Core Value Portfolio Update: Up 21.5% In H1 2017

Summary

• The Core Value Portfolio reached new highs towards the end of the second quarter.
• I share with you some of things that I believe are necessary for achieving long-term outperformance.
• Learning to suffer stretches of underperformance.
• Don't be afraid to miss out on hot investments.
• Accept that things can go wrong.

The Core Value Portfolio is a value-based portfolio that aims to achieve 20% CAGR over the long-term

Performance Since Inception

Source: Author’s calculations

After a lackluster 2016 and a poor start to the year, the Core Value Portfolio reached new highs towards the end of Q2 2017, firmly in line with its long-term goal of achieving 20% CAGR. Although there is absolutely no guarantee that this level of performance will continue, I believe that I am laying the groundwork to achieve this goal by buying only the best of the best.

To those of you that are not familiar with the Core Value Portfolio, I encourage you to check out the introduction to the portfolio. While it won’t aid you in determining the future performance of the Core Value Portfolio, it is a good resource to understand the investment process behind the portfolio and why I believe that the process will ultimately lead to superior performance over the long term.

I will not be discussing the portfolio’s specific holdings today as they are reserved for subscribers, but I will discuss some key attributes that I believe will allow me to outperform the market over the long-term.

You Must Learn To Suffer

Whatever sentiment created an opportunity could continue to persist and possibly get worse. If one were to invest in a broad index (SPY)(QQQ)(DIA), this would be less of a concern as irrational emotions at both ends of the spectrum tend to balance each other out. When you are running a concentrated portfolio however, you don’t get such luxury as there may not be an offset, meaning that its volatility is usually much greater than that of the index.

What you get in return for this inconvenience is greater returns, provided that what you think are opportunities are indeed opportunities. A stock is not a good buy just because it fell. Despite common sayings such as “be fearful when other are greedy” and “buy when there’s blood in the streets” - such platitudes have no practical use in the real world if an investor does not perform the research necessary to understand the investment. There are plenty of stocks that go to zero every year, were they good buys just because they went lower? Arguably the answer is no. On the other hand, if a company’s long-term outlook has not been impaired, yet the stock continues to fall, then one should take advantage this opportunity (by holding or buying more), even though the stock could continue to slide.

Investing in a concentrated portfolio also means that it is essentially mathematically impossible to have a smooth ride. The Law of Large Numbers states that the correct ratio of expected outcomes will be revealed if an experiment is repeated enough times. Every stock is an “experiment,” and the more experiments we run, the more even the results. Put into even simpler terms, getting 100% heads (supposing this is the undesirable outcome) in two tosses are much more probable than getting 100% heads in 500 tosses. Because the Core Value Portfolio invests in only a handful of companies, it does not have the luxury of letting probability work its magic in the short term. Even if we were playing with unfair coins (e.g. reflecting the fact that I believe my positions are more likely to go up than down), in the short-term we could still see plenty of heads. Because the Core Value Portfolio has so few positions it is very possible that we get an “all heads” scenario for the Core Value Portfolio over the short-term whereas it is virtually impossible for a diversified index to experience such a scenario to the same degree because the coin is flipped so many times and there are so many holdings.

Combine everything I mentioned above and you end up with a volatile portfolio that at times has little correlation with the index.

To illustrate this point, we can examine the graph below:

Source: Author’s calculations

Note how the trailing 1-month beta is very wild, reflecting the fact that the portfolio is not only significantly more volatile than the S&P 500, but the magnitude and the direction of the correlation also fluctuates significantly.

If an investor cannot accept greater volatility as a prerequisite for potentially greater returns, then I’m afraid outperformance over the long-term is out of reach.

Don’t Be Afraid To “Miss Out”

You must accept the fact that your investment will never be the best.; there will be many stocks whose returns far exceed those of your own. But that shouldn’t concern you because presumably you never did any research for those stocks. This means that the opportunity (if any) was never there for you to take advantage of in the first place. Perhaps your friends and family are still riding the bandwagon, and perhaps it is a good bandwagon, but that can only be determined through research, not the stock’s stellar historical performance.

Now there will certainly be times when you passed on a good opportunity after having done your due diligence, but in that case it should be treated as a learning experience. It is critical that you do not start counting your “could have beens” (i.e. missed opportunities) because doing so will just inflate your own ego and introduce bias to your analysis. There is nothing wrong with trying to understand what you’ve missed, but ultimately the takeaway should be objective.

Accept The Fact That Things Can Go Wrong

It’s important not to let ego get in the way of making the right decision. There were two instances where I had to make a decision that essentially implied that I had made a bad investment. First there was the dramatic reduction in the allocation of MagicJack (CALL) shortly after adding to it and second there was the eventual liquidation of PHI Inc (PHIIK). Although my thesis on MagicJack was eventually realized through activists, at the time management’s actions did not create value. Despite the fact that the management had been shareholder friendly prior to making a stupid move (i.e the Broadsmart acquisition, which has since been impaired), it doesn’t change the fact that the stupid move has been made and it’s time to move on. PHI Inc is a different case, but I did end up taking a loss on the investment. What made the stock so frustrating was that despite the company’s massive cash balance, the market was not seeing the value. And because the macro environment (mainly oil) has not improved enough for the company to make a profit, there wasn’t incremental value created every quarter. The stock is still extremely cheap, but without a catalyst to realize the value, I decided to move on and reinvest the capital elsewhere. The stock has since continued to fall.

Conclusion

Going forward, I expect the Core Value Portfolio to continue to experience substantial volatility. As mentioned earlier, I see this as a necessary “evil” in order to achieve what I believe will be greater returns. Thus far the portfolio is meeting its goal of achieving 20% CAGR, but two and half years are merely a drop in the ocean for a long-term investor, so I will continue to be diligent and make sure that my capital is invested wisely.

The Core Value Portfolio may not be the best performing portfolio every year, but as long as my investment process leads to sustainable long-term outperformance, then that is enough for me.

Author's note: Click the "Follow" button beside my name on the top of the page to be updated with my latest insights. To learn more about the Core Value Portfolio, whose goal is to compound capital at 20% over the long term, I encourage you to read the introduction to my investment process. Premium subscribers get full access to the Core Value Portfolio.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.