Investors who opened large positions in the stock market before August have got to be feeling the hurt right now. Trust me, I know what you guys are going through. Not only did I initiate a position, I executed a complete floor-to-ceiling house cleaning of a $20,000 portfolio during the middle of the year...right before the bottom fell out of this market. Out with the old, in with the new, and as a result, half of that portfolio is underwater right now. And you know the best part? I couldn't care less.
I'm banking on the fact that I bought these companies at discounts to their intrinsic value estimates, some of them at really deep ones. Most of these companies are fantastic, well-managed businesses with great economics that I have full confidence in owning. As long as the fundamentals of these businesses remain strong, I'm willing to wait out Mr. Market's depression. Of course, the knowledge that all the positions I sold out have crashed way harder than my current holdings as a group provides a bit of comfort as well. All in all, this portfolio is beating out the SPDR S&P 500 (NYSEARCA:SPY) by a few percentage points, though that figure is pretty meaningless right now given the short time it's been in existence.
It's not often that you get an inside peek at another investor's portfolio, and it's even rarer that you get a chance to hear the reasoning behind his picks, so I've always admired authors who put their money where their mouth is and lay it all out for their readers. Having just finished assembling my brand new portfolio, and in light of the market's recent vote of no-confidence in the stock market, I believe now to be the perfect time to follow in their footsteps. If you're shopping for a bargain amidst the bloodbath, here are five ideas for you, straight from my own portfolio. I'm so confident in the future of these companies that I've entrusted them with twenty grand of real money.
The only stock from my old portfolio that I'm still hanging on to. I bought BP in the middle of June last year, back when the fear and panic over the Deepwater Horizon oil spill cut the legs out from under BP's stock. I was convinced that it would take more than a mere oil spill to topple one of the largest energy giants in the world. It was also partly a political play - I just didn't think that the US government would risk offending our British allies by bankrupting one of the mainstays of its economy, a company that a lot of its citizens were depending on for their pension income. It was a risky bet, but my gambit paid off. Still, I haven't sold yet because I believe the stock still has another rally waiting in the wings before it becomes fully priced.
As an energy company, BP's margins fluctuate depending on the price of oil any given year, but if it could achieve a return on equity equal to the average of what it achieved over the past 15 years, it could pull in $17 billion easy in annual profit. The following facts make this a lowball estimate: 1) BP's sold off a lot of its low margin downstream operations to help pay for the costs of the spill 2) It has increased the amount of leverage its been using the past few years, and 3) The price of oil is through the roof, even after the recent pullback. Oil isn't a bad place to be right now, given the accelerating rate of urbanization in the emerging economies, and chances are good that the price of oil in the next 15 years will be much higher than in the previous 15.
I'm not excited about BP's management. Bob Dudley doesn't exactly inspire, considering that he keeps getting outplayed by the same gang of Russians at Alfa Access Renova, who really are supposed to be BP's allies in Russia and not its enemies. However, being a commodity company can both benefit and hurt you, and in this case BP benefits. It's hard for commodity companies to do significantly better than their competitors because they sell the exact same product. The same is true in reverse: even with inadequate management, it's also hard for them to do a lot worse. Despite Bob Dudley's lack of diplomatic finesse, his petrol will keep your Ford (NYSE:F) pickup chugging along just as well as any of his competitors', and as long as BP continues to be ridiculously cheap, I will continue to stay invested.
David Einhorn said that his position in Apple was one of his least clever picks, and I find myself in the same boat. Does anyone really need to explain why Apple is such a great company to invest in? If you've been living under a rock for the past decade, here's the five second newbie rundown on the Cupertino wonder: almost 100% year-over-year earnings growth, more than $70 billion of cash on its balance sheet with zero debt, most desired brand in the world according to Forbes, huge untapped expansion opportunities in the emerging markets. And the best part? It was trading at a P/E just a hair above 15 when I purchased it. This was for a technology stock, a sector that usually runs a cut more expensive than everyone else, especially if you're a dominant player. We're talking about a company with a moat that rivals Sirius XM (NASDAQ:SIRI), a balance sheet more fortified than Cisco's (NASDAQ:CSCO), and product expertise that equals Intel (NASDAQ:INTC). Apple is the golden boy of its industry, yet it was trading like one of the problem kids.
