsylvania, West Virginia, Virginia, Maryland, New York and New Jersey. The reason FE is cheap is because it has been caught up in a bribery case involving Ohio Bill HB 6. FirstEnergy contributed to a political action committee to support this bill. This piece of legislation deals with the bankruptcy of FirstEnergy’s previously owned nuclear power plants.

These nuclear plants were spun off from FE a few years ago, into a new company called First Energy Solutions (now named Energy Harbor). FirstEnergy’s management separated from spin off three years before the HB 6 bill was proposed, and FirstEnergy Solutions went bankrupt a year before HB 6. FE management claims they did nothing wrong. Based on the info so far, it appears FE washed their hands of the nuclear plants years before the bill, and the legislation does not benefit FE that much. 

Part of my strategy is to find stocks that are heavily sold off from negative news. These situations can create opportunities because oftentimes the market becomes overly pessimistic on the stock. I believe FE has a good chance of coming away clean from these allegations, but I will monitor the situation in the coming quarters. 

This holding could either be a “value flip” or a longer term, bond substitute that will protect against inflation. Once this negative news gets settled, it is possible FirstEnergy will revert back to its pre-selloff price. I purchased FE at $28 at share, and it was trading around $45 a share before the negative headlines. While I wait for this reversion, I will get a safe 5.5% dividend yield and hopefully enjoy the low volatility typically associated with utilities. 

Tanker Stocks

Tankers have continued to be disappointing, despite their great profitability this year. I probably bought these stocks at the top, which is frustrating, but I’ll continue to push through the pain. Frontline and DHT have been rewarding shareholders with juicy dividends, so that somewhat alleviates the sting. The Twitter account @calvinfroedge has been a great resource for oil tanker investors, and he nicely sums up tankers so far this year: 

Avg PriceCost BasisCurrent ValueCurrent Gain (Loss)
DHT8.171,755.901,109.40-36.82%
FRO10.661,738.291,059.50-39.05%
STNG26.631,742.67752.76-56.8%
TNK23.861,765.88802.16-54.57%

Deep Value

Deep value is a sub-strategy I’m employing in my portfolio. This a quantitative strategy that buys a basket of statistically cheap stocks. The metric I use is EV/EBIT, based on the wonderful book The Acquirers Multiple. Historically, this strategy has provided excellent returns, although it has not kept up with the S&P 500 the past few years. Additionally, I am making an effort to apply this strategy to microcap companies. Microcaps are classified as having a market capitalization between $50M-300M. These small companies are more volatile, but have the potential for attractive returns.

My position sizing is smaller than the discretionary side of my portfolio because I want to own a basket of about 20 stocks. Since this is a quantitative strategy, I do not spend much time analyzing these businesses. The main idea is that these companies are trading at very cheap valuations, and the winners will (hopefully) outnumber the losers. This quarter I added eight positions, which can be seen in the table.

Avg PriceCost BasisCurrent ValueCurrent Gain (Loss)
BBSI50.501,767.501835.403.84%
FF13.001794.001569.06-12.54%
FRD5.101800.101643.9513.74%
HXL36.801803.201643.95-8.83%
MUEL26.001768.001836.003.85%
RELL4.451802.251688.85-6.29%
RSKIA8.251740.752557.7029.70%
SPRS1.311819.301869.752.77%

401k and Precious Metals

My 401k is through my current employer and actively receives contributions. The 401k consists of a Blackrock Target Date Fund (which is no longer being funded), and the Oakmark Fund. The Oakmark Fund is a large cap value fund. Since I am actively contributing to my 401k, it will naturally have a growing influence on my portfolio. 

I also have a decent allocation to precious metals that are used as a bond substitute, recession and inflation hedge. The table below shows the YTD performance for the precious metals and 401k, which includes the effects of contributions.

12/31/199/30/20YTD Gain (Loss)YTD Contribution
Precious Metals$7,861.00$9,964.0026.75%
401k$10,962.24$23,687.3311.36%$10,863.00

Interesting Articles

If you think this post is boring, then  check these articles I read this quarter.

Monopolies are Distorting the Market

Buying Stocks Trading Above 10x Sales A Good Idea?

Books I’m Reading

A few weeks ago I went to the local used book store for the first time since the pandemic and found a copy of the classic Buffettology. This book contains a lot of info that Buffett die hards will have seen elsewhere. However, I think it is a great book for a newer investor to gain the right mindset about investing. One of the main points is thinking about a stock like owning a piece of a business, which is something I totally agree with. The book presents an interesting business valuation method. A gripe I have is that I think this method suffers from some hindsight bias, so I’m not sure how practical it is to use. 

