invest(igations)

My Investment Strategy Statement

Seeking Alpha, a website I write for, asked me a number of questions so that I could make the answers into an "investment strategy statement." I published it there a few days ago; I thought I'd publish it on my blog here as well.

My Investment Focus

I am a disciplined investor who believes that applying strict mathematical logic, sound financial principles, and thoroughly backtested strategies in a systematic and non-discretionary process will enable me to beat the market. I invest mostly in US microcaps that exhibit strong growth potential, have high-quality financials, and are underpriced.

The Securities I Choose From

The universe of stocks that I choose from is defined as broadly as possible, and includes over 4,000 stocks. Conceivably, I could choose some mid-cap and large-cap stocks, but those very rarely come out on top in the stock-picking system I’ve designed.

My Investment Process

I use a research platform called Portfolio123. There I have developed a ranking system based on over forty factors. Several times a week, I look at the top-ranked stocks and compare them to my holdings. I then increase and decrease my positions based on their ranks, and buy additional highly ranked stocks as need be. I also take into account liquidity and bid-ask spreads, putting less of my money into stocks with heavy transaction costs.

A lot of thought and experimentation goes into choosing the factors I rely on. I use some standard metrics, and a great variety of them; but I’ve also devised quite a few valuable metrics of my own. And I’m constantly tweaking my system as I develop new ideas for improvement or discover potential flaws.

I only use limit orders when buying and selling stocks. I place them before market open and if they don’t get filled, I adjust them through the course of the day.

Ideal Long Ideas

There are dozens of things that I look for in a long idea. But here are the ten most important ones:

1. strong operating income growth;
2. the industry the stock is in (I’ve classified them into groups and favor those most sensitive to the metrics I use, but I also take into account industry momentum);
3. steady sales growth—not too high, but accelerating;
4. low market cap;
5. low but increasing volume;
6. good sentiment indicators (estimate revisions, recommendation changes, earnings surprises);
7. low share turnover;
8. strong EPS growth (both estimated and GAAP);
9. high forward earnings yield; and
10. low price to sales (both estimated and actual).

My Approach to Valuation

When looking at the price of a stock, I think it’s important to compare it to other companies in the same industry. I do so with a variety of ratios: price to expected earnings and sales, price to actual sales, price to free cash flow, price to R&D expenses, price to tangible book value, and so on. But I also look at the stock’s enterprise value (unless it’s a financial or real estate company), and in those cases I compare it to other stocks in general. I use enterprise-value based ratios with unlevered free cash flow, gross profit, and long-term debt.

My Approach to Portfolio Risk

I use a performance measure called the omega ratio to measure risk-adjusted performance, and by designing my portfolios using that measure, I lower my risk. Omega basically takes the sum of a portfolio’s positive excess returns and divides them by the sum of its negative returns, so any time a portfolio’s return is worse than the median market return, it drastically lowers omega. Using omega as a performance measure thus ensures that your portfolio has as few periods as possible with low or negative returns. In addition, I favor stocks with low share turnover, which lowers my beta a lot. Although I invest in microcaps, the beta and standard deviation of my portfolio has been consistently far lower than that of IWC, the microcap ETF, while my returns have been far higher, with fewer and shorter drawdowns.

My Portfolio Return Objectives

I really only have two: to beat the market, and to make as much money as possible. I’ve been very successful at this so far, maintaining a CAGR of over 40% for over three years. My return in 2016 was 45%, my return in 2017 was 58%, my return in 2018 was 14%, and my return in 2019 so far is 15%. My objective is to keep this up despite the fact that I have a lot more money to manage than I ever have before.

The Investors I've Learned From

James P. O’Shaughnessy, Joel Stern, and T. Rowe Price. O’Shaughnessy’s approach not only has always made instinctive sense to me, but he has provided innumerable practical examples of how to carry out a thorough investment analysis. Basically, O’Shaughnessy posited that one could find out what factors have worked in the past and could then use that knowledge as a basis for a systematic analysis of stocks. This is precisely my approach as well. Joel Stern, on the other hand, came up with two of the best financial metrics I’ve ever seen, free cash flow and economic value added. He started with rigorous accounting analysis, and really understood what drove company profits and growth. His insights into cash flow and the cost of capital are priceless. Lastly, T. Rowe Price recognized that one could invest successfully in growing companies without ever considering what they cost. Price has been overemphasized in investing, whether you’re looking at fundamentals or using technical analysis. The inspiration of T. Rowe Price has allowed me to think of price as a secondary consideration. For me, a company’s quality comes first.

Liquidity Constraints

For me to invest in a stock, it has to have a moderate bid-ask spread and a minimum median daily dollar volume of $30,000; it also has to cost more than $0.50 a share. I buy and sell stocks three or four days a week.

