Seeking Alpha

Chowder's 'Lost Works' - Part 3: Portfolio Construction And The Valuation Scam

by: Eric Landis
Eric Landis
Dividend growth investing, long-term horizon, value, growth at reasonable price

One of our late members, Joni, created an archive of her favorite "Chowderisms" with the hope of sharing it with fellow dividend growth investors.

'Part 1' revealed Joni's story and presented Chowder's insights on investing for young investors.

'Part 2' moved to the older generation, sharing Chowder's thoughts on managing a portfolio for a retired investor.

The final installment shares Chowder's views on portfolio construction, managing positions, and avoiding the "valuation scam".

compass-cork-money-investingPhoto by Kevish Hurree from Pexels

Project Background

Chowder's 'Lost Works' was an effort made by the late Joni Repasch to archive the investment insights from one of Seeking Alpha's most prolific dividend growth commentators, Chowder.

Joni, along with fellow Seeking Alpha member Gabby1945, categorized two-years' worth of Chowder's since-deleted Instablogs and commentary into three PDF mini-books that were meant to be shared with novice investors interested in learning more about investing and the stock market.

Following Joni's passing in 2018, Chowder introduced me to the project and asked that I share her work and story with the Seeking Alpha community. Part 1 of this project was published in June, providing Chowder's insight on managing a portfolio and bringing his words of wisdom to a new audience of young investors.

Part 2 of the project was published in August, sharing Chowder's approach to investing for the older generation who are at or near retirement age.

Today's article will move to a topic that is helpful for all investors, as Chowder gives his advice on building a portfolio and shares insight on what type of mindset one should have as an investor in the stock market.

Joni's "Food For Thought"

Much of the content for today's article comes from Chowder's since deleted blog "Psychology Of The Market" and also from comments he made on his 'Project $3 Million' blog which covered the management of his son's investment portfolio.

Joni saved the content of those blogs and comments over the years, and in 2017 turned them into the document that I'm sharing today. This work covers a wide variety of topics and frankly has more content than I can fit into a single article.

I will do my best to highlight my favorite parts of that document, but for those interested in the full depth of her work, here is the PDF version for your enjoyment:

Building A Portfolio

The first topic I will highlight is one of the biggest questions facing new investors: how to go about building a portfolio. It can be overwhelming when starting out with investing, as one first needs to plan how to build a portfolio and then to decide which of the thousands of stocks that are available to build it from.

Fortunately, Chowder has provided us with his approach on how to build a successful long-term portfolio. He does it through an approach he calls: Building Out, and Building Up.

Here is how he explains it:

I've had a number of young people ask me what is the best way to establish a portfolio. I realize there are many ways to do so but I think the most prudent way is the one I am about to suggest and the way I establish every new portfolio for young people.

First of all we must be clear, most young people don't have a lot of money to invest and some of the older folks don't have a lot of cash to contribute monthly, so this would apply to them as well.

I suggest buying in $1k lots and I suggest on building the portfolio out and not up. What this means is that you might start with $5k and that means you'll own 5 companies. As you start investing more cash, keep adding companies until you have 20 or more (building out). You can decide how far out you wish to build your base. My son has 50+ companies but now we are building up.

While you are adding new positions, your old positions are doing what all stocks do, they go up and down in price. If they are going down you only have $1k at risk! If they are going up, those are the companies I start building up in size after your base has been established (building up). This is part of what I mean when I say build on strength. Add to your winners and avoid your losers until they start winning. It's an easy-peasy approach to minimizing losses and learning to eliminate fear.

And the best part? You don't need to worry about valuations when you are investing small amounts of money and have lots of time left to invest. Ignore the older folks about price and valuation worrying. Your job is to develop a base of companies you wish to own long term and you are not going to put a lot of money into them until they are successful, and it's only when you are investing larger sums of money when valuation worries will be more important.

This approach is similar to how I first built my dividend growth portfolio back in 2013, and I think is good advice for beginners. My portfolio was started when I liquidated about $25,000 worth of mutual funds in an IRA. With that I bought fifty dividend growth stocks to start the portfolio, and then began building up from there. It's good to get a nice foundation of quality stocks to begin with, and then you can build the walls up with future purchases.

I also like Chowder's recommendation to add to winners rather than losers, and wish I would have had this advice much earlier in the process. Looking back, I had a strong tendency to make repeat buys on stocks that were in the red, which resulted in capital being sunk into poor performers. That means multiple buys in stocks like CVS Health (CVS), International Business Machines (IBM), Occidental Petroleum (OXY), and Gilead Sciences (GILD), with all four companies still being losing positions after several years in the portfolio.