Another book I read this quarter was Capital Allocation: The Financials of a New England Textile Mill 1955 – 1985. This book is the history of Berkshire Hathaway in the decade prior to Buffett taking control, and his capital allocation decisions up until the mid 80’s. Capital Allocation tells the story of how a struggling textile mill became one of the strongest companies in this country. My favorite part of this book is the deep dive into the financials of Berkshire and its early investments that I have not seen elsewhere. I loved nerding out over all of the financial statement snippets. Capital Allocation has a new place in my top 5 investing books. 

For more value investing fundamentals check out:

Q2 2020 Portfolio Update

Intro to DCF Analysis Part 1

Intro to DCF Analysis Part 2

The Many Flavors of Value Investing

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Intro to DCF Analysis Part 2: How to Calculate a DCF

In part 1 of this series, I introduced the discounted cash flow model and its four input variables. These variables were cash flow of the business, short term growth rate, terminal growth rate, and investors discount rate. In this post, I will show how to calculate a DCF by running the numbers on Emerson Electric (EMR). Emerson is an established business that is not rapidly growing, and is not overly cyclical. Using a DCF is more suitable for a business with these characteristics.

PV of Future Cash Flows

Performing DCF analysis consists of three parts. The first part is looking at the company’s financials to determine the values we should use to plug into the model. Next is the calculation of the present value of future cash flows from the business. This means we have a black box that produces a certain amount of cash flows far into the future. The DCF equation allows us to place a value on this stream of cash flows. The last step is to make some adjustments so that we get the value of the company on a per share basis.

Determining Cash Flow

The first step is to determine what cash flow value to use. In this example I am using EMRs free cash flow (FCF). The FCF for the last few years, plus the trailing-twelve-month figure is shown in the table. Typically I average the last few years of FCF to use as the input to the model. In this instance, let’s use $2.5B as our starting cash flow.

Choosing a Short Term Growth Rate

Next, we have to determine a reasonable growth rate. Emerson is a diversified industrial company that sells HVAC units, tools, and the InSinkErator brand. These products are going to produce a low sales growth rate. Probably increasing a few percent a year at the rate of inflation. EMR also has an industrial automation division that could have a bit higher sales growth going into the future. For this example, let’s assume EMR can grow their free cash flow at a rate of 3.5% a year.

The Terminal Growth Rate

As described in part one of this series, I discussed the difference between short term growth rate and terminal growth rate. Terminal growth rate assumes the business will decline to a steady state growth rate that is about the rate of inflation. In my DCF models, I typically use a terminal rate of 2%.

Specifying a Discount Rate

The last piece to the DCF model is the discount rate. As a refresher, the discount rate is the investors desired rate of return. This desired rate of return affects the future cash flows of the business. One dollar is worth more today than it does 10 years from now. Because of inflation and because we can invest that dollar. Mathematically, the discount rate has an interesting effect on the future cash flows. However, I’m trying to keep light on the math in this series so that can be a tale for another day. For my models, I use a discount rate of 10%. Don’t forget that a higher discount rate will mean the stock needs to trade cheaper. And a low discount rate means you could pay up for that stock (you’d be getting less of a return).

Performing the Calculation

Bringing it all together, we are now ready to do the DCF calculation. I use the calculator from Old School Value, which is a paid service, to do my DCF analysis. However, there are many online DCF calculators, or you can do it in Excel. Inputting the four variables described above, the DCF spits out a present value of EMRs future cash flows equating to $27B.

What this means is that we have a black box that is throwing out $2B in cash that is growing at a rate of 3.5% a year. If we paid $27B for this black box, we would expect a 10% return on investment. In order to arrive at a per share value of EMRs future cash flows, we need to do a few adjustments to this $27B.

Converting to Equity

The last step in showing how to calculate a DCF is to convert the DCF output into a value per share. The number that the DCF calculation produces is really the value of the entire enterprise. The enterprise is commonly made up of equity (the stockholders) and debt (bond holders). Since we are buying the stock, we need to adjust the $27B enterprise value of Emerson to reflect the equity holders’ share of the pie. To illustrate this, let’s say the enterprise was made up of 50% equity and 50% debt. It is not fair to say that the equity holders get 100% of the cash generated by the enterprise. You have to make debt interest payments, and pay off the bonds when they come due.

