Investment Strategy Statement - Julian Lin

Includes: BABA, CBL, CGC, EPD, FB, SPG
by: Julian Lin

I believe that the tilting towards value or growth depends largely on the opportunities available in the market.

I hold a fairly concentrated basket of holdings whose business models I am most comfortable with.

I am willing to sacrifice potential returns if it means I get "best of breed" quality and lower risk.

I balance my portfolio with both growth and dividend holdings.

Investment Strategy Summary

I am a long-term investor focusing solely on fundamental analysis and very much welcomes stock price volatility. While I do not limit myself to specific sectors or types of stocks (like dividend or growth), I often am highly concentrated in one sector at any given moment in time based on my shallow and simplistic views of the macro environment. I have been a deep value investor in the past, but at the moment, I am focused on high-quality stocks.

I place a high emphasis on strong management teams and secular tailwinds, sometimes to the point of paying up for quality.

Background: Hit The Books

Let's get this out of the way: I have zero professional experience in the finance industry. Zero. But I just really, really like spending my free time analyzing stocks. Without a traditional financial background, I instead have turned to learning from the writings of investment greats.

From Benjamin Graham, I learned the concept of margin of safety. From Pat Dorsey, I learned how to identify a moat. From Christopher Mayer, I learned how to dream big about "one hundred baggers." From Philip Fisher, I learned to not give up on your winners too early. From Bruce Greenwald, I learned a framework for conducting financial analysis.

Of all the teachers I have resonated most with Peter Lynch. From Lynch, I learned that it is of utmost importance to make sure you understand the business model fully - I never buy something I don't understand. However, he most certainly did not say "buy what you know," despite seemingly only remembered for this quote. From him, I also learned how to classify an investment position in order to understand financial statement and return expectations. For example, I would be looking for a high-quality balance sheet, moderate growth, and a low-mid valuation for a "stalwart." One such example in my portfolio is Simon Property Group (SPG), which is an "A mall" real estate investment trust with a best in class balance sheet, long history of financial outperformance to peers, and churns out a growing 4.4% dividend yield. On the other hand, I would expect high growth and be OK with a relatively high valuation from a "fast grower." One example might be Alibaba (BABA), which is the "Amazon of China" seeing revenue growth in excess of 40% but trades over 40 times trailing earnings.

In total, my bookshelf holds 26 investing books which have shaped the investor I am today.

Disillusioned Value Investor

In my opinion, value investing can ironically lead one to invest in riskier names due to the disillusion that a low price always reduces risk. A typical value investor might look for ideas through a value screen - after all, real value plays are difficult to find otherwise. After finding a selection of cheap stocks one might then try to find the cheapest of the bunch or the best of the bunch - and here's where the problems might begin. I believe that one mustn't be too rigid to use the same screening criteria after the longest bull run in the history of the stock market as one might during a bear market. Doing so would inevitably reduce one's scope to lower quality names because the higher quality value stocks would be trading at higher multiples than they might be otherwise. This means that value investors are advised to be extra careful finding value in a heated bull market.

I feel much more comfortable buying a middle of the pack value play during a bear market than I would be buying a bottom of the pile value play during a bull market.

One example in the past couple of years is CBL Properties (CBL), a B mall REIT which, at the time I first started covering them in 2017, was yielding 13% and the dividend was apparently covered by cash flows more than two times over. Authors on this site were almost unanimously bullish - but there was a problem. In a typical value play, one might be OK with declining earnings if along the way (perhaps to bankruptcy), we received enough dividends to make the pain worthwhile. CBL unfortunately as a REIT has significant leverage, meaning that in order to avoid a liquidity crisis upon maturity of debt, they would need to direct cash flow toward debt repayment in increasing amounts exponentially proportionate to the rate of decline of their cash flows. This means that despite throwing off lots of cash, shareholders don't really get that cash, and the dividend coverage was just an illusion. From such an example it should be clear that margin of safety goes beyond just valuation.

Such a mistake can also be attributed to perhaps not adjusting one's return hurdle lower - trying to grab 13% returns in a market scant of such opportunities might make one impatient. I'm not saying that one must lower their hurdle rates - I am however suggesting that those who choose not to lower their hurdle rates must be careful to not let the scarcity of attractive investment options lead them to choose a lower quality and higher risk position than they otherwise would not enter. My other options would be to stick with the index or focus on growth stocks. In general, right now I am not buying deep value plays because I believe that deep value plays of today are of much higher risk than deep value plays of a bear market.

What I Look For In Growth

In growth stocks, I look for companies with easy to understand growth potential. This can be made evident through secular growth tailwinds or a very strong business model. Because I do not possess the abilities nor resources to accurately project forward revenues or earnings, I instead try to overcompensate by choosing companies with high present growth rates and large total addressable markets yielding long growth runways (think FANG). This all is very simple to understand but it is the most important part of my analysis. The human element is very important here because even more important than historical high levels of profitability is future levels of profitability, which can only be "predicted" with correct human judgment. There isn't really any structural way to do this besides just critically thinking and making sure I'm comfortable with the business model. I often just spend a lot of time at a cafe staring into space thinking about recurring revenues and ease of growth.

I also look for strong management, in which the most important factor is capital allocation. I want management teams that are transparent about why they are retaining earnings and are committed to returning capital to shareholders. While I do not want to see management buying back shares solely to boost EPS numbers at the expense of the balance sheet, at the same time I want to see them step up on buybacks when the stock price goes down.

