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3 Lessons in Portfolio Management Over 10 Years

publication date: Sep 3, 2020
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author/source: Brian Nelson, CFA
Dear members:
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We're finally getting a pause in the rapid ascent of the markets on September 3rd. Though headlines may look scary and momentum/volatility investors could start to pile on to the downside, a modest retracement is actually a good thing. We continue to focus on the long haul with our processes, and we're viewing the sell-off as profit taking, for the most part.
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In the near term, the markets will also have to digest some speculators betting on mean reversion between "value" (cyclical) versus "growth" (secular), but we maintain the view that the value-versus-growth conversation is largely nonsense (see block quotes below), and mean reversion is something akin to the gamblers' fallacy, in my humble opinion. Investors should also continue to expect outsize volatility, something every member should be anticipating given the prevalence of price-agnostic trading. Nothing in today's trading session should be surprising. 
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Here is what I wrote in the second edition of Value Trap
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Through the course of the COVID-19 crisis, I have learned to appreciate enterprise valuation even more. In the first edition of Value Trap (December 2018), I explained how investors should prepare for "one of the most volatile periods in stock market history," pointing to enterprise valuation and the Best Ideas Newsletter and Dividend Growth Newsletter portfolios, in particular, as ways to guard against the declines. Many Valuentum stocks, or ones that had key cash-based drivers of intrinsic value such as net cash and future expected free cash flows, as well as moaty attributes (sustainable competitive advantages), attractive economic castles (large foreseeable economic profit spreads), and asset-light (capex light) recurring business models not only persevered during the pandemic, but many of these companies turned out to be "pandemic-resistant," if not "pandemic proof."
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Though the concentration of undervalued equities, as derived by the enterprise valuation process, has been within the large cap growth bucket in the years following the Great Financial Crisis and during the COVID-19 crisis, bargains based on enterprise valuation (and the Valuentum process) will inevitably move around the traditional style box. However, with most measures of quant value failing to capture the very essence of intrinsic value estimation, the future hopes of systematic quant value, which weighs accounting book value heavily, are riding only on the gambler's fallacy, in my view. Accounting book value, which coincidentally Warren Buffett abandoned in his 2018 Letter to Berkshire Hathaway Shareholders (45), is about as arbitrary of an accounting measure as it gets (read more about this in Value Trap), and other single-year snapshot valuation multiples continue to suffer from the many shortcomings outlined in this text...
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...Whether it's B/M, P/E, EV/EBITDA, or another single-year snapshot valuation multiple, they all suffer from similar pitfalls, including but not limited to the application of realized (not expected) data and the absence of capturing the long-duration components of equity value in a fundamental anchor. If today's factor-based quant practitioners use the components of enterprise valuation, as in adjusting book value for intangibles (measured on the basis of future free cash flows in enterprise valuation) and point to interest rates (the discounting mechanism for future free cash flows in enterprise valuation) to explain varying performance of "growth" and "value" stocks, it only builds the case for enterprise valuation as the primary causal driver behind stock prices and returns, as Value Trap argues. Value investing is not dying or dead. Quant investors have been measuring value all wrong. In many ways, value investing has been thriving for those employing the enterprise valuation process.
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What I want you to understand is that traditional single-year snapshot valuation multiples are largely arbitrary. For example, a company with a large net cash position could trade at a high multiple of earnings just because of that net cash position (net cash elevates the earnings multiple, irrespective of growth or earnings). The opposite is also true. A company with a large net debt position could trade at a low multiple of earnings just because of that net debt position (net debt reduces the earnings multiple, irrespective of growth or earnings). The level of the multiple, itself, is not as informative as one may want it to be. There are many other examples that skew multiples, including off-balance sheet liabilities, hidden assets such as stakes in other companies, and many, many others. Single-year snapshot multiples could at times be very misleading, and stocks are often mis-categorized into arbitrary buckets as a result.
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In this light, most quantitative processes that are employing traditional single-year snapshot valuation multiples aren't really measuring "value" as most investors want to believe they are. When academics or the media talk about the growth-versus-value conversation, they are talking about two sets of stocks that are, at best, ambiguously defined, in my view, and most of the conversation therefore just doesn't hold water. We continue to prefer big cap tech, large cap growth, and many entities in the NASDAQ, not because of the nature of the group, but rather the composition of the stocks in the group, including the likes of Facebook, Alphabet, Visa, etc. 
 