To arrive at the equity value, you take the enterprise value and subtract the value of the long term debt the company has. In some cases, it is applicable to also subtract capital lease. Emerson has $7B in debt, so we subtract that from the $27B. The next step is to add back the current amount of cash the company has. This means we can add $2.5B to our $20B. This resulting figure of $22.5B is the value of Emerson’s equity.

From here, we can obtain the value of EMR at a per share basis by dividing the $22.5B equity value by the amount of shares outstanding. Currently, Emerson has 600 million shares outstanding. This results in a per share value of $49.90 for Emerson’s stock.

DCF Example Summary

To summarize, if we could buy EMR stock at $49.90, and our DCF assumptions held true, we could expect a 10% average rate of return. Now that we have determined a back of the envelope value for EMR, we can check what it’s trading for in the market. When I entered my position in EMR, I paid $41 a share. Currently, Emerson is trading for about $70 a share, so you probably would expect a lower return if purchased at that price. Buying below the value calculated from the DCF provides some margin of safety in case our assumptions on Emerson’s cash flows or growth rates are wrong.

Conclusion

With this two part series on discounted cash flow analysis, I hope to provide a foundation for business valuation by showing how to calculate a DCF. Understanding that a stock is really a business that produces a stream of growing cash flows instead of a price that fluctuates is key to being a successful investor. Even though DCF valuations are not perfect, they do capture the growth of the business where a simple P/E ratio does not. Going forward, I want to occasionally highlight examples stocks are overhyped and trade at valuations that do not make sense, even if they can produce a high rate of growth.

For more value investing fundamentals check out:

What is Value Investing Anyway?

The Many Flavors of Value Investing

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Intro to Discounted Cash Flow Analysis, Part 1

The discounted cash flow (DCF) method is one of the more popular choices for finance professionals. I often use DCFs as a rough, back of the envelope calculation to see if the business is trading at a reasonable price. The thing I like the most about DCFs is that they factor in the growth of the business. Valuation ratios, such as price-earnings, are just a snapshot of the business at that point in time. In this post, I don’t want to get into the math, or how to make super accurate DCF models. However, I will provide an introduction to discounted cash flow analysis, by describing the four inputs to the DCF calculation.

In simple terms, a DCF approximates the value of a company based on the stream of cash flows it generates into the future, a growth rate of these cash flows, and then factors in the investors time value of money (ie their desired rate of return).

Cash Flow

The first DCF input is the amount of cash flow the businesses currently generates. Cash flows can be measured in several ways, such as net income, earnings per share, free cash flow, among others. I typically use free cash flow (FCF) because I believe it is a better measure of the earnings an owner would receive from the business than net income. 

Using the latest FCF number makes sense if the business is stable and predictable. However all businesses are going to have varying cash flows year to year. Some companies are cyclical, so you don’t want to use the peak earnings for that economic cycle. Other companies produce very random earnings, complicating things as well. Instead of using the current free cash flow, in most cases it makes more sense to average the past few years  value. I usually average the last three years of FCF as the input to the DCF. For companies that seem cyclical, or have an unusually high FCF figure for the current year, I will handicap it a bit to a more conservative value.  

Growth

A reasonable business is going to produce a certain amount of cash flows into perpetuity. Ideally, these cash flows are growing as well. The growth rate assigned to the businesses cash flows is the next input to the DCF model. A large, stable business may grow at the rate of inflation, so about 2-3% per year. Many businesses can grow above the rate of inflation, and certain companies (like tech stocks) can grow their business at high rates. High growth rates can greatly increase the value of a company produced by a DCF. 

A Note On High Growth Rates

High growth rates are why some stocks can appear expensive on a price-earnings basis, but they may be a reasonable price when you factor in high future growth. However, many times everyone is saying that a stock is The Next Big Thing, that revenue will grow a ton, and the stock price will massively increase. These stocks are too expensive even though they may have high growth rates. DCFs anchor the growth of the business to its fundamentals, allowing the investor to make sure the growth story isn’t getting ahead of a reasonable valuation.   

The problem with plugging a growth rate into the DCF model is that it is an estimate since we cannot predict the future. Oftentimes narratives about a stocks high growth prospects is pumped by the financial media. It is easy for an investor to get caught up in the hype and plug in an unrealistically high growth rate when performing DCF analysis. 

The other problem is that companies cannot sustain high growth rates forever. There are eventually diminishing returns, where the company’s growth will slow as it gets larger. DCFs typically use a 10 year forecasted growth value. An investor has to be careful that even though the company has grown at 10% the last few years, it will still be growing at that rate ten years from now.

