Fully Invested, but Defensively So

I first posted on Seeking Alpha 27 months and 227 articles ago. For those who have followed my submissions, you are aware that I combine top-down and bottom-up analysis and technicals to produce those 2 articles a week on average. You may not be aware that for the past year I have been running a model portfolio that reflects the views that I share here. While the past year has been tough, with the S&P 500 declining in value by approximately 1/3, I am celebrating my Top 20 Model Portfolio's first anniversary appreciating that it has declined only 8% despite being fully invested over the entire time-frame.

Two things have helped me to beat the market so soundly: active trading and a willingness to take concentrated sector bets. While I certainly expected lower turnover when I launched a year ago, only five names remain from the original twenty stock portfolio. We have bought and sold a few of the names on multiple occasions. The fact of the matter is that high market volatility, such as we have experienced, leads to many opportunities for those willing to take advantage.

The portfolio today is much different than the one I went with on the launch a year ago. At that time, I was optimistic that the bear market was nearing an end and positioned the portfolio aggressively. While it never really lagged the market despite its poor positioning, including a big zero in Fannie Mae (FNM), it has really done well since I repositioned it during Q4 for a more defensive environment. Here is what it looks like now:

Before I share further insight about the portfolio, it's worth considering what it looked like on inception. Below is a list of the 15 names besides the original five that remain in the portfolio (Catalyst Health (CHSI), EZCORP (EZPW) Stratasys (SSYS) and Ladish (LDSH) and Shoe Carnival (SCVL) which we sold and then repurchased):

• Americredit (ACF)
• Allergan (AGN)
• Administaff (ASF)
• Astec Industries (ASTE)
• Carpenter Technologies (CRS)
• Federated Investors (FII)
• Fannie Mae (FNM)
• Lincare (LNCR)
• Lowes (LOW)
• Middleby (MIDD)
• Men's Wearhouse (MW)
• National Instruments (NATI)
• NetApp (NTAP)
• Surmodics (SRDX)
• Timberland (TBL)

Other names that were added later but have been subsequently removed include Advisory Board (ABCO), BedBathBeyond (BBBY), Biomed Realty (BMR), Cisco (CSCO), Cintas (CTAS), Intuitive Surgical (ISRG) and Thor Industries (THO). So, there have been a total of 42 names over the past year.

Looking at the current portfolio, it is pretty clear that I like strong balance sheets. The highest net debt-to-cap names are rather average, while overall the portfolio has typically companies with net cash. Similarly, I have been focused on price-to-tangible book. While some of the names are quite distant from that metric, 13 of the 20 are below 2.5X.

Reviewing the list by sector, the Energy holdings represent a much larger portion of the Top 20 than they do of the S&P 500. Chevron (CVX) is the only large-cap name, while the other three are small-cap. Contango (MCF) is a producer leveraged to natural gas. Carbo Ceramics (CRR) is also leveraged to natural gas but land-based and is more of a technology play. Lufkin (LUFK) is involved in both energy, where it competes with Weatherford (WFT) as well as power transmission for industrial applications. In all cases, these are "value" stocks. Despite the big run recently, I am sticking with these names for now.

We are underweight Industrials, but our two names Ladish (LDSH), which we have trimmed significantly, and Met-Pro (MPR), a recent addition, are both very tiny companies. LDSH is in a duopoly with Precision Castparts (PCP) in the jet engine component market and trades at tangible book value. MPR is a company involved in green applications - water filtration and pollution control.

The portfolio was extremely heavy in small-cap retailers early in the year, but we have trimmed a lot of the exposure. What remains is a collection of small and rather inexpensive companies. Dorman Products (DORM) and America's Car-Mart (CRMT) are both plays on the slowdown in new car sales. Shoe Carnival (SCVL), which had a great report this morning, trades way too cheaply. They sell shoes to a lower-income demographic, and the decline in gasoline prices over the past year as well as pent-up demand should continue to help them to perform better than typical retailers. Columbia (COLM) is just a plain old-fashioned value stock, with significant inside ownership. So, we are still overweight the sector, but in a defensive manner in my opinion.

