Our Investing Philosophy In Action

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Includes: BHC, BKE, BMY, DG, HSII, JBLU, MAN, NCLH, TILE
by: Paul Price

Summary

1. Value-oriented investing philosophy.

2. Methodology for buying quality stocks trading at attractive levels.

3. Guidelines for building a portfolio.

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A. Our Investing Philosophy

Our investing philosophy is captured well by these famous quotes from Benjamin Graham and Warren Buffett:

"Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal." ~ Benjamin Graham, The Intelligent Investor

"The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in that market." ~ Warren Buffett, speaking at Columbia Business School in 1984

B. Methods

1. Price Assessment

We like to take advantage of price vs. value divergences when we find them, so we start by trying to value a company. Our assessment relies to a large extent on past performance and previous trading patterns.

Stocks go "on sale" for various reasons such as earnings misses, company-specific setbacks, and/or general market weakness. Sometimes there is no clear explanation. Whatever the cause, price weakness often leads to very favorable risk/reward profiles - i.e., a good time to buy.

Buy/sell decisions can't be made until we establish "fair value" - our target price or target zone - for the stock in question. To arrive at that, we use a combination of fundamental analysis along with the stock's historical valuation metrics. Applying normalized metrics to forward estimates, we determine a reasonable 12-month target price range.

Experience shows that "reversion to the mean" occurs predictably over most six- to 18-month time periods.

Identifying inaccurately priced shares is key to success. However, keep in mind that not all stocks trading near their lows are being mispriced.

2. Averaging into Positions

We generally begin by initiating a partial position in a new name. If the price drops, we may add to our position. Our analysis is based on a disparity between price and our assessed value, thus a lower price means the stock is a better bargain (unless new information conflicts with our original analysis).

3. Stop Losses

We never use mechanical stop loss orders. Why intentionally take the thought-process out of decision making?

4. Holding Periods

Our actual holding periods vary. When analyzing a stock, we determine both a good buy price and a target zone. We typically expect stocks to reach their mean pricing - our target - within six to 18 months.

If our expectations change, or we find better opportunities, we may revise our goal or sell early.

5. Options

We frequently sell options to hedge positions (covered calls) and/or increase our returns. For example, we often sell covered calls on positions nearing full value in lieu of selling the shares. This provides "sell discipline" - the willpower to exit a hot stock while it is still running.

We also like shorting naked puts on stocks we would like to own, but at a lower entry point. By selling puts, we'll either buy the stock cheaper or get paid not to buy it. Either outcome is good.

C. Building a Portfolio from Scratch

1. Step 1: Pre-plan the Size of Positions and to Diversify

Even "safe," well-loved stocks occasionally blowup. Remember WorldCom and Enron years ago? And more recently, Bill Ackman's infamous and costly overexposure to Valeant (VRX)?

Money in the stock market is always at risk. While occasional stock blowups are unavoidable, crippling losses can be avoided by limiting your position sizes and maintaining adequate diversification across companies and industry groups.

Diversification

To be properly diversified, we suggest holding at least 20 separate companies belonging to a variety of different industry groups.

If your investing capital is modest (e.g. $10,000), we suggest spreading your risk over at least five stocks in at least several industry groups. You can then add more names later as your total account value grows. If you are unable or unwilling to do that, consider owning closed-end mutual funds, at discounts to NAV, or low-cost index ETFs (Exchange Traded Funds).

Mindful Position Sizing

Most of us, at one time or another, have been a victim of "unmindful" position sizing.

It starts with our tendency to over invest in, or overload ourselves with, just one or a few favorite companies. Sometimes a favorite stock drops and we double down; maybe we even double down several times. Other times, a stock rises and we decide to buy a lot more. Before we know it, we have way too much money in a single position and have set ourselves up for potential disaster.

"Mindful" position sizing simply requires setting, and maintaining, maximum position size limits. First, predetermine the minimum number of stocks you want to own. Second, divide your total investing capital by that number of stocks. That dollar amount should be the maximum allocated to any one position.

For example, if your account is $100,000, you'd ideally want to hold at least 20 stocks. The maximum amount of money in any position will be $5,000 - i.e., 5% of the total account value. With this limit, no position can ever cause you to lose more than 5% of your account value. Such a loss would certainly hurt, but it's manageable.

When starting a new portfolio, begin with equal dollar purchases in amounts less than your allocated maximum. We like averaging into positions. With a $100,000 portfolio and a $5,000 per position limit, we'd start with a $3,000 purchase, leaving room to increase the position by another $2,000 later.

2. Step 2: Consider Timing

No one can consistently predict the market's direction. However, during pullbacks or sharp selloffs, we can often find many quality names trading at "on sale" prices.

Thus, while we don't try to time the market, we do watch for good buying opportunities, and we typically see more of them when the market is weak (as in January and February of this year).

Today's market is neither extremely cheap nor outrageously expensive (although some stocks seem overpriced). With the market near all-time highs, there is no urgency to immediately put all your money to work. It presently makes sense to wait for good opportunities and commit capital gradually.

That said, individual stocks can get unusually cheap even in strong markets. We've recently highlighted a number of high-quality names that we believe are trading at attractive prices right now. For example:

  1. Norwegian Cruise Line Holdings (NASDAQ:NCLH)
  2. Interface (NASDAQ:TILE)
  3. The Buckle (NYSE:BKE)
  4. Manpower Group (NYSE:MAN)
  5. Heidrick & Struggles International (NASDAQ:HSII)
  6. JetBlue (NASDAQ:JBLU)
  7. Bristol-Myers Squibb Company (NYSE:BMY)
  8. Dollar General (NYSE:DG)

Knowing why you own a stock, and having a clear idea of what it is worth, is critical to having the confidence to buy or average down on good names during a sell-off or to take profits when appropriate. If you rely on market moves to tell you what a stock should sell for, you'll probably be too scared to buy more after large dips.

3. Step 3. Consider Leverage

Avoid buying stocks on margin. We employ a bit of leverage through our put-writing activities while holding adequate cash to maintain solvency and sanity during inevitable sell-offs. Having only low-to-moderate leverage (and ideally some cash) is a key factor in resisting the urge to panic sell during market sell-offs, when you should be buying.

4. Recap: Basic Portfolio-Building Rules

  1. Do not commit more than 5% or your total capital into any one stock (unless your account is initially small).
  2. Own at least 20 different names. More than 20 is okay.
  3. Spread your holdings over many unrelated industry groups.
  4. Start positions with approximately equal dollar values. Average in.
  5. Have a clear 12-18 month price target in mind. Only buy at significant discounts to your target prices.
  6. Avoid excessive leverage.
  7. Deploy cash gradually, unless the market is really cheap. With today's market trading at highs, it is best to hold some cash and wait for opportunities.

Following these portfolio building rules will keep you out of trouble. You'll avoid the most common pitfalls of investing and have a good chance to outperform the broad market.

Disclosure: I am/we are long MAN, TILE, NCLH, BKE, HSII, DG, JBLU.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.