Calculating Growth

There are many ways to estimate a businesses growth rate, such as historical  revenue growth, net income growth, FCF growth, or the company’s return on equity. I typically use a 5 year average of revenue growth. This probably isn’t the best way to estimate growth, but this metric is easily found on the website I use to research stocks. Like with the FCF, I often handicap the revenue growth rate by lowering it a couple of percentage points just to produce a more conservative valuation. 

Terminal Growth Rate

The growth rate discussed in the previous section estimates the growth in the next 10 years. Since the DCF assumes the business is going to produce cash flows in perpetuity, we need to use a growth rate from year 11 to forever. Since diminishing returns will take into effect eventually, we can assume that after a long enough time the company will just grow at the rate of inflation. For my DCF calculations, I use a terminal growth rate of 2%.

Discount Rate

The discount rate is the last input used for the discounted cash flow model. Discount rate is the hurdle rate, or the investors desired rate of return on the investment. Finance professionals and academics typically calculate the discount rate by using the businesses Weighted Average Cost of Capital (WACC). In simpler terms, calculating WACC, produces a discount rate that reflects what the market thinks is reasonable for the business. I am critical of the WACC method, but that is a discussion for a different day.

The other method of determining a discount rate is to just use a personal desired rate of return. When I perform DCF analysis, I almost always use a 10% discount rate. I figure this value is not too low, or too high, but should still beat the market. 

DCF valuations are highly sensitive to the discount rate you use. A lower discount rate will increase the value of the company. This is because you are willing to pay more for this stream of cash flows and accept a lower return. This can create a tricky dynamic because I am a young, hungry investor who wants to beat the market. In this case, I want to use a 10% discount rate. However, I am competing with some institutional money manager that is ok buying stocks that return 7% a year. Many stocks seem reasonably priced at a 7% discount rate, but would have to fall a large amount to be cheap based on a 10% discount rate. 

Conclusion

This wraps up part 1 of the introduction to discounted cash flow analysis. I described the four DCF inputs (cash flow, short term growth, terminal growth, and discount rate), and how to calculate them. Keep in mind that DCF inputs are all estimates. This can lead investors to creating overly optimistic valuations. However, I believe the main benefits to using DCFs is that they can help an investor really think about the business, since it considers the current earnings power, the growth of the business, and the time value of money. By introducing DCFs, I can help support one of the themes of this blog: don’t buy hyped up growth stocks.

For more value investing fundamentals check out:

What is Value Investing Anyway?

The Many Flavors of Value Investing

 

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The Many Flavors of Value Investing

One of my favorite things about value investing is that it is a broad church. A lot of people typically talk about value in generic terms, comparing value stocks to growth stocks. The reality is there are many strategies under the value investing umbrella.In this post, I’ll outline several of the main value investing strategies, give some examples, and discuss which ones I focus on. 

Growth at a Reasonable Price (GARP)

GARP investors try to balance buying high growth companies while still maintaining an anchor to business fundamentals. Companies like Tesla, Beyond Meat, Uber, pot stocks, tech companies, are growing their sales at very high rates. Oftentimes, the narrative of their growth is driving the stock price to valuations that would imply unrealistic growth.  Additionally many of these companies are not profitable. GARP investors would find high growth stocks that still had a profitable business trading at a reasonable price. 

One of the main metrics used to find GARP stocks is the Price to Earnings Growth ratio (PEG). The PEG ratio was made popular by the famous fund manager Peter Lynch. Examples of GARP stocks are Apple (AAPL), Microsoft (MSFT), and Lowe’s (LOW). I don’t utilize this strategy in my investing since I typically focus on more modest growth, and more emphasis on being undervalued.

Quality

Warren Buffet says to “buy great companies at fair prices”, which is the definition of this value strategy. Quality stocks have strong brand names, competitive advantages, constantly growing profits, little debt, high returns on equity, low growth. These are companies like Coca-Cola (KO), Procter & Gamble (PG), and Johnson & Johnson (JNJ). It makes sense to want to invest in high quality stocks, however these companies are typically very expensive. With their predictable earnings, and often recession proof businesses, they are almost treated like bonds. ETFs such as QUAL contain these types of companies, but they appear overvalued for my liking. I would love to own a handful of quality companies at a good price. In reality, the only time you can find remotely cheap quality companies is during a market panic.  

Compounders

Compounders are quality businesses with competitive advantages, good return on equity, and modest to high growth. The idea is that these companies will continue reinvesting earnings into their business in order to compound at attractive rates for 10 years or more. In many ways these are similar to GARP and quality stocks. Compounders will have high return on equity and consistently growing earnings. Finding an attractively priced compounder is an investors dream, but difficult to do so in a bull market. 