Investment Time Horizon

Some stocks I keep for months, others I sell within a month. My median holding period is about two months.

Asset Allocation

100% in equities. I usually have one or two stocks in which I invest 8% to 12% of my portfolio; my other positions are smaller.

My Hardest Investment Lesson

It took me close to two years losing a huge amount of money while the stock market was rising before I realized that buying and selling ETFs based on technical analysis was a surefire way to go broke. At that point, everything changed for me.

How My Investment Process Has Changed Over the Last Few Years

Since I had the epiphany, late in 2015, that the best way to invest is

• a) to examine every single purchase from as many angles as possible
• b) to do so systematically rather than by discretionary means, and
• c) to do so using a ranking system rather than screens,

my basic investment process hasn’t changed much. The biggest changes have been

• a) the realization that reliable backtesting should always be done on a much larger portfolio than the one you plan to invest in;
• b) using variable portfolio weighting rather than putting the same amount of money into each stock;
• c) selling only when I need money to buy a better stock;
• d) using divided universes and time periods in backtesting;
• e) using good risk-adjusted performance measures like the omega ratio;
• f) employing innovative value and quality measures that are starkly different from what I used at first; and
• g) allowing projected transaction costs to influence portfolio weights (i.e. I put less money in stocks with big bid-ask spreads than I do in stocks with more modest spreads).

My CAGR since 1/1/2016 is 39%.

My top ten holdings right now: PCOM, CVGI, ARC, PCMI, NATR, RLGT, VLGEA, GSB, KMDA, CTEK.

Shouldn't Price-Fixing Be Legal?

When I lived in Bolivia a few years ago I noticed some market behavior that I’d never seen before. In the central market, all the vendors got together and set their prices, which they posted for the public to see. There were two bus companies in Sucre, and they charged the same amount and drove the same routes. Much of the local economy seemed to be based on price-fixing.

When I thought about it, it made sense. If you have thirty people all selling the same products—vegetables, say, or potatoes, or cow snouts (yes, there’s a whole row of cow-snout vendors in the central market)—does it make sense to have each one compete with the rest by lowering prices? Wouldn’t that cause every vendor to starve? Vendors in the Sucre market competed with each other to see how nice they could be to their customers, often offering a yapa—a little something extra­­—with each purchase. They hawked wares based on quality, appearance, and taste. Price was not—could not be—a basis for competition, because it would be ruinous.

This was an eye-opening revelation. Price-fixing is illegal in practically all of North America and Europe. Yet it was common practice in Bolivia. And it seemed to work.

So it occurred to me that, contrary to our conventional understanding that the most natural mode of economic behavior is the kind of ultra-competitive “free” market where price-fixing is not allowed, perhaps an economy that includes price-fixing is more natural.

Indeed, Adam Smith, the founder of modern economics, recognized this. In The Wealth of Nations, he wrote, “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in . . . some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which could be executed, or would be consistent with liberty and justice.”

In other words, Smith did not foresee a world in which price-fixing was illegal. Such legislation seemed impossible to him—not to mention contrary to “liberty and justice.” The maximization of profit and price-fixing go hand in hand.

But now it is almost equally impossible to imagine a world in which price-fixing is legal. Except if you’ve spent time in Bolivia.

So let’s imagine it: the entire Western world does away with its laws against price fixing, perhaps with certain exceptions (for example, for price-rigging in government contracts, or price-fixing that effectively creates an industry monopoly). What would happen?

Well, there has been plenty of tacit price-fixing in the Western world, and it seems to have worked quite well.

For thirty years I worked for publishers, and I am 100% certain that we never met with other publishers to discuss the pricing of our books. Yet there currently is an implicit understanding that a hardcover under three hundred pages will almost always be priced at $26.99, and twenty years ago a paperback of a certain length would always be priced at $14.99. When pricing a book, we didn’t try to undercut the price of other publishers—we always tried to price it the same as everyone else did. There was no price-fixing per se, but the result was exactly the same. Competition in the book industry is almost completely unrelated to price, and is based almost solely on quality and appeal.

The airline industry used to operate in a similar manner. A flight from Los Angeles to Atlanta might be offered by four different airlines, and the price was the same. Instead of competing on price, the airlines competed by advertising the quality, comfort, promptness, and friendliness of their flights.

In a competitive market, the legalization of price-fixing would encourage innovation, quality, and diversity.

But there’s something else going on in the developed world, the world where price-fixing is illegal. And it’s actually more insidious than price-fixing itself.

In Bolivia, when all the vendors in the market fix prices, or when the competing bus companies decide to serve the same customers and charge the same price, they get together and form a syndicate (also known as a cartel).