It is just as important for management teams to be able to recognize undervaluation as it is overvaluation.

High Dividend Stocks

I also own a significant dividend portfolio - but the reasons to do so are more macro-related rather than a desire for income (I focus more on total returns). I am agnostic as to whether a company pays their earnings as dividends or share repurchases (the underlying assumption is that I own the stock, so I think company is undervalued) - but I do think most companies should pay at least a small dividend. In a well-run company, I view dividends as representing cash the company can distribute without inhibiting their ability to maintain and grow earnings. My main reason to hold dividend stocks is for the potential alpha that may occur if interest rates once again fall back down. In this manner, dividend stocks provide significant diversification as an alternative strategy to a growth portfolio.

In dividend stocks I again focus first on the underlying business model - I judge the stability of the dividend based on the stability of the earnings (others might instead emphasize payout ratio or historic dividend growth). Because high dividend stocks tend to be more capital intensive and rely heavily on execution, I usually stick with management teams with long histories of outperformance. Couple this with my preference for strong balance sheets and I am usually going to pick the slightly more expensive best of breed operator instead of the "relative value" operator.

Here's an example: I like Enterprise Products Partners (EPD), a best of breed vertically integrated master limited partnership which has been moving towards being able to fund their growth capital expenditures without needing to rely on the equity markets. At a 6.2% yield, the stock is attractive but definitely not the cheapest in the sector. Their dividend was covered at 1.5 times distributable cash flow, among the top in their industry. Their balance sheet is very strong at only 3.7 times debt to EBITDA, which is among the lowest in the industry. The cream on the top: they also announced a $2 billion share repurchase authorization. Thus while EPD is by no means the cheapest pick in the MLP universe, it is nonetheless my largest holding in the sector because of the lower risk profile it entails. I am again willing to pay up slightly for higher quality, while still aiming for strong annual returns (albeit, potentially not the maximum returns).

What I look for in Shorts

An attractive short is a stock which even using unrealistically optimistic assumptions still trade at unrealistic valuations. As an example, my most recent short idea was Canopy Growth (CGC). At the time, shares were trading at above $17 billion in represented market cap, but there are huge promises for future growth. I estimated that in the scenario that they would take a disproportionate 20% of all retail cannabis sales in Canada and have a very high 25% net margin, CGC was still trading 48 times earnings - suggesting growth and more was fully priced in. Admittedly, my optimism makes me tilted toward more long holdings as shorts tend to be more uncommon.

Valuation: Don't Sweat About Rounding Errors (in Growth)

Valuation is important, but I view it as less important compared to analysis of the business model. When I do a valuation, I am mainly trying to filter out obviously overvalued stocks, basically just finding reasons not to own the stock. I think this is due to influences from Fisher and Lynch - I believe that paying 20-30% over a "fair value" would turn out to just be a rounding error in the long term. As I stated above, I don't try to accurately project future earnings. I strongly rely on my judgment in determining whether a company's business model might lend it to be able to continue strong growth moving forward. As for valuation, I use two steps. First, I determine an appropriate "mature earnings multiple" for the company. Next, I compare my expected growth rates against the current multiple to determine projected returns if I bought the stock now. My hurdle rate varies depending on the valuation of the broader market but right now it is 12%.

As an example, Facebook (FB) trades at 22 times trailing earnings and has a strong balance sheet with secular growth tailwinds. I believe that its mature earnings multiple should be around 18. I believe it can continue to grow earnings 15-20% for the next decade, which suggests that FB can return 15-20% annually over the next decade (in just one year FB would already trade at the mature multiple, thus its total returns would be equivalent to the rate of earnings growth).

With dividend stocks, I would in general use the same framework, but I would also consider the valuation if the stock were to be valued based on dividend yield and growth. This would be my "bull case" valuation should interest rates fall.

Risk Management

In terms of risk management, I feel that sticking with top management and companies with strong balance sheets already goes a long way. As an investor with a long term time horizon, I am OK with stock price fluctuations and thus do not measure portfolio risk by beta. I instead think about risk as being the answer to the question:

How might your portfolio perform in an economic recession?

I want to be owning companies which have strong balance sheets and strong business models, the combination of which would enable them to not only survive a recession but potentially emerge even stronger because of any recession.

If my thesis is proven wrong on a stock, I sell immediately - I do not endorse bag holding.

I try to own a maximum of 20 core holdings - I think an underrated risk is not knowing what you own.

Views for current market and beyond

In this rising interest rate environment and peak market cycle, I am holding mostly strong balance sheet companies with lower leverage and consistent earnings power. China presents potential value due to its relative undervaluation compared to the US (MCHI has a P/E of 12.4 as compared to 21 for the S&P 500). That said, I am suspect of their balance sheets and capital allocation and thus have limited to my holdings to only BABA and a few others and have limited position sizes. I am very bullish on tech (in various sectors) because the innovative disruption is likely to continue for decades. I do note however that many tech stocks appear to trade at rich valuations - it would thus be wise to be choosy.

Disclosure: I am/we are long BABA, FB, SPG, EPD. 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.

Additional disclosure: I have collaborated with Rida Morwa on a marketplace service in the past, but these views are my opinion only and do not represent the opinion of Rida Morwa or High Dividend Opportunities.