This value investing strategy gets a bad rap from “Compounder Bro’s”. These investors buy companies like TransDigm (TDG), Roper Technologies (ROP), or software-as-a-service (SaaS) stocks, which are great businesses. Compounder Bro’s stereotypically over pay for these stocks, or may have over-optimistic projections of future growth. Additionally, Compounder Bro’s brag about how great their stock picks have done since these types of companies have greatly outperformed typical value stocks lately.  

Traditional Value

What I consider traditional value stocks are good or decent companies that are temporarily undervalued. Reasons for their cheapness could be bad news, law suits, sector headwinds, being misunderstood, or the business is out of favor. Usually if the financial media is saying a sector or business is “dead”, then it’s time to sift through the depressed industry and find any hidden gems. These types of stocks are one of my main areas of focus. I typically look for solid businesses with low debt, then try to understand the narrative and decide if the consensus is overreacting.  

In my current portfolio, Capital One, Emerson Electric, and Simon Property Group fall into this category. Emerson was simply sold off because of the dramatic March sell off. Capital One has to navigate this low rate environment, which means it’s cheap along with a bunch of other financial stocks. SPG has high quality malls in major metros which I think will do fine, while crappy malls in crappy cities will die. 

Another example is in 2017, when all the headlines were saying Amazon is killing retail. Sure, Amazon will destroy companies like Sears and JC Penny who sell undifferentiated products. But retailers like Tractor Supply and Williams-Sonoma got caught up in the industry selloff. I thought these businesses were higher quality, niche retailers that would not immediately be impacted by Amazon. These companies had strong fundamentals but were selling at a discount. I bought both of these companies and sold them a year later for a 40-50% gain.

Quantitative Value

This strategy involves buying a basket of statistically cheap stocks. Out of this basket, some of the stocks will do poorly but hopefully a subset mean-revert to a typical valuation. The valuation metrics used to screen for these stocks could be price-to-book value (P/B), price-to-earnings (P/E), price-to- free cash flow (P/FCF), enterprise value over earnings before interest and tax (EV/EBIT) among others. 

Buying low P/B stocks is a classic implementation, is often used in academic value investing papers, and often is used in value indices. Supposedly accounting standards don’t accurately account for book value with tech companies, or businesses with a great brand name. P/B seems to work better for financials or old economy businesses with little R&D or other intangible assets. Given these apparent limitations, I do not screen specifically for low P/B stocks.I like looking at P/FCF in general as a shortcut valuation, however I don’t screen strictly for low P/FCF stocks. 

Deep Value

Deep value falls under the quantitative value strategy. The book “Deep Value” by Tobias Carlisle wonderfully discusses this strategy. I wanted to particularly highlight this strategy since I am interested in implementing it in my portfolio. This metric is also known as the acquirer’s multiple because instead of using the stocks market cap (the price), it uses enterprise value. 

Enterprise value is the market cap of the equity, plus any outstanding debt, minus cash on the balance sheet. This reflects the price someone would have to pay to buy the entire business since they would have to retire the debt and could use the cash to offset the purchase price. EBIT is basically operating income, which is higher up the income statement than net income (earnings). Net income takes into account a companies interest payment on debt, but this metric factors in debt with the enterprise value. 

Studies have shown that EV/EBIT is one of the most robust quantitative valuation metrics. This strategy has historically outperformed the S&P 500. Lately all quant value strategies have underperformed, with value investing in general having a hard time keeping up with the frothy market. I plan on incorporating the acquirers multiple strategy in my portfolio because of its long term track record of outperforming. Another reason I am drawn to this strategy is because it can be rare to find quality stocks at cheap valuations. Low EV/EBIT stocks can fill up my portfolio until opportunity arises. 

Asset Plays

Asset plays are similar to buying low P/B stocks, but with a twist. The difference between asset plays, and simply buying cheap P/B stocks, is that the value of the company is based on a physical asset. Occasionally an investor can buy into these assets at attractive prices. If you really dig for treasure, you can find companies where the assets are under reported on the balance sheet, which creates value. An example would be a Maui Land and Pineapple (MLP), that has real estate recorded on its books at the price paid decades ago. Of course Maui real estate has greatly appreciated, but this value is not showing up in the accounting. Another example could be a timber company, or quarry, that owns natural resources. Additionally, these hard assets will probably do well during inflationary periods. 

