Investment Strategy Statement - Ian Bezek

by: Ian Bezek
Summary

Why this young investor has such a conservative portfolio.

On core holdings, what else I own, and why I aim to minimize turnover as much as possible.

Why I don't follow a strict value investing approach.

How I use short positions to reduce portfolio volatility.

Long-time readers know that I cover a wide variety of stocks spanning different sectors and countries. Given that, it's worth taking a closer look at my investment philosophy. What are the core principles that drive my portfolio construction and management?

Managing Risk: Why This Young Guy Owns Conservative Stocks

At 30 years old, I am a relatively young investor. However, I manage a rather defensive portfolio. I maintain this posture due to my circumstances; I worked for a New York hedge fund for a few years out of college and saved up a nice sum of money. Since then, I moved to South America, married a Colombian, and we have a daughter. We have no interest in moving to the U.S., and as such, preservation of my capital is of utmost importance, since it would be difficult to earn New York-level wages while residing in South America.

As the saying goes, you only need to get rich once. After you reach a point where your investment portfolio is sufficient to meet your needs, there's little reason to endanger your financial independence for stratospheric returns. I'm content to beat the S&P 500 and the Vanguard Total World Stock ETF (VT) over the long-term. I don't care much about annual returns, and certainly not quarterly ones, however, my portfolio must outperform both the above indexes over full economic cycles for me to be meeting my investment objectives.

I'm more than content to have a portfolio largely consisting of a mix of blue-chip large-caps along with smaller-cap names in defensive industries and/or with good balance sheets. I also hold a fair number of Latin American stocks for reasons I explain below. I mix in a few more aggressive growth names, but these are a small portion of my holdings and could go to zero without having a dramatic impact on the overall portfolio's long-term results.

It's also worth noting since I have no intention of residing in the U.S. again, I have kept my funds entirely in taxable accounts. For Americans my age or younger, it's worth thinking about whether the current 401K/IRA system will exist as it does now by the time we hit retirement age. Given the gaping holes in the federal budget out past about 2030, I'm skeptical that tax-sheltered investments will stay as favorably taxed then as they are now. In my case as a permanent ex-pat, in particular, there's little reason for me to use tax shelters.

What I Invest In: Core Holdings

My living/tax situation highly incentivizes me toward long-term investments. Capital gains taxes are a real killer to compounding over the decades. I almost never sell a core stock holding due to modest overvaluation as long as its business model and outlook remain favorable. Overall, I aim for a portfolio turnover in the low double-digits.

As such, it should come as no surprise that my top holdings are conservative blue-chip names like Hormel Foods (HRL) - a company that has grown EPS 26 out of the past 30 years. I am heavily overweighted to consumer staples, conservative regional banks, and high-moat services companies. A great core investment is one with high returns on invested capital, steady earnings growth, low earnings volatility, and which has a long track record of treating its shareholders well. An additional plus is family or charitable trust ownership or some other mechanism to encourage management to think for the long-term rather than playing the quarterly earnings game. I particularly like Hormel, Brown-Forman (BF.B), and Hershey (HSY) among others due to their focus on building their businesses with a multi-decade time horizon.

In general, these sorts of fantastic companies rarely get back-up-the-truck cheap. Usually, they look overvalued. Over time, I've grown to realize that it's better to buy one of these sorts of businesses at a 52-week low when it is near the bottom of its historical PE ratio range rather than waiting for it get cheap on an absolute basis. Periodically, you'll get scares such as low turkey prices (Hormel), Brexit (Diageo), or a controversial acquisition (McCormick) that allows you to buy these outstanding businesses at fair prices when the shares are trading below their average PE ratio and above their average historical dividend yield.

Once I get in at an okay price, there's no reason to sell unless the business fundamentally loses its way. A company with a great return on its invested capital will tend to put up market-beating returns unless you buy at an egregious price. I'll cite a Charlie Munger quote that sums this up well:

Over the long term, it's hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result."

