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Overweighting Outperformers

publication date: Oct 22, 2020
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author/source: Brian Nelson, CFA
Best Ideas Newsletter portfolio (trading session October 21, interim)
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Image: The performance of ideas in the Best Ideas Newsletter portfolio during the trading session October 21. Many of the higher-weighted ideas in the newsletter portfolio (weightings shown here) are propelling the portfolio to relative outperformance. The Best Ideas Newsletter portfolio comprises a portfolio constructed of Valuentum's best ideas. These are companies that have scored favorably on the Valuentum Buying Index (VBI) and have been included in the newsletter portfolio with consideration of sector diversification and market/economic risk. The Best Ideas Newsletter portfolio is found in the Best Ideas Newsletter, which is released on the 15th of each month. Its archives can be accessed here. Source: Seeking Alpha.
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Hi everyone,
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As we talked about in the "The Skill Paradox Is a Myth in Investing," there is a higher probability of deviating materially from the market return with a portfolio of about 15-20 securities that overweight the strongest ideas. We view this construction as the foundation for potential outperformance. Most investors suffer from over-diversification ("di-worsification"), however, where too many holdings are included in their portfolios, pushing returns to the market average (and sometimes worse).
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We wanted to illustrate the ongoing benefits of our portfolio management process, "The Merits of Concentrated Portfolios." We continue to overweight our favorite positions in the likes of Facebook (FB), Alphabet (GOOG), and PayPal (PYPL), and these names have been near the top of the newsletter portfolio for some time now when it comes to their percentage weighting in the portfolio.
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During the trading session October 21, Facebook's shares are showing strong relative performance on account of optimism following Snap's (SNAP) quarterly report. Facebook remains one of our favorite ideas, if not our very top idea, for long-term investors. The high end of our fair value estimate range for Facebook is north of $350 per share, and there could be further upside from there if e-commerce initiatives pan out.
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Alphabet is also showing relative strength today. We continue to prefer large-cap tech companies with pristine balance sheets, strong cash flow profiles, and promising long-term growth outlooks. Ideally, we are searching for companies with outlooks that are supported by secular growth tailwinds, allowing for several winners in their respective end markets. Alphabet fits the bill perfectly, in our view, and it remains a top-weighted idea.
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Then, there's PayPal (PYPL). This is a company that we have been pounding the table on for some time, and we have increased its weighting in the Best Ideas Newsletter portfolio on a number of occasions in the past. The news today is that PayPal will introduce a new service aimed at enabling customers to facilitate cryptocurrency transactions. PayPal will continue to play a leadership role in payment processing, and the high end of our fair value estimate range for the company is $240 per share.
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We continue to accept the higher corresponding firm-specific risk that comes with overweighting some of our favorite ideas. The Best Ideas Newsletter portfolio has performed fantastically during good times, and it has held up nicely during the COVID-19 market crash. We think the Valuentum process that avoids "catching falling knives" holds substantial merit. Read our book, Value Trap.
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With that said, we wanted to let you know of a few report updates. On October 8, we revamped our consumer discretionary sector, and aggregated some of our top names in a new industry, Discretionary Spending. You can find links to download the reports here. We did a similar thing with the consumer staples sector, aggregating some of our favorite names into a new industry, Recession Resistant. The links to download those reports can be found here.
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We've also been busy following the news of many of the newsletter holdings. Our thoughts on Intel's (INTC) sale of its storage unit to SK Hynix can be found here. Our thoughts on Lockheed Martin's third-quarter report, released October 20, can be found here. We talk about ConocoPhillips purchasing Concho Resources in this note here, and we continue to warn investors about the fragility of too-good-to-be-true dividend yields in our work on Global Net Lease (GNLhere
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We continue to be excited about how the Dividend Growth Newsletter portfolio is positioned, and we point to continued strong fundamental performance in one of its top weightings Johnson & Johnson (JNJ). Our thoughts on J&J's fundamental momentum can be accessed in our note here. We manage the Dividend Growth Newsletter portfolio for dividend growth, while we manage the Best Ideas Newsletter portfolio for capital appreciation.
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We maintain our view that the markets are trading below a fair value estimate of their intrinsic value. We think a fair value of the market today is 3,530-3,920 (the S&P 500 is trading at ~3,450 at the time of this writing); the fair value range is derived here. We generally continue to steer clear of the banking sector as we outline in this work here, and the energy sector doesn't fit too well in the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio, though it does have a role in the High Yield Dividend Newsletter portfolio.
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When it comes to rolling up our thoughts in simplistic fashion, we remain bullish on the equity markets, and our favorite broad-based areas remain large-cap growth, big cap tech, and the NASDAQ. Though some names have been dislodged from their valuations, these areas are overflowing with moaty, net-cash-rich, free-cash-flow generating powerhouses with excellent business models. Exclusive members should expect a note in the coming days, as we'll look to close more winners!
