My Year in Trading - Why I Looked for 'Survivability' in Companies

At the beginning of each calendar year, I sit down and see how my expenses have tracked over the past year. I make a table and a pie chart to show my wife. She is always amazed at how much goes to taxes, though the new amazement is what it takes to put children through college. We spend some time discussing plans for the next year. Since my wife is not money-oriented (not a big spender, and focused on teaching the children) this gives her a quick way to get reoriented in our financial situation.

After that, I look at investment income. 2008 was an unusual year for me in this way: it was the first year in my working life that my net worth fell. Though painful, at age 48, I’m grateful that I have had a good past.

I then look at how individual stocks in the portfolio did. Here’s a chart for 2008:

click to enlarge

The chart is in order from the biggest gain to the biggest loss. XIRR is the internal rate of return on funds during 2008, and days was the number of days I held a position during 2008. Needless to say, this was my worst year ever, but I still did better than the S&P 500 by a middling single digit percentage.

That is important to me, because in 2009 I hope to gain my first external client. I have been banging my head against the wall, because I have a small bunch of investors that want to sign on, but they all don’t want to be my first client. They want to see an institutional investor invest in my fund, then they will invest with me. Frustrating.

Since strategy inception in 2000, I have beaten the S&P every year except 2007, where I missed by less than a percent. And, given the performance of many well known value managers in 2008, beating the S&P ain’t bad.

Going back to the table above, I got whacked on names with bad balance sheets, life insurers, and names with too much cyclicality. I did well on a number of names that I bought cheaply, and particularly on my October reshaping, where I focused on survivability.

I still think survivability is the watchword here. I’ll be putting out my candidates list for the next reshaping soon, as well as my main industry model, but in an environment like this, raw cheapness doesn’t matter; a company must survive to realize the discount on its valuation. Remember, the main rule of value investing is not “buy them cheap,” is not “lowest average cost wins,” but is “margin of safety.”

One more note: the present portfolio “long only” portfolio is 22% cash. That is the highest level in eight years. I have raised cash into the recent rally through my normal rebalancing discipline. I will deploy cash as I get opportunity into strong names with strong balance sheets.

Asset Allocation

I also look at our asset allocation. Excluding our house (no mortgage), it looks like this:

• 30% Cash and TIPS
• 20% International Stocks
• 18% Large Cap US Stocks
• 17% Small Cap US Stocks
• 15% Private Equity

I have no debts, but I have eight liabilities, two of which are going to college, and six of which might do so. That is my main financial challenge for the next fifteen years (the little one is almost seven, and what a cutie.)

Even though I am bearish, I am comfortable with the amount of risk that I am taking, partly because I may derive a business from it through my ability to pick stocks that do relatively well. The private equity is illiquid, but in this environment even it is doing well — having clever businessmen as friends is a help.

Recent Changes

Here’s a list of my moves since the last time I wrote:

Outright Sale — Gruma SA

Swap — Bought Japan Smaller Capitalization Fund, sold Small Cap Japan (The CEF was trading at an extreme discount)

Rebalancing Sales

• Assurant (3)
• RGA
• Valero Energy
• CRH
• Magna Automotive
• Safety Insurance
• Charlotte Russe
• Shoe Carnival
• Devon Energy
• Japan Smaller Capitalization Fund

Rebalancing Buys

• Assurant (2)
• Charlotte Russe (2)
• Magna Automotive
• Shoe Carnival
• Nam Tai Electronics

I also participated in the RGA exchange, where I traded my A shares for B shares when the discount was wide, and received RGA shares one-for-one when the exchange was complete.

Blog News

I have several book reviews coming, including one on Technical Analysis, and one on how wealthy people got that way. I also have a panoply of other article ideas:

• How the lure of free money corrupts politicians
• Setting up mutual banks
• The risk of no significant change (not yes we can, but, why do we need to change?)
• Hidden correlations
• The mercantilists lost
• Analyzing TIPS
• Momentum strategies
• Buybacks
• Confidence means keeping assets inflated
• How securitization could aid resolution of our current crisis

It is a lot of fun writing this weblog. I enjoy it a lot. As I close this note, I would like to thank:

• Those that read the blog
• Those that comment here, and send me email (all of which I read, but I can’t answer all of it)
• Seeking Alpha
• Others that republish me
• Those that buy products at Amazon through my site
• Those that buy blogads at my site
• Other bloggers that give me good ideas
• And the firm that employs me, Finacorp, but bears no liability for my mutterings here.

2009 may prove to be a better year than 2008. If that is not true, we will be rivaling the Great Depression. That said, there are opportunities even in bad economic environments, and let's see if we can’t make the best of what we do get. Here is to making the most of our opportunities in 2009. May the LORD bless us all in our endeavors.

Full disclosure: long COP SBS DIIB.PK MGA IBA XEC VLO TNP JSC NTE VSH SAFT CHIC SCVL HIG RGA HMC ESV KPPC DVN ALL PRE CRH PEP GPC LNT NUE AIZ (yes, that is the complete current portfolio).

Comments

[Tom Armistead:]

You beat Bill Miller...handily.

I like the paragraph on survivability - 2008 was a bad year for value investing and you have put your finger on the problem.

Jan 04 12:01 PM

[Jason Rines...:]

1) I admire your writings Mr. Merkle. They reflect a strong level of detail combined with self-analyzation. You put yourself out there not fearing differing opinions.

2) First-In - Ah yes. As an entrepenuar I can appreciate your knowledge of this and your frustrations. I advise taking your five year numbers of how you accumulated wealth by stock-picking into a simple to understand spreadsheet as a value-proposition.

3) Survive then thrive. Any form of middle man will be questioned and re-questioned after the breakdown of trust in everything financial. No, it's not fair we played by the rules and should be trusted. We seem alike Mr. Merkle, we tend to make our goals grandioise. We probably belong being on 3-4 boards and making a fine living that way. However, first we must finish accumulating wealth as we run the risk of becoming too spread out. I own a Consumer Health and Higher Ed marketing business. One of the hardest choices I had to make was realize there was only so much time in the day and give my focus to the best hedge in the survivability equation. That choice was made in February of 2007. I am drawn toward Higher Ed for many reasons, but the timing will not be right until the second half of 2009. Disclipling myself is required.

4) Why won't they listen?!?! Leadership in Washington and Corporate America was used to a heavy-debt model that was non-sustainable. America is going back to Save and Invest economy, despite leadership attempting to patch up a broken boat. It should not be surprising current leadership is still defending the broken model. Emerging leadership is the category both of us fit into. I stopped being frustrated and started doing something about it. But this is part-time public service stuff I am doing. It cannot and will not replace the focus on Consumer Healthcare survive/thrive model. As you seem to relate, family comes first. America chooses it's leadership, they will become wiser (slowly but surely) in this regard as they have in the past during other financial meltdowns.

Jan 04 01:02 PM

[Steven Hansen:]

David, thanks for sharing. Good luck in 2009.

Jan 04 07:24 PM

[Old Trader:]

Dave,

First, let me say that I think that you're definitely one of the better contributors to SA, and I make it a point to ALWAYS read your contributions.

I do have a question, however. Relatively recently, you mentioned allocating even dollar amounts to all of your positions, when constructing your portfolio, because you didn't feel you could make proper allocations. Do you still feel that way? I'd think that even a rudimentary allocation by sector would be very helpful. (Like you, evidently, I dunno whether PEP or KO would be the "better" buy, for example).

Hope your new year goes well..

Jan 05 10:44 PM