We launched with no Consumer Staples stocks, but have picked up some gems over the past six months. We started with Hormel (HRL) around Thanksgiving and remain pleased with this very inexpensive food manufacturer with one of the best balance sheets in the industry. We added Walgreen's (WAG) next, but have trimmed it after the nice run. Finally, we most recently added Sysco Foods (SYY). It has lagged its restaurant customers significantly, though it should benefit from some of the same factors. The dividend is high and sustainable, a rarity these days.

Healthcare is our largest exposure. Volcano (VOLC) is a recent add and truly a growth name with a very high percentage of its sales in consumables. It competes very well with its larger, less-focused rivals, and I really like the CEO and his vision. C.R. Bard (BCR) is more of a value play that I appreciate because they don't sell any capital equipment. Catalyst (CHSI) is a small PBM with greater transparency than its rivals. While it did very well last year, it has been a disappointment in 2009. The valuation is compelling, but I am watching the 19 support level. We caught Zimmer (ZMH) at a great time and have trimmed a bit recently, though it remains very inexpensive. Investors are just too pessimistic on the ortho players. This one has the best balance sheet and valuation. Finally, we like the diversity and consistency of Johnson & Johnson (JNJ), and the valuation is very attractive.

Our only exposure to Financials is through EZCORP (EZPW), which is primarily a pawn lender being weighed down by concerns over its payday lending (regulatory). The company has a fantastic balance sheet and should continue to be counter-cyclical. It is truly a defensive name in many respects. Our only Technology name is Stratasys (SSYS), which has been too cheap to sell but not particularly defensive except for its high cash and relatively low valuation compared to its book value. I think that Tech could disappoint over the next couple of quarters and remain underweight despite the sector having better balance sheets than others.

The model portfolio doesn't allow me to make short bets or to move to cash, so it's important to remember that these picks are relative to the market and not absolute. I happen to own 17 stocks currently, 15 of which are currently in the model. As always, I post my holdings on my website. I look forward to the days ahead, whenever they return, when I can invest with a longer time-horizon and not have to churn the portfolio so much. I wouldn't expect to beat the market in that environment by 25% a year again, but it sure would be a lot less work!

Disclosure: Long BCR, CHSI, COLM, CRR, CVX, DORM, EZPW, HRL, JNJ, MCF, MPR, SCVL, SYY, VOLC and ZMH

Comments

[Teak]

Is this real money that you are spending to build the portfolio (including broker fees), or is this a Play Portfolio. I don't trust players, I only want to see what people with "skin in the game" are doing.

2009 May 28 10:26 PM

[Alan Brochstein]

Teak, I run two model portfolios through a 3rd party platform. I also manage a real portfolio that is very similar but not the same. It is run at 60% stocks +/-15% and 40% bonds. The account was down 10% all of 2008 and is up 14.3% in 2009. So, it's a little different than the model described above, especially in its allocation to stocks. If I were to take the 14.3% return and gross it up (since stocks are only 60% and the bonds haven't done much one way or the other, that would be 24%. That's a little behind the Top 20 model, but I would attribute it to being quicker with real money to take profits. The account I just described is traded at Schwab at $9 a pop, while the model doesn't reflect those costs (as trivial as they are cumulatively).

2009 May 28 10:48 PM

[ArtfulDodger]

AB:

Another informative article; thank you for sharing these insights with us.

One of the more important statements in this one, I think, at least for those learning to build portfolios is this one: "Two things have helped me to beat the market so soundly: active trading and a willingness to take concentrated sector bets."

Indeed, I'm sure by "active trading" you mean (1)dumping losers when applicable and (2) moving to less risk oriented and more opportunistic plays, both of which are proper money management; and proper money management is mandatory to successful investing.

And the phrase "willingness to take concentrated sector bets" means that you're raising the odds on growth and/or income opportunities as well as cutting risk by keeping your funds in more active sectors where your money is alive.

If I'm right, then I agree wholly with sector-specific investing and this type of money management.

Am I following you properly? If not please expound, if you would, on the two points I pulled out of the one statement.