Meanwhile, my five best performers of Apple (AAPL), Lockheed Martin (LMT), Microsoft (MSFT), Ross Stores (ROST), and Starbucks (SBUX) never saw additional purchases. So while they've grown into some of the larger positions in the portfolio, they could have had a much bigger impact had I simply added to them over the years rather than to the losers.

Asset Allocation: Portfolio Weighting

The next topic that should be of interest to investors is asset allocation and portfolio weighting. Chowder shares his thoughts on how to build a well-balanced portfolio:

Young people, here is how I manage my son's portfolio and the portfolio of other young folks that have asked for help. I try to come up with a balance between growth and income. The older folks are more income oriented in how I set up their portfolios.

I break the portfolios down into 3 sectors, using the Morningstar model. The sectors are defined as Defensive, Sensitive and Cyclical. I want 50% of the portfolio in the Defensive sector and 25% each in Sensitive and Cyclical. The model calls for 50-25-25.

  • Defensive positions include consumer staples, utilities and healthcare. [telecoms]
  • Sensitive (to the economy) positions include industrial, energy and technology.
  • Cyclical positions include consumer discretionary, financials and REITs. [basic materials]

Most of my son's Core holdings are Defensive. The goal is to have all Core and Defensive holdings at a full position or more, other positions just a 1/2 sized position. These 1/2 sized positions have to grow into full positions hence the term growth. ... Ha!

When investing small amounts of money as you build your positions, you don't know where price performance is going to come from. It was unexpected that CAT and DE would perform as well as they have the past year and a half, but then who expected DIS or SCG to show negative returns over the same time frame. So I don't try to guess, I only try to insure that all positions are properly sized so that when that surprising price explosion that CAT and DE have provided, it helps impact performance and makes up for those who haven't performed as well.

Sector weighting wasn't really on my radar when I first built my DGI portfolio, but looking back, it may have helped me avoid some losses had it been more of a focus. I was heavy into discretionary and materials stocks, and took losses in speculative positions like Potash Corp., Southern Copper (SCCO), Coach Inc., Linn Co., and GameStop (GME). I was also light on consumer staples, healthcare, and utilities, with nowhere near the 50% that Chowder recommends.

I've made some adjustments to the portfolio over the years, and am getting a bit closer to his targets, with 33% defensive, 35% sensitive, and 32% cyclical today. Part of the reason for still being overweight sensitive and cyclical is the out-performance of companies in those higher-beta classifications, as stocks like Apple, Microsoft, Digital Realty, Lockheed Martin, Ross Stores, and Starbucks have been my biggest gainers.

With 25+ years to retirement, I'm not too concerned yet about my weightings, but I suspect as I get closer to retirement age, I'll start switching out from the lower yielding growth stocks into higher yielding income stocks in order to harvest the capital gains and boost my income to live on.

Stock Picking & The Valuation Scam

In what I could see being a contentious comment for some people, Chowder weighs in with his thoughts on valuations when picking stocks for a portfolio. In short, putting your focus on valuation when first selecting your base of stocks isn't a good way to start building a portfolio.

Have you heard the pundits talk about being stock pickers and as stock pickers our chances of beating the market were slim? Have you really listened to some of the comments by others in this comment stream and elsewhere? People are trying to be good stock pickers. People are also showing their lack of understanding on what it takes to build a long-term portfolio in my opinion.

Ask anyone here today where they are investing their money and the first thing they are going to look at is valuations. Many of you are holding back on putting money to work because you bought into what I call the valuation scam.

Long-term investing isn't about picking good stocks, it's about partnering with good companies, companies that are still going to be in business in 30-40 years and earn a profit over that period of time.

Stock picking is for traders. Value Line and other rating firms that provide buy, sell or hold ratings are for traders and those who can't see further out than 6 to 12 months.

Valuations are based on what short term traders think a company is worth today based on some wild-assed guess about what the company is going to do over the next quarter or two, and those numbers and valuations they base their decisions on change all the time. If they are going to continuously change in the short term, what's it going to be like long term? And if they are going to change so often, why should I treat them as the Holy Grail of investing?

Long term investing is about investing in good companies with good financials and have a high probability of being around in 30 years or more selling the same product or service. They may have different ways of bringing it to market over the years, but it's still basically the same product or service.

This is why you don't see me giving valuations the respect too many of you give them. All they have done is kept companies you wanted to add to at smaller positions than you wish you had. You still haven't learned how to build the dream instead of chasing it. You are still seeking that short term ego gratification in knowing your small position has a nice gain but the market is going to snatch it away at some point and that's why I stay focused on the income. That doesn't get snatched away.

I think there are several excellent points here from Chowder. The first being that long-term investing is finding good companies with good financials that have a high probability of being around in thirty years.