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We're available for any questions.
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Kind regards,
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Brian Nelson, CFA
President, Equity Research
Valuentum Securities, Inc.
brian@valuentum.com
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Here are some of my recent articles you may have missed.
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Michael Mauboussin, while highlighting in his own words in The Success Equation how stock portfolios have conformed over time due to a reduction of active share brought about by myriad influences in how active managers are "playing the game," completely misses using this explanation as the correct conclusion for the observation of declining standard deviations of excess returns. There is no paradox of skill in investing. Investors are conforming to the same playbook due to conflicting incentives (perhaps even driving active management skill levels collectively lower), and this is resulting in what we're seeing today. Unlike his work in evaluating baseball and basketball, Mauboussin seems to completely miss that active mutual funds and ETFs are also only 15% of the market. In the case of investing, analyzing the standard deviation of returns of 15% of the stock market, as in active funds and ETFs, tells us little about luck or skill. Warning about the use of small sample sizes early in the book, the combination of this errant conclusion has only padded the indexing propaganda making The Success Equation an absolute tragedy of a text, and I must say it hurts me a lot to say it (I know how much work goes into writing a book, and I generally enjoy Mauboussin's work).
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All things considered, not much has changed since our last update. I think the newsletter portfolios--Best Ideas Newsletter portfolio, Dividend Growth Newsletter portfolio, High Yield Dividend Newsletter portfolio--are well-positioned for this market environment, our new options idea generation has been great, the Exclusive ideas have had tremendous success rates (we just closed another two winners recently), and we continue to add tremendous value in providing our work in full transparency for readers. Thanks for tuning in.
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From February 15 through June 11, or through the course of the worst of the COVID-19 meltdown and its abrupt recovery, we estimate that the Best Ideas Newsletter portfolio exceeded the market return by about 7.8 percentage points.
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At Valuentum, we seek to identify strong, competitively-advantaged companies that are underpriced [with solid cash-based sources of intrinsic value (net cash, strong expected free cash flows)] whose share prices are either 1) also advancing, 2) have strong relative pricing strength, or 3) have just started to begin to advance toward an intrinsic value estimate (with a nice growing dividend to boot, where applicable). Third-level thinking is our foundation at Valuentum, and it continues to serve investors well.
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ICYMI: How Big Is Your "Too Hard" Bucket?
In investing, it's okay to admit that there are some things that investors can't know. It's not a poor reflection of one's analytical ability or a possible shortcoming of one's experience, but rather quite the contrary: Understanding and accepting that some things are "unknowable" is a sign of the quality of one's judgment. Quite simply, certain critical components of the equity evaluation process are more "unknowable" than others. The intelligent investor recognizes the variance (fair value estimate ranges) and the magnitude of the "unknowable" between companies and generally tries to identify entities that have the least "unknowable" characteristics as possible or situations where the "unknowable" might actually be weighted in their favor (an asymmetric fair value distribution).
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Richard Thaler in his groundbreaking book Nudge, co-written with Cass Sunstein, talked about the role of the choice architect. A choice architect is basically someone or some organization that has the responsibility for organizing the context and content in which people make decisions. At Valuentum, we can never provide personalized buy/sell advice, but in providing publishing services, we've opted for the healthy option for members, and that sometimes means you won't find a large selection of dessert options. This isn't a shortcoming of our service (i.e. we know desserts are tempting), but rather a key positive attribute. As we've shown time and time again, you don't need to look far to beat the market return (or, by comparison, to have a healthy diet). If something is not on the menu at Valuentum, it means the chef has something better cooking in the kitchen. Here's to your long-term financial health!
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To my amazement, the equal-weighted hypothetical returns of our top 10 COVID-19 ideas not only exceeded the market return over the simulated measurement period by a huge margin, but because of the impeccable timing of their release, they also did better than the returns of a backfilled index from the start of the year that--get this--was filled with stocks that in April were already "outperforming the S&P 500 since the start of 2020." I sincerely hope this provides some perspective of just how awesome our research and idea generation has been this year. If I had a mic, I would drop it!
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Have you ever wondered why so many trust the TV for financial advice or stock tips? You guessed it: It comes back to "brain science" or the concept of familiarity. When we see a celebrity or our favorite stock guru on the television, it arouses our emotions and connects us with the idea, making the experience more memorable. The brain tends to treat our favorite newscaster or celebrity as a trusted, familiar friend, and therefore we translate those feelings into expertise and a "valid" endorsement.
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Valuation multiples tend to trigger the reflexive side of our brain, and we process the multiples through anchoring, in most cases. On the other hand, enterprise valuation, or the process required to answer the second set of questions in this article correctly, shows that our reflexive process can be quite incorrect at times. In fact, cognitive biases such as anchoring can completely trip us up into missing out on truly undervalued companies while baiting us into value traps.