These sorts of companies also tend to have track records of steadily rising dividends dating back decades. You get paid nicely over the years, even if, like me, you have no intention of selling your shares any time soon.

With those sorts of holdings as the core of my portfolio, downside risk in the portfolio tends to manage itself. Take Hormel Foods for example. Dating back to the early 1970s, the stock has never drawn down more than 40% from its all-time high share price on a total return basis. Through the 70s stagflation, the 1987 crash, the 2001-03 bear market, and even the great financial crisis, Hormel stock largely held its value. That makes it easy to sleep well at night. Given that Hormel's management targets 10% earnings growth per year (and has delivered it for decades), if you can buy the stock at or under 20x earnings, you're bound to get excellent results if you hold on long enough.

What I Invest In: Other Positions

In aggregate, I have a fairly substantial allocation of my portfolio to Latin American stocks. There are several reasons for this. For one, I speak Spanish and live in Latin America, making it much easier for me to do due diligence locally. Additionally, my savings are in dollars and my expenses in pesos, which creates a mismatch. By owning a sizable position in local stocks, it puts a chunk of my assets and dividend stream into local currencies, hedging my cost of living. In particular, if the dollar were to fall sharply, the value of my emerging market stocks would rise, offsetting the higher costs to take care of my family.

I'd also argue, on the whole, that Latin America has the best corporate governance and investable companies of the emerging markets universe. There's a lot of variation - you need to be extremely cautious in Argentina and Brazil for example - but markets like Chile and Mexico stand well above others such as China, Russia, or India in terms of taking care of shareholders and avoiding corporate fraud. The political systems tend to be somewhat more reliable and investor-friendly as well.

Additionally, there are certain segments of the economy that can still have tremendous growth in emerging markets such as Latin America that are already played out in developed markets. In Colombia, for example, fewer than 10% of the population has either a mortgage or a credit card. That's a long growth trajectory for the local banks. Similarly, I'm heavily invested in Latin American airport operators - budget air carriers are just starting to reach their potential here and a long runway remains for switching travelers from buses to cheap flights.

Occasionally, these stocks go on deep discount due to transitory factors. For example, Mexican stocks and its currency went into freefall following Donald Trump's election in late 2016. Mexico bottomed right around his inauguration in January and went on a furious rally as it became clear that Trump wasn't going to wreck U.S.-Mexican trade relations. I, living in Mexico at the time, saw that the malls were still full and the economy was humming along despite the election results up north. I called "top pick" on Guadalajara, Tijuana, and Puerto Vallarta airport operator Grupo Aeroportuario del Pacifico (PAC) during the Trump panic, leading to a 50% gain over the next six months.

My Take On Valuation

Regrettably, it seems much of the investing community has turned the valuation question into a false binary recently. Either you buy high growth companies at nosebleed valuations, or you stick to low-quality businesses trading at "cheap" valuations. In recent years, high growth stocks, such as the FAANG names, have clearly been the better play. David Einhorn's dreadful -34% performance in 2018 highlighted the dangers of buying supposed deep value stocks while shorting high growth names in particular. Eventually, the pendulum will swing the other way and the high valuation stocks will collapse again.

However, I don't think investors have to fall squarely into either of these camps. For one, we're not in the 1950s anymore. You can't read The Intelligent Investor and copy those value strategies blindly. The market has become more efficient. Just buying stocks because they are net-nets, have low PE ratios, or trade under book value is unlikely to lead to significant alpha in this market.

While buying stocks at 100x earnings or 20x price/sales will always be highly risky, I think a bunch of investors is falling for a different trap by relying too heavily on dividend yields or PE ratios as the be all and end all metric. To give one recent example, about two years ago we had a bunch of consumer staples stocks all trading at fairly similar valuation ratios.