Look at some of the great dividend paying stocks of the last fifty years, and you'll notice that many of them are boring businesses selling every day products. You have companies like Coca-Cola (KO), Clorox (CLX), McDonald's (MCD), Starbucks (SBUX), and Home Depot (HD) that sell sugar water, bleach, hamburgers, coffee, and hammers, and they've consistently done it better than all their competitors for decades on end.

It doesn't take a genius to find these companies, but it does take patience and persistence to build them up in size and let them grow over time, and to buy them over the flavor of the day that may be more exciting to own.

Chowder's second point is not to get hung up on valuations when making your initial picks, but instead focus on the business you want to partner with. This was a mistake I made early on, as I shunned companies like Visa (V), Mastercard (MA), NextEra Energy (NEE), Lowe's (LOW), and others because they had high PE's and lower dividend yields.

I think back to my selection of Mattel (MAT) over Hasbro (HAS) since it had a slightly higher yield at the time. I made that choice despite the fact that Mattel's credit rating was several notches lower than Hasbro, and I didn't like its products as much. Since then, Hasbro has returned 20% annualized and continued to raise its dividend, while Mattel has seen its credit rating drop further, cut its dividend, and returned -10% annualized.

Putting my focus on value over quality led to a poor decision for the portfolio, which hurt my performance. Sometimes it's easy to forget we aren't just buying 'stocks' when making an investment, but in fact we are actually buying part of a business. Thinking in those terms can really help keep the junk out your portfolio.

Quality matters, and often-times it's worth paying up to get it!

Managing Losing Positions

Next up is Chowder's thoughts on managing a losing position in your portfolio. This is a topic that I see often in comment threads, as investors often wonder if they should keep adding to losing positions since they are "on sale".

This past week I have been talking about how to manage losing positions. I thought I clearly stated that a new person start small and build out the number of holdings they wish to own. If the number is 30, 40 or 60 it doesn't matter but a person should have a general idea of how many companies they are willing to hold.

Once you have those positions in place, I thought I was clear that you go back and start building up the positions that are showing a profit, what I refer to as building your winners.

I know I have been very clear about saying I only allow myself to average down one time and one time only while still keeping the position at no more than a 1/2 sized position on losing positions. This is what I refer to as minimizing losses.

Just this past week I talked about a losing position in my son's portfolio, KMI which is less than a 1/2 sized position, and I gave the scenario where I would consider adding to it while it is still down, and that scenario is that management said they would raise the dividend in 2018. If they do that I believe it may allow others to feel free to start investing in them and I'm not talking about those who were burned. There are many others who weren't and I believe a rising dividend will attract them. Fund managers may not have any other choice.

If KMI refuses to raise the dividend in 2018, then they have provided the catalyst for me to sell the position, take the loss, and then move on.

The point is, I did not continue adding to KMI while it has been an under-performer. I did not allow myself to be in a position where it became a 2 to 3 times a normal sized position. That's poor portfolio management. The people who tell you that if you loved it at $35, you should really love it at $20 are fools if they don't consider the condition of the company at the time they regurgitate that crap.

This comment from Chowder is a strong reinforcement of what was said earlier. Build your base, and then build up your winners, not your losers.

As I mentioned, I've been guilty of doing this on multiple occasions, and have come around to Chowder's way of thinking. It's difficult to admit you were wrong on a stock, and its often tempting to 'double-down' because a stock is cheap.

But you need to look at the business rather than the price to see if that is a good decision. There's often a good reason why share price keeps falling, and that's because the business isn't performing up to market expectations. Look at IBM, which has seen declining annual revenues for several years now as it tries to reinvent its business model. Share price has gone nowhere for five years, while other tech stocks have performed quite well.

I made the mistake of making three purchases of the stock as I waited for a rebound that has still yet to materialize. Meanwhile, I never did make add-on purchases to Microsoft or Apple, and they've produce gains of several hundred percent.

Closing Thoughts On The Series

I could go on and on quoting more of my favorite Chowderisms, but with the article now approaching 3,000 words, I think it's time to wrap things up. People aren't here to read my thoughts, they are here for Chowder's Lost Works, and thanks to the efforts of Joni and Gabby, we are able to enjoy those works and the wisdom they contain.

It's been a great pleasure putting these articles together, and I'm forever grateful that Chowder asked me to participate in the effort. I hope I was able to present the information in a useful and honorable manner, in a way that will help young and new investors as was intended.

Best wishes to all, and happy investing!

Disclosure: I am/we are long AAPL, CVS, GILD, HD, IBM, LMT, LOW, MA, MCD, MSFT, EE, OXY, ROST, SBUX, V. 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 am an engineer by trade and am not a professional investment adviser or financial analyst. This article is not an endorsement for the stocks mentioned. Please perform your own due diligence before you decide to trade any securities or other products.