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For every Amazon that made it, there are hundreds, maybe thousands, from the dot-com era that didn't. Very few remember Pets.com or etoys.com, both of which went belly up during the dot-com meltdown. For every Tesla, there is a DeLorean Motor Co. We might have completely forgotten about DeLorean were it not for the blockbuster movie, Back To The Future, that immortalized its futuristic sports car. For every streaming enterprise like Netflix, there is a Napster that failed. Most of us probably don't even remember the original Napster, which encountered legal troubles before closing shop shortly after the dot-com bust. For every Alphabet, there's an AltaVista or Netscape. For every Apple, there is a Palm or Blackberry. Who remembers how popular the Palm Pilot and Blackberry were? How about the Motorola Razr? For every Facebook, there is a Myspace or Friendster. As investors, we underestimate the role of luck in a company's long-term success. In February 2000, a month before the dot-com market crash, a fledgling Amazon raised $672 million in convertible notes to European investors. If the company hadn't done so, there'd likely be no Amazon today, and one of the wealthiest men in the world, Jeff Bezos, might have just been a mere footnote in stock market history. Amazon would have been insolvent in 2001-2002 just like many of its other dot-com peers.
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We have to be on high alert about how our minds work. PBS is premiering a four-part series examining about how easily our minds are being hacked, and why it is so important to "think slow." Tune in (5). When it comes to the active versus passive debate, does the analysis suffer from parameter risk? With respect to empirical, evidence-based analysis, does the analysis have the entire construct wrong? When it comes to short-cut multiples, are we falling into the behavioral trap of thinking on autopilot? I hope that you found this article helpful, and don't let your mind get hacked!
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The skills to successfully invest for long-term capital gains or long-term dividend growth are much different than those required for generating high yield dividend income. Income investing is a much different proposition. However, the skills do center on a similar equity evaluation process, but one that requires an acknowledgement and heightened awareness of considerably greater downside risks. Income investing, or high yield dividend income investing, should at times be considered among the riskiest forms of investing, as many high dividend-yielding securities tend to trade closer to the characteristics of junk-rated bonds than they do most net cash rich and free cash flow generating powerhouses that we like so much in the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio.
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Management's willingness to pay is critical, so an understanding of how dividend growth has been the past few years is very important, but when we look for fantastic dividend growth ideas for the future, we also want to make sure that the management team has the capacity to keep raising the dividend--meaning there's so much more to dividend growth assessments than backward-looking analysis. For starters, we want our long-term dividend growth ideas to have strong competitively-advantaged business models, solid secular growth trends or recession-resistant characteristics, impressive balance sheets (sometimes and preferably with hefty net cash positions) and growing future expected free cash flows (strong Dividend Cushion ratios).
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There are three primary benefits of a well-executed dividend growth strategy, one that is carried out with prudence and care and one that pays careful attention to the intrinsic value of the stock and its critical cash-based components. Albert Einstein is reported to have called compound interest the "eighth wonder of the world," but dividend growth investing has the potential to offer long-term investors so much more! Let's explain.
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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." -- Brian Nelson, CFA
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To some degree, each investor has to pick their own preference. With widely-diversified index investing, firm-specific risk is largely eliminated as such investors are taking on only systematic risk. On the other hand, investors seeking portfolio concentration are taking on firm-specific risk, in addition to systematic risk. This could either help mitigate broader market movements or exacerbate them. I hope this was helpful, and may today's nearly all-green Best Ideas Newsletter portfolio brighten your spirits. Let us look to even better times ahead.
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It's Here! 
The Second Edition of Value TrapOrder today!
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Related: SPY, QQQ, SQ, VRSK, BTC, GBTC
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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, VOT, 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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The High Yield Dividend Newsletter, Best Ideas Newsletter, Dividend Growth Newsletter, Valuentum Exclusive publication, and any reports and content found on this website are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of its newsletters, reports, commentary, or publications and accepts no liability for how readers may choose to utilize the content. Valuentum is not a money manager, is not a registered investment advisor, and does not offer brokerage or investment banking services. The sources of the data used on this website and reports are believed by Valuentum to be reliable, but the data’s accuracy, completeness or interpretation cannot be guaranteed. Valuentum, its employees, independent contractors and affiliates may have long, short or derivative positions in the securities mentioned on this website. The High Yield Dividend Newsletter portfolio, Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio are not real money portfolios. Performance, including that in the Valuentum Exclusive publication, is hypothetical and does not represent actual trading. Actual results may differ from simulated information, results, or performance being presented. For more information about Valuentum and the products and services it offers, please contact us at info@valuentum.com.