However, there were two groups within them - consumer staples with consistent strong EPS and organic revenue growth, and another where sales have been flat to declining for years. At the time, the market was focusing on dividend yield excessively, thanks to low interest rates. Thus, fast-growing lower-dividend companies like Hormel and McCormick were trading at just a couple PE turns higher than no organic growth companies like General Mills (GIS) or Kraft Heinz (KHC). Since then, as dividend yield has receded in importance, the market has rediscovered growth, delivering huge alpha for those of us that caught that trend early, paying a slightly higher PE ratio for much better businesses:

Chart

HRL data by YCharts

Valuation is certainly important, but you need a framework to compare multiple variables against. I'd rather buy a Hormel or McCormick at a higher PE ratio and lower dividend yield than a company that has no organic growth and is sailing against changing consumer trends and preferences such as the cereal companies.

I'd say, more generally, that the market tends to not be totally off base when valuing stocks, particularly with large-cap S&P 500 constituents. If one stock trades optically way cheaper than another one, there's often a good reason. Make sure you understand why before buying the "cheaper" one. Great companies will tend to stay at premium valuations, and mediocre ones tend to stay in the discount bin. I'd rather buy a proven great company at 20x earnings rather than a mediocre company at 15x earnings. Over time, you get what you pay for.

Portfolio Management & Short Positions

First up, where do I get my ideas? There are a few sectors that I've studied pretty heavily, reading 10-Ks for most industry constituents, such as food, beer and liquor, and tourism-related stocks since they tend to deliver market-beating returns over time and make up a sizable portion of my core holdings. I also invest thematically and tend to research certain trends such as: Hispanic immigration in the U.S., the global diabetes epidemic, or consolidation of the banking system. After reading numerous books on these topics, it leads to a lot of investment ideas to explore further. Finally, members of Ian's Insider Corner ask me to look at individual stocks or ETFs, and I write up an analysis with my findings for subscribers; sometimes I end up investing in these reader suggestions as well.

Moving to my portfolio's asset allocation, I remain nearly fully-invested in the stock market at all times. On average, the stock market tends to rise 8% or so a year. As such, holding cash puts you at a substantial disadvantage right out of the gate. While there are some folks that can time the market, most people that try fail. At least for me, it's generally not worth the stress.

Instead of holding cash, I try to find short positions to offset some of my long exposure. This allows me to hold my fully-invested stock portfolio while still taking less risk than the market overall. These short positions can come in several forms. One example would be shorting a weak player against my stronger holdings in the same industry. For example, Argentine banks were extremely expensive and the local economy was heading for a tailspin in 2017, setting up an ideal hedge to my long exposure to other Latin American banks. My short position, Banco Macro (BMA) (blue line) in fact underperformed my other Latin American bank holdings nicely:

Chart

BMA Total Return Price data by YCharts

Another example would be shorting a highly valued stock with limited growth prospects. My top idea short PriceSmart (PSMT) - often described as Latin America's Costco - back in 2016 was a great example. If the stock market boomed, it would only go up slightly as it was already at 32x earnings and did not have many near-term opportunities to boost EPS. If the economy and stock market dropped, Pricesmart stock would have tanked. As it turns out, PSMT stock didn't do much, but that's fine, as it provided cheap downside insurance for my portfolio while the market continued to surge:

Chart

PSMT data by YCharts

While fixed income certainly makes sense for many conservative portfolios, I prefer using tactical short positions to reduce my overall portfolio risk. That said, unless you're really good at short selling and have a strong stomach, it remains far easier to make absolute returns buying stocks. I use short positions to reduce portfolio volatility much more than in pursuit of huge profits.

Again, the stock market tends to go up, a lot, over time. Most investors will do better concentrating on long investments rather than short positions. In particular, glamorous controversial shorts like Tesla are poorly-spent time for most investors. It's hard to get an investment edge on widely-covered stocks, and in companies with high short interest, the short squeezes and high borrow fee tend to kill your returns. I much prefer shorting under-the-radar companies that get little to no publicity for my portfolio hedges.

Disclosure: I am/we are long HRL, MKC, BF.B, PAC, BAP, CIB, BSMX, HSY, KHC, DEO. 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.