2009 May 29 12:01 PM

[Steven Hansen]

alan, thanks for sharing this. most punters talk the talk without having skin in the game. this is why you are on my watchlist.

my only comment is that each of us have different needs - and these needs effect how we invest. in my case, i live on my investments and i live overseas most of the year. i need to be much more conservative with capital preservation, and i have to worry about the dollar's value so investments are biased overseas as the value of the dollar is declining (i try for a double pop - currency value increase and asset value increase).

anyway, i have lost a good sum of money on investment real estate and this i doubt i will recover in my lifetime.

2009 May 29 12:38 PM

[Alan Brochstein]

Hey, Steve. Thanks for your comments. I agree with you 100% and offer a more conservative model portfolio as well.


On May 29 12:38 PM Steven Hansen wrote:

> alan, thanks for sharing this. most punters talk the talk without
> having skin in the game. this is why you are on my watchlist.
>
> my only comment is that each of us have different needs - and these
> needs effect how we invest. in my case, i live on my investments
> and i live overseas most of the year. i need to be much more conservative
> with capital preservation, and i have to worry about the dollar's
> value so investments are biased overseas as the value of the dollar
> is declining (i try for a double pop - currency value increase and
> asset value increase).
>
> anyway, i have lost a good sum of money on investment real estate
> and this i doubt i will recover in my lifetime.

2009 May 29 07:02 PM

[Alan Brochstein]

Artful Dodger, I do sort of mean what you said, but if you had just asked me to elaborate, I would have expounded as follows.

Active trading: The markets have been wildly volatile, and that can work to an investor's advantage if he or she is willing to trade. For example, I put ISRG in the model at 90. I scaled out at something like 125, 140 and 160. I was willing to average down (something I normally don't like to do) on some very beaten up small-cap retailers (like THO at 10). When I created this model, I really thought that 65% turnover would be about right. That means buying 20 names originally and replacing 13 over the course of a year. In fact, I added 24 new names! I also calculated that there was a lot of tweaking - a total of 161 buys and sells. Had I not been willing to "churn", I would not have captured even 1/2 the 25% relative pick-up.

Concentrated Bets: This one has little to do with the current environment. Unless one is willing to take a stand on certain sectors , it is very difficult to differentiate oneself significantly from the market (closet indexing). Whether it's one of the 10 economic sectors, small vs. large or growth vs value, positioning the portfolio can make all the difference in the world. My biggest and best bet was to load up on small-cap retailers. Now I am very heavily exposed to Energy and Health ( a barbell).

I hope this explanation clarifies!


On May 29 12:01 PM ArtfulDodger wrote:

> AB:
>
> Another informative article; thank you for sharing these insights
> with us.
>
> One of the more important statements in this one, I think, at least
> for those learning to build portfolios is this one: "Two things have
> helped me to beat the market so soundly: active trading and a willingness
> to take concentrated sector bets."
>
> Indeed, I'm sure by "active trading" you mean (1)dumping losers when
> applicable and (2) moving to less risk oriented and more opportunistic
> plays, both of which are proper money management; and proper money
> management is mandatory to successful investing.
>
> And the phrase "willingness to take concentrated sector bets" means
> that you're raising the odds on growth and/or income opportunities
> as well as cutting risk by keeping your funds in more active sectors
> where your money is alive.
>
> If I'm right, then I agree wholly with sector-specific investing
> and this type of money management.
>
> Am I following you properly? If not please expound, if you would,
> on the two points I pulled out of the one statement.

2009 May 29 07:10 PM

[ArtfulDodger]

Yes, AG, I understand now. A little too much trading for my taste, but if you have it in you to do it (and with your ability), it's fine.

I like the sector betting idea.

Thank you for the explanation. You are very helpful to a lot of people, I'm sure.

The best to your investing, as always.

2009 May 29 09:08 PM

[Mr Informer]

VOLC is going down in flames, their quality sucks ask a Boston Sci. reps. They continue to cut corners on quality.

2009 Jun 05 03:50 PM

[Alan Brochstein]

Not sure what led you to post so negatively on VOLC, but so far it seems to be working. The market (and I) liked the unwind of the Goodman distribution agreement - they managed it very well.


On Jun 05 03:50 PM Mr Informer wrote:

> VOLC is going down in flames, their quality sucks ask a Boston Sci.
> reps. They continue to cut corners on quality.

2009 Jul 21 09:17 PM