Net-Nets

This is the original value investing strategy devised by Benjamin Graham. While there are a couple of ways to implement this strategy, the most common is to buy companies that are trading below their net current asset value. Current assets are things such as cash, inventory, and accounts receivables. Current liabilities consists of short term debt coming due, and account payables. The net current asset value is arrived by subtracting the current liabilities from the current assets. When the market cap of a stock is below this figure, it is really freaking cheap. You are paying less than the cash on hand and the inventories of the business. 

Warren Buffett cut his teeth on net-nets back in the 1950’s, helping him create a great early track record. The problem with net-nets is that everyone knows they are awesome, so it is very rare to find any. Right now there are only a few net-nets that may be worth buying. However, during big market selloffs, net-nets make a reappearance. Finding a handful of net-nets is something I am always on the lookout for. 

Special Situations

Special situations, or “work outs” as Buffett called them back in the day, are corporate spinoffs, mergers, or emerging bankruptcies. I think this is one of the coolest value investing strategies. The unfortunately titled book “You Can Be a Stock Market Genius”, by Joel Greenblatt, explains special situations in great detail. 

Occasionally companies spinoff operations into a new company in order to simplify the core business, among other reasons. Institutional investors are typically more interested in the parent company, so they indiscriminately sell off their shares of the spinoff. This selling can create tremendous value. Companies emerging from bankruptcy (not going into it like Hertz) can be dirt cheap, and ridden of their burdensome debt. These stocks, under the right circumstances, can provide great returns. I would love to invest more into special situations, however it is time consuming to research these opportunities. 

Conclusion

There are probably a few variations of value investing that I missed, but the strategies outlined here are the most commonly discussed. I personally utilize a blend of value strategies. The most desired types of value stocks are probably cheap, quality stocks, and net-nets. In the meantime, I will continue searching for good companies that are misunderstood and share more reliable value investing strategies. Finally, I will use quantitative deep value to round out the portfolio. 

Check out my other posts on the fundamentals of value investing:

What Is Value Investing Anyway?

Intro to Discounted Cash Flow Analysis, Part 1

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What is Value Investing Anyway?

So far on this blog, I’ve written about my current stock positions and have casually mentioned that I use the value investing strategy. In this post I want to define what value investing means to me. Value investing was pioneered by Benjamin Graham, who was Warren Buffett’s professor and for a short period, boss. Buffett took value investing to new levels. He built the juggernaut of Berkshire Hathaway and teaching his investing philosophy along the way. Other well known value investors include Charlie Munger, Walter Schloss, Lou Simpson, Bill Miller, Peter Lynch, Bill Nygren.  

Value investing is the process of buying an undervalued asset and selling it if it becomes overvalued. This sounds like the age old “buy low sell high” mantra, which is what everyone is trying to do right?

The difference is that for a company to be undervalued, you must know what is a fair value…what the business is worth. There are many ways to value a business, which I’ll save for a different post. All valuation techniques involve some analysis of the earning power and growth of those earnings. Value investors believe each business has some intrinsic value, or a reasonable valuation, based on its earnings power. The price that a stock trades at reflects to some degree the performance and economic environment of the business. However, a large degree of a stock price is based on psychology and other market forces. This means that a stock can trade at a discount to its intrinsic value if the market is pessimistic on the company’s outlook. On the other hand, a stock can trade at a premium if the market is overly rosy on the business.

How Does Value Investing Make Money

Investing in a company at its fair value can be a reasonable proposition. The real money is made by buying below intrinsic value, and waiting for the company to appreciate back to its fair price. It may sound silly that businesses trade at a discount, then revert back to a reasonable price, but opportunities like these exist. The goal is to buy $0.50 dollars and wait for them to go back to being a dollar. This sounds simple…but it is not easy.

The Philosophy 

Value investing to me is more than just another strategy like growth, momentum, trend following, technical analysis, risk parity, etc. It is a philosophy. Most people think stocks are a piece of paper that gets traded bank and forth, numbers on a screen that go up and down, a spin of the roulette wheel, some get rich quick scheme, or some amazing story of how this company is going to be the next Microsoft.

I saw the light when I read Warren Buffett’s shareholder letters. In these letters he described stocks as owning a fractional share of a business. Owning stocks means you are a business owner. Therefore you should only be buying good businesses that you understand. Businesses sell things, pay employees and incur other costs, produce a profit, reinvest those profits back into the business to grow, pay out some profits to the business owners (stockholders). Value investing is estimating what this business is worth, and opportunistically buying it when the market does not agree with you.   