Most of small cap value, on the other hand, is heavily weighted toward banks and financials, an area that perhaps we like the least. Banks and financials struggled relative to other sectors following the Great Financial Crisis, and the sector was among the worst performing groups amid the COVID-19 breakdown as it failed to participate meaningfully in the rebound (there's a great image in the second edition of Value Trap that shows how the sector was down for the count). I see very little reason why small cap value would come into favor in the longer run, meaning I see little basis for a "reversion to the mean" relative to large cap growth on the performance of small cap value alone. 
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Image: A popular small cap value ETF (IWN) weights financials at nearly 30% of holdings. Tightening net interest margins and higher expected loan loss reserves make financials a rather unattractive area, in our view. The group also experienced one of the biggest falls during the COVID-19 crash and failed to participate meaningfully in the rebound. The sector never really recovered completely from the Great Financial Crisis, and today, many banks could be viewed more like utilities given their participation in government stimulus programs.
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That's not to say that certain quantitatively-defined "value" stocks aren't undervalued, but it is to say that any reversion between growth-and-value will be primarily due to luck, not due to "science," "empirical support" or "evidence-based analysis," as commonly marketed. In many respects, given the ambiguous nature of single-year snapshot valuation multiples and the lack of applying expectations in the process, there's actually not much support for what many quants are betting on at all these days. Since the publishing of the first edition of Value Trap (December 2018), a large cap growth ETF has advanced nearly 70% while a small cap value ETF has declined 5% (including today's sell off). We maintain our view that such arbitrary buckets are irrelevant, and that it is the underlying intrinsic value (and the important cash based sources of intrinsic value) of the equities that is driving the divergence. 
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Image: Large cap growth stocks have been on a tear since the publishing of the first edition of Value Trap. They are taking a pause today. We don't expect the category to fall out of favor, and we continue to dislike the make-up of small cap value given the heavy banks/financials exposures.
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When I left as director in the equity and credit department at Morningstar in 2011, I thought I knew a whole heck of a lot about investing. I felt like I was one in the top 5-10 in the world as it relates to the category of practical knowledge of enterprise valuation (maybe include Koller at McKinsey, Mauboussin at Counterpoint, and Damadoran at Stern on this list). After all, I oversaw the valuation infrastructure of a department that used the process extensively, and the firm was among just a few that used enterprise valuation systematically. Then, at Valuentum, our small team would go on to build/update 20,000+ more enterprise valuation models. There can always be someone else out there, of course, but I don't think anybody has worked within the DCF model as much as I have across so many different companies. That said, through the past near-10 years managing Valuentum's simulated newsletter portfolios, I've also learned a number of things to become an even better portfolio manager.
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Image: The figure shows the performance of the simulated Best Ideas Newsletter portfolio from inception May 17, 2011, through December 15, 2017, relative to its declared benchmark, the S&P 500 (SPY), on an apples-to-apples basis, with dividends collected but not reinvested for both the newsletter portfolio and the SPY, as reported in the monthly newsletter.
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Image: The figure shows the average monthly returns and standard deviation of returns for the simulated Best Ideas Newsletter portfolio relative to its declared benchmark, the S&P 500 (SPY), on an apples-to-apples basis, from inception, May 11, 2017, through December 15, 2017, with dividends collected but not reinvested for both the newsletter portfolio and the SPY.
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First, some context, the simulated Best Ideas Newsletter portfolio's performance was generated in a market where 84%-92% of large-cap managers, mid-cap managers, and small-cap managers lagged their respective benchmarks over a 5-year period ending 2017 and 92%+ of managers lagged their respective benchmarks over a 15-year period ending 2017. The Best Ideas Newsletter portfolio is not a real-money portfolio, but on this comparative basis, the performance puts Valuentum near the very top of the measurement spectrum, in our view. Despite the nice showing, I learned three critical lessons during the past 10 years that I think have made me an even better portfolio manager.
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1) Stay Largely Fully Invested