After considering the growth rate of the global middle class and extrapolating the ten-year projected size of Apple's target markets, I estimated that the company could roughly double profits from its current product line before reaching moderate saturation. What made this an even better deal was that this growth could be had with minimal capital expenditures due to the nature of Apple's business. And this was after baking in a 50% margin cut for the iPhone. This projection did not take into account any future product releases. Considering that the Cupertino crew is probably hard at work at the home office right now cranking out the next revolutionary gadget, this was a very, very conservative forecast.
Caveat: I bought Apple when it bottomed out at around $320 and it has appreciated massively since then, so I'm actually thinking about cashing out part of my position and shifting the capital to other opportunities in the market. However, this still doesn't change the fact that Apple remains an excellent company and a great stock, and I'm definitely going to hold on to some of my shares no matter how high this one climbs (at least until the fundamental picture changes).
American Eagle Outfitters (NYSE:AEO)
Retailers have taken a beating since the recession started, but the best time to buy cyclical stocks is when they're flat on the ground after getting their clocks cleaned. Here was a company that was hurting from the recession, but no more so than its competitors. As a consumer, I liked American Eagle's products, but as an investor, I liked its story even more. Even with the decline in consumer spending, American Eagle was still turning a tidy profit year after year, though it's a bit less than it used to be. It was holding almost 25% of its market cap in cash, had practically zero debt, and insiders were snapping up shares left and right with their own money. It also had huge expansion opportunities both domestic and overseas, and this was a very high return on equity industry - it's not unusual for new stores to recoup their invested capital within a few years' time. In my opinion, American Eagle was the best play in the sector, especially compared to richly valued peers like Abercrombie & Fitch (NYSE:ANF) and Lululemon Athletica (NASDAQ:LULU).
American Eagle's brand was strong, its clothes were stylish, and it paid out a 7% special dividend last year due to lack of opportunities to re-invest capital in the current retail environment. Management wasn't anything to write home about, but shares were cheap enough that it didn't matter. I would never invest in a bad company no matter what the price, but I didn't mind investing in an average to slightly above average company if it was selling for a large enough discount. American Eagle, at the price it was trading for when I bought it, was a company that even Benjamin Graham would invest in, and that's saying something in this era of sky-high valuations and hyperinflated financial bubbles. To top it all off, Eagle has all the trimmings of a first class acquisition candidate, which may lead to a shareholder windfall sooner than expected.
JPMorgan Chase & Co (NYSE:JPM)
Warren Buffett likes to say that you don't know who's swimming naked until the tide goes out. The tide went out for America's big banks in the 2008 financial meltdown, and we saw most of these formerly proud institutions in their birthday suits. JPMorgan, on the other hand, was one of the few that were fully clothed, and not only that, it was dressed for success. When I dug into the company's annual report for the first time, expecting to find the standard two page boilerplate message from the CEO, I was instead blindsided by Jamie Dimon's hardback novel of a letter. That letter took me to school on banking. The more I learned about Dimon, the more I liked him. Here was a leader who loved his job, who's honest with his shareholders, and who's one of the best at what he does. To find one of these qualities in a CEO isn't a particularly noteworthy occurrence. Find two, and you might have yourself a gem of a company that's worth investing in. But to find all three? That's when you know it's time to back up the truck.
Still, I was initially resistant to opening a position on JPMorgan, mainly because banking is such a complex industry and I didn't feel I had a good enough handle on the business to stake my money down on it. But the more I heard about how much the financial sector was a value trap that only foolish investors would buy into, the more I wanted to be one of these foolish investors. Investing, unlike high school, is one of the areas of life where it pays to hang with the unpopular crowd. I decided to gear up and put in the necessary man-hours to learn the ins and outs of banking.
