In November 2015, I set out to document on Seeking Alpha my journey to grow an initial investment pool of $275,000 into a $1,000,000 within a 10-year period or by November 2025. It was a fairly audacious goal, given that it would require capital growth at a rate of almost 14% annualized over this period, a level that is almost 4% above the historical annualized return achieved by the S&P 500. The inception of the project is documented here.
Last month, roughly 3.5 years into the project, I brought up a fairly significant milestone, with the portfolio crossing $500,000, achieving an annualized return since inception of 21%. I felt it would be of value to document my learnings for other similarly self-directed investors looking for alternatives to the S&P 500 for investment returns.
When I set out constructing Project $1M, I made the very deliberate mind shift to think like a business owner and not a 'stock market investor'. It's a subtle distinction but a very important one. This involved the conscious, deliberate decision to fill my portfolio with high quality businesses that had very large moats, rather than potentially hold hundreds of companies that I would trade in and out of as I saw fit. I looked for qualitative as well as quantitative evidence of the existence of a moat. Pricing power, high barriers to entry, robust revenue growth, and high returns on equity were things that I evaluated in my search to uncover superior businesses. I also looked for underlying secular drivers that would provide momentum for the business.
I think of MasterCard (MA) as one of the best examples to illustrate this type of thinking. MasterCard brings together merchants and consumers in delivering electronic payments. Any business trying to displace MasterCard would need to win over both of these groups, and do so at scale. It's hard enough to convince just one of these groups, either consumers or merchants, that they should consider an alternate payment mechanism, let alone being able to simultaneously convince both, in large numbers. This strong moat coupled with a secular driver toward digital payments shows up in MasterCard's results. MasterCard has grown annual revenues at a rate of 13% over the last 5 years, operating margins are consistently north of 55% and the business sports returns on invested capital north of 50%. It's consequently no surprise that the strong moat results in very strong investment returns, with MasterCard delivering a 163% return for the Project $1M portfolio, or an annualized return of almost 32% since portfolio inception.
Diversification is an often touted tenet of sensible investing. This is the idea that you should own every stock and every sector under the sun and diversify away any stock specific risk. Owning 100 stocks is a sure fire way to ensure that any one specific stock won't have a catastrophic effect on your portfolio, but it's also guaranteed that you will 'be the market'. Project $1M flouts every rule of diversification. The top 5 positions (MasterCard, Visa (V), Facebook (FB), Amazon (AMZN), Mercadolibre (MELI)) account for almost 60% of the portfolio with MasterCard and Visa combined accounting for almost 30% of the portfolio value. Technology represents almost 80% plus of the portfolio, and the portfolio is only limited to 16 holdings.
Rather than fearing concentration, I've learned to embrace it. For me, it's very consistent with thinking like a business owner. I don't believe I could feasibly look to own and understand 100s of businesses, even with the best operating managers, so why should I not run my investments in stocks the same way?
This is easier said than done, but many of my strongest performers in my Project $1M portfolio have been businesses that have been prone to exceptional swings in price, both on the upside and the downside. Mercadolibre, an emerging e-commerce and payments provider in Latin America has had swings of north of 60% in the last 12 months. In spite of this volatility, my initial investment capital in Mercadolibre has increased 450% since it became a core holding of Project $1M. It's worth a reminder here that while the market often gets valuation right over the long term, it's prone to steep bouts of fear and emotion in the short term. Mercadolibre was similarly the subject of fear. Fear around Amazon's Latin America market entry and volatile economic conditions in Brazil and Argentina knocked the share price around all over the place. In spite of this price movement, MELI continued to power forward and increased revenues at a rate of 25% annualized over the last 5-year period. Understanding that strong short-term price moves aren't indicative of fundamental changes in business value is very important in being able to master irrational concerns around downward share price movements, providing you have selected the right underlying business.
My discipline as an investor has improved over the duration of my Project $1M journey, and one of the ways that I have improved is in being able to make an aggressive move when the opportunity presents. When I saw that Facebook had been irrationally sold off in December of last year, changing hands at just 16x forward earnings while growing revenue north of 30%, I increased my capital investment in the business by more than 50%. Facebook then came to represent the greatest amount of my invested capital. I've previously recognized attractive businesses trading at compelling value. Alibaba (BABA), in 2016, which I nabbed for the portfolio, as well as Atlassian (TEAM) in 2016. Both made their way into the portfolio but not in a meaningful enough way (only 2-3% of capital) to really make game changing impacts on the overall outcome. While both Alibaba and Atlassian have performed well for the portfolio, the potential upside could have been significantly more had I deployed a more meaningful amount of capital when the opportunity presented itself.
I made a number of mistakes in my portfolio construction. These were both mistakes of inclusion as well as omission. What I've learned from this is that you don't need to get everything right, to still enjoy some very good returns. The notion of thus needing to own 500 businesses to diversify errors is misleading in my view.
Errors of inclusion include persisting with Baidu (BIDU), Ctrip (CTRP), and Celgene (CELG), in spite of declining fundamentals, while selling such businesses such as Illumina (ILMN), Moody's (MCO), and Chipotle (CMG) prematurely denied the portfolio the opportunity to capture some very strong gains. In spite of this, I'll happily take the returns that I've derived. Mistakes are okay in a portfolio provided they aren't fatal.