A write up of my Q2 2020 results can be found here

Check out my summary of my March Stock purchases

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Q2 2020 Portfolio Update

Performance Overview

For Q2 2020, the portfolio is up 6.65% and is up 4% year to date. The Q2 starting balance was $80,525.94, and finished the quarter at $89,241.80. Contributions to the portfolio during the quarter amount to $4,551. 

No stocks were sold during this quarter, but four new positions were added. The four companies I have bought are Teekay Tankers (TNK), Frontline Ltd. (FRO), DHT Holdings (DHT), and Scorpio Tankers (STNG). These positions are oil tanker companies, and all were bought at the end of April and early May.

The  current allocation of the portfolio is shown in the chart below. Currently, the portfolio  consists of discretionary value stocks, oil tankers, 401k stocks, precious metals, and cash. It can be seen that 39.1% of the portfolio is in stocks, while 60.9% is in cash and safe haven assets. I would prefer to deploy more of the cash to undervalued stocks, but I am remaining cautious despite the market surging during the second quarter.

During the quarter I received $260.65 total in dividends, which is broken down in the table below.

TickerQuarterly Dividend 
FRO114.1
STNG6.8
DHT75.25
EMR42.5
COF22
Total260.65

My Thoughts

Under normal circumstances, it should be a boring quarter where I don’t feel the need to rant comment on current events. However these last few months have been insane. Here are some of the notable crazy things, things that confuse me, things that worry me that have happened this quarter:

  • Unemployment around 20% and much higher for the service sector
  • The S&P 500 nearly breaking even for the year despite the quickest 30% selloff ever and then follows it with the best quarter since 1938
  • The Federal Reserve upping their game by buying bond ETFs
  • Consumer spending somehow rebounded quickly
  • Compelling arguments on either side saying that COVID is as bad as predicted, or not that bad at all
  • Whether you wear a mask is a strong indicator of your political affiliation 
  • Rookie traders who stereotypically use the brokerage Robinhood gambling on airlines, cruise ship, vaccine biotech, work from home tech stocks among others
  • Barstool Sports founder Dave Portnoy becoming a stock market influencer…stocks only go up suckers
  • Hertz, Chesapeake Energy, probably others, massively rallying after announcing bankruptcy
  • Although they called it off, Hertz almost issued stock to gamblers after they declared bankruptcy…that means selling stock to suckers that will go to zero when the bond holders wipe them out
  • Protests…which I’m all for if done peacefully, but we are still in a pandemic which is scary
  • Riots (not cool) and autonomous zones
  • Nikola, a Tesla clone that makes trucks is now worth $20 Billion, an 8x increase in stock price, despite not having actually built a single truck  
  • Negative $40 a barrel of oil…ie paying people to take the oil because it costs too much to store it

It’s like we’re living in the tech stock mania of the late 90’s, social unrest of 1968, and the economy of 1932 all at the same time. I’m just trying to think rationally, be empathetic of others, filter out the noise, do my best to keep my family healthy, and do my best to efficiently allocate my capital. 

Or ya know, stocks only go up…

Discretionary Summary

Discretionary value is the label I’m giving to the positions that are fairly large (~5% of the portfolio) I believe are undervalued and may have the following characteristics: quality business, competitive advantage, misunderstood by the market, or a good company in a heavily sold off industry. The current discretionary value stocks I own consist of Capital One Financial (COF), Emerson Electric (EMR), and Simon Property Group (SPG). All three were bought during the March sell off. The table below shows the cost basis, current value, and gains/losses for these positions.

Avg PriceCost BasisCurrent ValueCurrent Gain (Loss)
COF63.253,478.753,442.45-1.04%
EMR413,485.005,272.5551.29%
SPG74.53,427.003,145.48-8.21%

After the March lows, EMR quickly rebounded, which makes sense because it is probably the best quality company I own. Since March, COF and SPG were struggling, both down around 20-30% from purchase. Recently, the market has raised all ships, where all three of these companies were in the green for me…however the market has taken back some of those gains.

Notable News

There is not too much news to report for this set of stocks. Simon began reopening their malls in May, so hopefully Q2 results show some optimism. SPG also canceled their merger with Taubman Centers (TCO), which is another large mall REIT. These properties would be a nice addition to Simon since the ownership of quality malls is pretty concentrated to a few large players. However, given that 2020 is going to be very rough on SPG, it seems prudent to reserve capital. 