Although the Best Ideas Newsletter portfolio revealed excellent risk-adjusted performance, we felt performance could have done better had we allocated a larger percentage of the portfolio to the ideas within the portfolio (instead of cash). The average monthly long exposure of the Best Ideas Newsletter portfolio was just 74.4% from inception through December 15, 2017. Though the strong relative performance (despite a large cash position), speaks to excellent stock selection and a methodology that has proven its effectiveness, we were not expecting one of the biggest bull markets in history to ensue over the course of the measurement period, and we weren't expecting 2017 to be one of the best performing risk-adjusted years by the benchmark in the past 50 years. One of the big lessons I learned is to stay largely fully invested over longer periods of time.
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2) Don't Layer on Too Much Protection All the Time
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Though the performance of our options ideas out of the gate for the new options commentary has been great, many of our put-option ideas in the Best Ideas Newsletter portfolio during the past 10 years expired worthless and periodically weighed on newsletter portfolio performance. Though their expiration had more to do with strong broader market returns than anything else (a good thing), had we to do it over again, we may not have dabbled in as much put options exposure (at times) in the Best Ideas Newsletter portfolio. That said, we also acknowledge the unique environment during the period following the Great Financial Crisis, where stocks almost went straight up with very little volatility. We may have had better success with put options in a bear market, but the lesson remains: Derivatives can weigh on portfolio returns, so use them infrequently.
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3) Not Prioritizing Cash-Based Sources of Intrinsic Value Early On
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As noted in the block quotes at the beginning of this article, I've grown to appreciate enterprise valuation even more throughout the years, but I've also grown to appreciate its cash based sources even more (e.g. net cash, future expected free cash flow growth). A few of the ideas we added to the Best Ideas Newsletter portfolio definitely made the cut with respect to strong value and strong momentum characteristics and scored highly on the VBI rating system, but their business models, net balance sheet positions, and free-cash-flow growth prospects could have been better. In hindsight, I probably wouldn't have added them, even though a few of them contributed nicely to returns. In many respects, through the course of the past 10 years or so, the Valuentum stock selection process has been further refined and improved.
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All in all, I remain a very humble student of the markets. I hope you enjoyed these three lessons that I've learned having managed the simulated Best Ideas Newsletter portfolio for almost a decade now. Keep your seat belts on as the market digests some of its huge gains during the past many months. Always my best to you and yours! 
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Kind regards,
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Brian Nelson, CFA
President, Investment Research
Valuentum Securities, Inc.
brian@valuentum.com
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Note: The simulated Best Ideas Newsletter portfolio outperformed the S&P 500 (SPY), including reinvested dividends in the benchmark, since inception (May 17, 2011) and since the inaugural release of the newsletter (July 13, 2011) through the end of the measurement period (December 15, 2017). The results are hypothetical and do not represent returns that an investor actually earned. Past results are not indicative of future performance.
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It's Here! 
The Second Edition of Value TrapOrder today!
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Tickerized for holdings in the SPY.
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Valuentum members have access to our 16-page stock reports, Valuentum Buying Index ratings, Dividend Cushion ratios, fair value estimates and ranges, dividend reports and more. Not a member? Subscribe today. The first 14 days are free.
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Brian Nelson owns shares in SPY, SCHG, DIA and QQQ. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.

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J Strawn (Cocoa Beach)
 

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