In the United States and Europe, by contrast, that kind of activity is highly illegal. The technical term for it is a “horizontal price-fixing conspiracy.”

But there’s actually a very easy way around it. Here in the developed world, all the vendors in the market can also agree to fix prices. They simply get together and form a . . . firm.

Now I’m not talking about monopolies here. If you didn’t like the prices in the mercado central in Sucre, you could always go to the mercado campesino, which was a lot cheaper, though also a lot more chaotic. In the US, horizontal price-fixing agreements are illegal even if they don’t work, even if other competitors are going to be around. Similarly, if vendors get together and form a firm, there very well may be other firms that will compete with it.

So what are the essential differences between a price-fixing syndicate and a firm?

In a syndicate, each vendor owns her own operation. In a firm, each vendor is either a part owner or an employee. She can no longer make a little extra money by giving away yapas or having her goods be of better quality than those of the other vendors. A firm’s products rarely compete with each other, while those of a syndicate are perfectly free to. A firm aims to be efficient; a syndicate has no such need. A firm has a strong interest in standardizing all the goods it produces, while a syndicate has a strong interest in individualizing them. When firms innovate, they replace their old products with new ones; when syndicate members innovate, their new products are sold right alongside the old ones.

In a syndicate, the vendors all earn more or less the same amount. A firm, on the other hand, is run by executives, who earn huge sums of money, while the employees who actually make and sell the products earn relative pittances.

It has been commonly believed for a very long time that regulations against price-fixing are essential to a free market. But in fact, the result is a less free market. By outlawing syndicates and promoting the formation of firms in their place, the government is effectively shutting down small businesses and encouraging the proliferation of corporate monsters.

If you don’t believe me, try reading a recent paper by Sanjukta Paul called “Antitrust as an Allocator of Coordination Rights.” The abstract reads, “It is conventionally understood that the purpose of antitrust law is to promote competition. . . . [But] our current antitrust framework authorizes large, powerful firms as the primary mechanisms of economic and market coordination. . . . The pro-competition norm has served to undermine other coordination mechanisms—such as workers’ organizations, ‘cartels,’ and the public coordination of markets.” (I’m grateful to Matt Levine of Bloomberg, who alerted me to this paper in a recent very smart column.)

Paul basically argues that the right of business entities to coordinate with one another is allocated by current antitrust law to the firm and to the firm only. This is not a natural or foretold outcome but rather a product of the influence of the Chicago School and especially the famous judge Robert Bork (author of the vastly influential book The Antitrust Paradox), which redefined competition to exclude collaboration and coordination, both natural features of competitive markets worldwide. Antitrust legislation originally didn’t make exemptions for firms—“trusts,” which were the original focus of antitrust legislation, were firms, since they were business entities under common ownership and control, and lawmakers treated trusts and corporations interchangeably. The language of the Sherman Antitrust act made no distinction between inter-firm and intra-firm coordination, but that distinction is central to antitrust actions today.

Basically, Western governments favor firms over business consortia, unions, so-called cartels, syndicates, and other forms of business associations, all of which are suspect, and all of which are enjoined from setting prices. In doing so, these governments are acting not in support of competition, but against it.

Paul gives a couple of terrific examples.

Let’s say there are five trucking companies, with twenty drivers each. Each trucking company sets the prices its drivers charge. This is not considered price-fixing, and is perfectly legal. Now let’s say one of those companies goes belly-up and the twenty drivers employed by it decide to form a bargaining unit for the purpose of negotiating their contracts with customers, agreeing on rates. The situation, for all intents and purposes, is the same as when there were five trucking companies, rather than four, but the independent drivers are now engaged in a “price-fixing conspiracy,” simply because they own their own labor rather than being employed by a firm.

Let’s say a number of organists who play for special events get together to fix prices. This actually happened, and the organists were prosecuted by the Federal Trade Commission. Now let’s say a bunch of investors create a corporation that contracts with those same organists and charges a set price for organists who play at special events, skimming a bit off the top. This is perfectly legal under current US practice. The net effect is almost the same. The organists get a little less money; the investors get a little more. But more perniciously, an organizer of a special event now has less control over which organist to hire—that’s largely up to the corporation; and the organists themselves will get much less advantage out of giving superb performances.

And then there’s Uber. What exactly is Uber but a price-fixing syndicate made up of independent drivers? Well, it’s a firm, and a very big one too, so it’s perfectly legal. But if all of Uber’s drivers suddenly quit and decided to drive independently but agreed to use a price algorithm similar to the one that Uber developed, the FTC would hound them, stop them, and levy huge fines on them. Why should this be the case?

In the United States and Europe, large businesses have numerous advantages over small ones, many of them due to government regulations. Large businesses require tremendous government support in order to survive. And one of those supports is the current interpretation of antitrust laws.