EMR and Portfolio Management

At one point this quarter, Emerson was up 70% from my cost basis. While it was exciting to see the stock run up so much within three months of purchase, it creates quite the dilemma. A lot of people spend the majority of their time finding and researching stocks in order to make a buy decision. However that is only half the work. Now that you own the stock you have to decide when to sell, which could be:

  • The Stock runs up some random amount that makes you feel good, so you sell to take some money off the table
  • The stock reverts back to your estimate of the stocks true value, so you sell to find another undervalued stock
  • Lastly, you hold onto the stock indefinitely, allowing the businesses earnings to compound which will steadily increase the share price

Plus I’m not even getting into the thoughts that enter your head when a stock is down…The naive investor probably does the first scenario, buying a stock and selling it some arbitrary gain. There’s technically nothing wrong with the second scenario, but you’ll have to pay capital gains tax and it only makes sense if you have another good opportunity to roll your gains into, which is never guaranteed. The last scenario reflects investing in its truest form, and makes your life a little easier by reducing your tax burden, reducing the chance you’ll roll your gains into something dumb, and generally more hassel free. If you think about it in terms of internal rate of return (IRR), on paper the last option most likely will have lower (but still attractive returns). It’s possible to have higher returns value trading, but there is execution risk involved. 

Long story short, it’s tempting to sell Emerson, but for now I don’t have a better company to reinvest in. I consider EMR fairly priced right now, my thought process might change if it becomes significantly overvalued. At this valuation, Emerson should have slightly above-inflation business growth, and throws off an attractive amount of free cash flow (I like cash flow over earnings but that’s a different tangent) from here. 

Tanker Stocks

During the last quarter I jumped on the oil tanker trade (see my analysis) and entered positions in DHT, FRO, STNG, TNK. The table shows my cost basis, the current value, and the current percentage losses. I will probably do a write up revisiting the tanker thesis so I’ll keep this short. Oil tankers were very profitable during the first quarter. Oil tankers probably earned as much or more during the second quarter which will reflect the crazy high spot rates seen in April. In other words, the thesis played out just as the smart people predicted. The oil tankers have made record profits in the last 9 months, some even paying juicy dividends…yet I’m down 50%. 

For now at least, the craziness in the oil market has subsided which has shortened the duration of the tanker thesis. However there are some other factors that are positive for tankers in the medium term. I was hoping this trade would have panned out by now, but I still think the value of these companies will eventually be realized. 

DHT8.171,755.901,102.95-37.19%
FRO10.661,738.291,137.74-34.55%
STNG26.631,742.67871.08-50.01%
TNK23.861,765.88948.68-46.28%

401k and Precious Metals

My 401k is through my current employer and actively receives contributions. The 401k consists of a Blackrock Target Date Fund (which is no longer being funded), and the Oakmark Fund. The last asset class is the decent allocation to precious metals, which are used as a bond substitute, recession and inflation hedge. The table below shows the YTD performance for the precious metals and 401k, which includes the effects of contributions.

12/31/196/30/20YTD Gain (Loss)YTD Contributions
Precious Metals7,861.008,712.5610.83%
401k10,962.2417,301.35-9.37%7,728.00

Value Papers

If you think this post is boring, or want to nerd out on value investing research papers, then  check these papers I read this quarter.

Is Value a Value Trap?

Is Systematic Value Investing Dead?

A Quick Survey of “Broken” Asset Classes

Books I’m Reading

Usually I try to focus on one book at a time, but the past few months I’ve been multitasking. Eventually I may do full reviews of these books, but for now a little summary. I just finished The New Jim Crow: Mass Incarceration in the Age of Colorblindness. Given the current events, I thought I should go out of my comfort zone and read about race and the criminal justice system. It was a very powerful book that made me question some of my beliefs on why society is the way it is.

Next, I’ve been slowly making my way through Titan: The Life of John D Rockefeller, Sr. This book is huge, so it’ll take me awhile to plow through it. So far I’m at the stage of his career where things are really starting to pick up. It was fascinating to learn about the very strange childhood Rockefeller endured.

Finally, I’m almost done with The Rise and Fall of the Conglomerate Kings. This is a business history book of the founders and the companies that led the high flying conglomerate movement in the 1960’s. This includes Textron, Litton Industries, Gulf + Western, ITT, and LTV. These guys were pioneers at buying other companies and using financial engineering to drive up their stock prices. This book highlights these companies’ capital mis-allocation, which contrasts to everyone’s favorite conglomerate, Berkshire Hathaway. 

Conclusion

This wraps up my Q2 2020 portfolio update. Hopefully Q3 is less eventful and my stocks go up…or better yet some new buying opportunities emerge.

A write up of my Q1 2020 results can be found here

Check out my summary of Berkshires Q1 portfolio changes

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