One week later, I concluded that the pessimism against banks was unjustified. No doubt their returns on equity were going to take a huge hit when the new Basel regulations clamp down, but by my estimates, they will still be profitable businesses. In time, I expected banks to take on some of the characteristics of America's regulated utilities, which have agreements in place with state governments that allow them to make just enough money to earn an acceptable return on their invested capital. In the meantime, Wall Street was pricing these companies like they're never going to earn a single extra penny ever again. Sure, JPMorgan was the best house in a rough neighborhood, but the hooligans in this neighborhood were graffiti artists and vandals, not serial killers. In addition, it was the most diversified of the big banks, and as such, was the best positioned to capitalize on the growing international economy. It's a lot easier for banks to export their wholesale businesses than their retail businesses, and the reputation JPMorgan earned as "last bank standing" during the financial crisis gave it credibility with foreign businesses that its competitors lacked.
I don't expect my investment in JPMorgan to appreciate until the financial sector as a whole improves, and that won't improve until the US economy regains its footing, but I'm willing to wait. Patience is a virtue, after all, especially in investing.
My readers have no doubt discovered by now that I love quoting the Oracle of Omaha, but it's only because he's so flippin' quotable. I learned some of my most important lessons in investing from the wit and wisdom of Warren Buffett, and it's a miracle it took me so long to finally put some money down on his company. My initial thought was that while Buffett is really, really smart, he's also really, really old, so it didn't seem worth it to invest in Berkshire at this late stage of the game, a point of view many others no doubt shared. However, one thing I learned from Buffett was that the best companies to invest in are usually those you dismiss the first time you hear about them. It isn't until you move in for a closer look that you discover the true value of the company, and by then you have an edge over the market because most people do not bother to move in for a closer look.
When I took a closer look at Berkshire, I found that I liked what I saw. What I saw was a holding company that owned a dynamic group of smaller companies, each with the potential to become the next multinational juggernaut. These companies shared common characteristics: they were run by passionate, capable managers, they had very high returns on tangible equity, and they were leaders in their industries in one way or another. What I saw, too, was a corporate structure that was the most shareholder-friendly I'd ever seen, one that protected owner value and held management accountable for its performance. Finally, I saw a unique corporate culture deeply ingrained in the company's DNA, a culture that emphasized doing business with integrity, of standing by your partners and employees in both good times and bad, and of maximizing shareholder returns by capitalizing on all available opportunities.
I hope Buffett lives to 120, but if he croaks before then, I know he's leaving behind a legacy that will survive and transcend him. Berkshire's a great company, but another thing that I learned from the Oracle was that great companies are useless if you can't buy them at a reasonable price. After running some calculations, I concluded that Berkshire was trading at a handsome discount even if it was to lose Buffett tomorrow. There was no longer any excuse not to buy ... so I did.
It's Game Time
Peter Lynch said that five is a good number of companies to own in a portfolio. In his experience, if you own five stocks, three will perform exactly as you expect, one will tank, and one will bust through the roof. I, on the other hand, am fully expecting all of my stocks to outperform the bar that I've set for them. No one in this portfolio is going to get carried (though right now the financial is taking a pretty hard beating).
Though this portfolio has been outperforming its benchmark in the short time that it has been operational, only time will tell if I've backed the right horses in this race. I fully plan on returning to this article in a year or so to re-evaluate all of these holdings and my original reasons for buying them. Benjamin Graham has always believed that analysts should put their reputations on the line by calling forward movements instead of dissecting past ones. This is my way of doing that. If a few years go by and it turns out this portfolio is a dud, then you know never to listen to what I have to say ever again. And if the portfolio crushes the market? Well, that's useful information too.
No brownie points for guessing which outcome I would prefer.