I've also realized that it's important to give a strategy time to work. It can be seen from my returns that 2016 was quite disastrous. The process of figuring things out and chopping and changing positions and making some costly mistakes while I tweaked my strategy had me questioning whether what I was doing made any sense. However, I never deviated from my philosophy that solid returns could be derived by applying a philosophy of owner like thinking and investing in strong franchises with high quality moats, acquired at the right price.
Making the decision to actively manage your own money and taking a route that doesn't consist of index investing is quite a lonely journey. With so much of the popular media focus for investing now on indexation, a concentrated, active approach to management is definitely going against the grain.
During particularly difficult times in 2016 when I was massively underperforming the index, I found it inspiring to look at moves that like-minded investors were making and how they assessed the market. Seeing that Polen Capital, Wedgewood Partners, and Magellan Global were persisting with their approach of high quality, high growth names gave me the reassurance that I should also not abandon my approach so soon, even if the results were not initially there.
What's most noticeable to me when I assess my body of work is the number of businesses that I have which have returned multiples of my initial invested capital. Roughly 7 of my 15 portfolio names have returned double or better of their initial investment. Pro Medicus (OTCPK:PMCUF), Mercadolibre, and Atlassian have been multibaggers and all returned more than 3x initial invested capital. That's encouraging for me because it shows that I'm allowing my investment returns to compound in the absence of taxes and trading costs something which represent significant leakage of returns. Furthermore, the advantage of such a long-term hold is that I've now built a powerful psychological edge in my portfolio. With many of my positions having built up such strong capital gains, it will take significantly more than a little negative volatility to create any permanent loss of capital.
While market valuations are starting to become stretched, I generally refrain from substitution of positions in the portfolio unless something about the business model or value proposition of the business is broken, or valuation of the position is so excessive that a normal market rate of return going forward will be impossible to achieve. I tend to err on not removing positions on valuation concerns because high quality businesses have a tendency to surprise on the upside and can often use their entrenched position to drive into adjacent markets relatively easily, providing an additional source of value creation.
Macroeconomic trends also don't greatly influence me. While economic growth will likely slow at some point over the lifetime of the portfolio, I've selected businesses that benefit from secular drivers which will continue to last over the next decade. A slowing economy will thus not influence portfolio composition, even though it may lead to a downward rating of valuation multiples for specific positions. I also don't like to make arbitrary changes in portfolio weighting just because a position represents a disproportionate weight in the portfolio or if a sector exposure has become very large weighting. I'm happy for the market to be the ultimate arbiter on these things.
From a business model and value proposition standpoint, the two positions that I am most concerned about are Baidu and Ctrip. While both are now very modest holdings in the portfolio (approximately 2% combined), there are changing consumer behaviors that make each vulnerable. Tencent's (OTCPK:TCEHY) WeChat poses a real risk as far as diverting consumer usage from Baidu's search function and Ctrip's travel portal to corresponding functionally within WeChat. With so many 'mini programs' within WeChat, the need for more generalist search among consumers has been declining, something which is starting to show up in Baidu's numbers. I also firmly believe that WeChat will soon start offering travel booking functionality as a mini program, something that will start to soon take share from Ctrip. At present, valuation of both businesses more than compensate for this risk, however, these are things I'll be watching closely.
As far as valuation levels of individual positions, the position I'm most concerned about is Atlassian. For SaaS companies, I generally consider 10-15x revenue an appropriate valuation range. Very high quality SaaS businesses such as CRM and Adobe (ADBE) both trade at less than 15x revenue. At almost 30x revenue, TEAM has been providing me with some concern because at these levels, even the slightest slowdown in revenue growth will trigger an aggressive re-rating of the stock. I plan to watch TEAM's upcoming quarters fairly carefully to look at growth rates in the business, with a view to lightening the position on further surges in valuation multiples or weakness in growth.
I have my eye on Adobe as a business that I would potentially add should capital be realized from any existing portfolio positions. Adobe is another business that benefits from the secular trend to video consumption and other high resolution media, with the company's content creation and analytic tools being the programs of choice for serious developers.
To conclude, the strong capital growth that the portfolio has enjoyed over the last 3.5 years mean that an annualized capital growth rate of just under 11% will be required from here on out to achieve the Project $1M objectives. Given the high quality of all of the positions in the portfolio, I firmly believe that this is well within the realms of possibility over the next 6.5 years.
This article was written by
I am an investor who is focused on disruptive businesses that are transforming industries lead by visionary leaders with substantial skin in the game. I have spent nearly 20 years in a formal capacity in various investment banking and corporate advisory roles, having attained my MBA with a concentration in finance. This led me toward a path in Venture Capital and working with entrepreneurs building new technology businesses, and I have had the opportunity to not only invest in a number of amazing privately held businesses, but also play a meaningful role in growing several of these early stage enterprises as well. I am now focused on applying my lens of private market disruption and leveraging secular tail winds to the public markets. This was a journey which I started with my public Project $1M portfolio series and which I have deepened with my marketplace service, Sustainable Growth
Disclosure: I am/we are long ALL STOCKS IN TABLE. 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.