Some Thoughts on Investing

I've been picking stocks and managing my own portfolio since 2005, buying undervalued positions based on the strategies of Benjamin Graham and Warren Buffett. See Concepts page for discussion of Graham and Buffett. For about half this time I was highly concentrated in a handful of good companies a la Warren Buffett. I held these companies as long as they were undervalued or fairly valued based on a conservative analysis of discounted cash flow (with low, medium, and high estimates of value). This usually led to holding periods ranging from three to five years.  

For the remaining time from 2005 to 2016 I managed a portfolio of 12 to 30 "cigar butt" stocks. These companies were chosen based on Graham-style quantitative analysis. This second approach was focused on limiting downside risk. Stocks were selected and held only if they appeared undervalued based on ratios like price to earnings, price to "owner earnings" (similar to free cash flow), enterprise value to operating earnings, and price to tangible book. This often resulted in more turnover, especially if positions were rising. Tax avoidance did not enter the decision making process.

With both these approaches I tried to stay in companies that were fairly unleveraged and had reasonable levels of working capital, consistent with Graham's writings. A highly leveraged company with low liquidity can be forced into bankruptcy through a single period of poor profitability and tight credit conditions — even if historical profits have been good. As Buffett notes, "any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero." From a psychological standpoint it’s also harder to buy additional shares of a highly leveraged company getting beaten up in a broad economic downtown — it’s harder to be contrarian. That’s because the market may be correctly assessing the leveraged company’s ability to survive a more difficult economic environment.

Out of this experience the following seems worth noting (these are all personal observations/opinions and are not intended as investment advice -- anyone considering a stock market investment should consult a registered investment advisor):

  1. With Buffett's concentrated approach I was looking for good companies I could hold for a long time. To justify a long holding period -- and keeping money tied up in the investment -- I tried to predict future outcomes and understand everything about the company.
  2. I generated good returns with Buffett's approach, but I had difficulty keeping these returns because I sometimes held fairly valued positions too long. I invested so much time learning about each company that I "fell in love" with certain picks, making me less objective about buy/sell decisions. With big gains I was also reluctant to take the tax hit. These problems led to money sitting "fallow" and not generating a return.
  3. With Graham's cigar butt approach I did not fall in love with positions. I was always in undervalued stocks and had a firm selling rule, so emotions didn't really come into play. Because this approach was mostly quantitative, and because I had a diversified portfolio (rather than a highly concentrated portfolio), I felt less pressure to know everything possible about each company. I felt less need to predict future outcomes.
  4. Comparing Graham and Buffett, I think it's easier to take advantage of cigar butt volatility -- through a quantitative approach -- than it is to pick a handful of good companies that will grow over a long time period. That's because: (1) Buffett's approach presents emotional challenges, as already noted; and (2) stock volatility is a more common/reliable phenomenon than a single company's growth/survival. All stocks experience volatility and temporary mispricing, while few companies grow/survive over long periods. As Ben Graham observed, you cannot reliably depend on past trends to continue, growth or otherwise. You have to recognize what you don't know or can't reliably predict.
  5. I seem to do better -- and sleep better --  by trying to avoid losers rather than pick winners. In my experience, when you focus on downside risk you improve long term returns more than you do by trying to predict the future or find growth. Losses are hard to recoup -- if you lose 25% you have to make 33% on that money to get back to even. Graham's cigar butt approach seems better if your first priority is avoiding loss.
  6. I did worse when I became too concerned about avoiding taxes or holding on for maximum gains. I now focus on avoiding loss by making sure I stay in the cheapest low debt stocks I can find.
  7. One way to beat the tax issue is to "out-run" the tax hit through great returns, even if it means higher turnover from a quantitative, cigar butt approach.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. This article should not be construed as investment advice.