An unfettered free market can present terrible problems. But in the case of price-fixing, I think a little more freedom and less regulation might prove a valuable corrective to the over-corporatization of the American economy.

My top ten stocks right now: ARC, PCMI, GSB, KMDA, PCOM, CTEK, PERI, SCX, CLCT, PFSW.

CAGR since 1/1/16: 40.5%

 

How to Sell Your Stocks

Just after New Year, an amazing paper was posted on SSRN called “Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors.” A few days later, Matt Levine, who writes daily for Bloomberg and whom I read almost religiously, published a terrific column about it called “Investors Have to Sell Stocks Too.” They’re both worth reading in full. But I’ll tell you about this new research in case you don’t feel inclined to navigate away from this page.

Basically, the paper found that professional investors—portfolio managers—put a lot of thought and effort into what stocks to buy, and they’re very good at choosing them. The stocks they buy tend to perform much better than if these managers had simply picked stocks at random. However, when it comes to selling these stocks, portfolio managers basically have no idea what they’re doing. If they had just trained monkeys to throw darts at their portfolios, they’d perform considerably better. How much better? By over 1% per year. And that really adds up. Training monkeys to throw darts is considerably cheaper.

Portfolio managers tend to sell stocks based on astrology. Just kidding. Actually, they base their decisions on price performance, which is almost as bad. The study shows that stocks that have performed extremely well or extremely badly are those most likely to be sold (actually, 50% more likely!). This is the exact opposite of what these managers do when they choose stocks to buy. When buying stocks, portfolio managers look at the fundamentals, not at price performance. But when choosing which stocks to sell, fundamentals go out the window. Instead these managers seem to rely on silly heuristics like “sell your losers and let your winners run” or “sell if you double your money” or “sell your most volatile holdings.” It doesn’t take a lot of savvy to realize that these “rules,” if strictly followed, would rather quickly bankrupt almost any investor.

Value investing has always focused on finding bargains to buy, not on choosing holdings to sell. There are many good psychological reasons for this emphasis. For one thing, buying things is always more fun than selling them. Think of all the things you’ve bought in your life that you probably should sell but haven’t. Buying is an act of optimism—you’re meeting a new friend, looking forward to future gains. Selling is an act of pessimism—you’re saying goodbye to an old friend, abandoning a once-promising prospect. As a result, most investors base their decision to sell on gossip, a hunch, or a drastic move in price.

But your overall performance as an investor is going to be based not only on knowing what stocks to buy and when, but also knowing when to sell them. It’s essential to develop a reasonable and successful strategy for doing so.

I have only two rules for selling stocks, and they’re both rather simple. By sticking to these rules, I’ve kept my CAGR at 40% or higher for more than three years now.

Rule #1: never sell a stock unless you need the cash for another investment. Even if it has failed to live up to your expectations or has posted a terrible earnings report, if you have nothing to replace it with, hold it.

Rule #2: rank all your holdings before you sell. Either sell the ones with the lowest rank, or diminish the number of shares you own of the stocks whose weight is out of proportion to their rank.

To implement this second rule, think of all the factors that motivate you to buy a stock. Make a list of them, even if it’s a long one. It could be its P/E ratio or its EV/EBITDA. It could be a recent price and volume move, or a terrific earnings report. Maybe it’s an innovative CEO or even a tip from a trusted friend.

Now rank all your stocks according to each of these factors, and add up the ranks. Some of your holdings should rank quite a bit higher than others.

At this point, you have two options. You can simply sell the lowest-ranked stock. Or you can build an upside-down ideal holding pyramid, in which the highest-ranked stocks have the greatest portfolio weight. You can then adjust your holdings by buying and selling to better conform to that ideal.

There are subscription services that can help you accomplish this. I’ve been using Portfolio123 for years to rank my holdings, and as a result I no longer agonize over what stocks to sell. I have my own subscription service that will rank stocks for you.

But you can do this with pencil and paper if you’d like, or talk it out with fellow investors. Just disregard price movements.

Sometimes I sell stocks that have gone way up, sometimes I sell stocks that have gone way down, and sometimes I sell stocks that haven’t moved much at all. But I don’t look at what they’ve done price-wise: I look at how likely they are to do well down the road. And after I sell them, I don’t look to see how they’re performing, and I don’t try to second-guess my choice. Saying goodbye to an old holding now gives me just as much pleasure as saying hello to a new investment. After all, if the fundamentals are good, I may buy that old holding back one of these days.

My top ten holdings right now: ARC, PCMI, RLGT, GSB, LNTH, KMDA, CTEK, PERI, SCX, CLCT.

CAGR since 1/1/16: 41%.