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Data Driven Portfolio Strategy

Jul. 10, 2020 2:17 PM ETAmazon.com, Inc. (AMZN)8 Comments
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July 10, 2020

This article offers some ideas to better understand the Data-Driven Portfolio. The philosophy behind the portfolio, the risk management framework, the stock selection process, some typical questions from members, and how to read the spreadsheet. Please feel free to ask any further questions that you may have.

Performance And Long Term Vision

The performance numbers as of July 9, 2020 are very strong. But we need to fully acknowledge that performance will fluctuate over time.

2018 2019 2020 YTD Cumulative
Data Driven Portfolio 13% 33% 45% 118%
S&P 500 -4% 27% -2% 19%

It is crucial to understand that the portfolio is being managed with a long term horizon and short term volatility is unavoidable. Especially now that the portfolio is doing so well, we need to keep in mind that there will always be corrections and drawdowns along the way.

We have to focus on performance over long periods of time, ideally 5 years or more, and including both bull and bear market periods for the stock market.

Since 2017 the portfolio has gone through two major bear markets, one in the fourth quarter of 2018 and the second one in March of 2020.

On both periods the portfolio outperformed the market by protecting capital when markets were trending down, but executing well during those kinds of periods is always difficult and uncertain.

You Have To Make Your Own Decisions

The Data Driven Investor provides research and ideas, but I am not allowed to provide financial advice. I can tell you what I do with my money - I follow the Data Driven Portfolio - and I can also tell you what I think about different stocks and ETFs and about the market in general.

However, I cannot tell you what you should do with your own investments. I don't know your risk tolerance levels, time horizon, and other considerations, so financial advice is not allowed.

Building Wealth Over The Long Term

The main objective in the Data Driven Portfolio is building wealth over the long term, which means at least 5 years and ideally much more. I do not care at all about relative performance in comparison to the index.

I show performance in comparison to the index because it is important to understand in what kind of context the portfolio performance was generated, but the main objective is building wealth over the long term irrespective of how the stock market in general performs.

The Risk Management Process

The Data Driven Portfolio is managed for the long term, but this does not mean that it is just a "buy and forget" portfolio. I am focused on risk-adjusted returns as opposed to returns in isolation, and I actively manage portfolio risk depending on how market conditions evolve.

I do not care much about a 10%/15% correction in the market, which typically happens once per year and is completely tolerable by my standards.

However, when we are facing a potential decline of 25% or more in the markets I generally reduce portfolio risk by increasing cash levels and/or hedging the portfolio.

Raising cash levels can be done by selling some tactical positions or reducing the size of the positions in the portfolio. Hedging can be done with bonds, metals, inverse ETFs or even short-selling ETFs.

If you want to replicate these moves in your own portfolio it is better to make sure that you have the authorization to buy inverse leveraged ETFs and to short-sell ETFs in your brokerage account in case you want to do it in the future.

In the fourth quarter of 2018, for example, the portfolio was net short in some periods, meaning that we were making money as markets declined. This was an extreme positioning because at the time the Fed was raising rates while the global economy was decelerating. It is not very likely that we are going to get net short again in the future, but I just want to be clear regarding the fact that we can have significant bearish exposure in some exceptional circumstances.

During the coronavirus market crash in March of 2020, we just raised cash to 50% of the portfolio and concentrated the portfolio in companies focused on internet and software businesses that can still do well during the lockdowns and the global recession. I was actively looking for a hedge in the first stages of the decline, but I didn't find any good entry points to hedge. Besides, cash and strategic positioning were providing solid defense at the time, so I didn't want to complicate things too much.

Depending on how the specific situation evolves in the future, we could use a combination of cash and other hedging vehicles to protect the portfolio when the time comes.

The best method and instrument generally depends on the specific situation, but the main point is that we use dynamic strategies for portfolio protection in bear market environments. You don't need to replicate these moves, of course, but it is important to make plans for bear markets before the bear market comes.

For some investors, it is easier and more straightforward to just raise more cash when the bear market comes, and this is perfectly fine if it works better for you.

Looking For Exponential Returns

The strategic positions in the portfolio are planned for the long term as long as the fundamentals remain strong. You can always find a research article in the spreadsheet explaining the thesis for each of these individual positions.

These strategic positions are generally focused on companies with big potential for growth. There is an important reason for this, and it is that the best growth stocks can produce game-changing returns over the years.

Let's say that you buy a classic value stock - a mediocre business - which is underappreciated by 30% or so. The business is not growing by much, but the stock is cheap. When the stock rises by 30% it is no longer undervalued and you need to sell it, you have to pay taxes for the realized gains and try to find another opportunity. Even if the investment works well, there is no guarantee that you will find other undervalued stocks to rotate your money into.

But when you find a business that can sustain attractive growth rates over long periods of time, buying and holding can produce massive gains over multiple years. This can be a game-changer in terms of returns, even if you pay an elevated price for such a high growth business.

A historical example can show how powerful this can be. Warren Buffett and his mentor, Ben Graham, both made big amounts of money by investing in GEICO. Graham had always gravitated towards "cheap" stocks, but he paid a relatively expensive price for GEICO in 1948.

In the words of Ben Graham himself. “Almost from the start, the quotation appeared much too high in terms of the partners’ own investment standards”.

This investment was truly game-changing for Graham. In the words of John Hubber

So it was ironic that Graham ultimately made far more money in this single GEICO investment than all of the other investments he made during the course of his lengthy career… combined. It was also strange that Graham invested nearly 25% of his partner’s capital into GEICO in 1948, acquiring 50% of the growing enterprise for the small sum of just $712,000. This would eventually grow to over $400 million 25 years later!! That is a 500 bagger. To make an understatement: For a guy who made a living hitting base hits, this was a home run.

Ben Graham wrote in The Intelligent Investor:

Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions.

What happens if you start looking for the GEICOs of the future right now? Buying one or several of these stocks can generate exponential returns, so focusing on these kinds of opportunities can make a massive difference in your wealth over multiple years.

Car insurance was a high growth opportunity back in 1948, and the best growth opportunities today are generally in areas like technology, internet, and software. That is the main reason why you will find many high growth companies in these sectors in The Data Driven Portfolio.

How To Find High-Quality Stocks

You can always find in the spreadsheet a column entitled Research Article that explains the specific investment thesis for each position. There are some important particularities in each case, and each investment should be assessed on its own merits. Nevertheless, there are some main attributes that I always keep in mind when selecting companies for the portfolio.

The quality of the management team

The right people are the most important long-term drivers behind a business. In most cases, the companies in the Data Driven Portfolio are run by their founders. If the founder is no longer around, it is generally a CEO with at least 15 years of experience in that company. This is very different from an externally hired CEO or a "professional business manager".

Company founders have a large share of their net worth invested in the company. If the company wins they win and if the company loses they lose. This is how it should be, and it is also the reason why I replicate The Data Driven Portfolio with my own money.

Even more important, the company is a big part of their life for these business leaders. Their mission in life and their legacy are intrinsically tied to the future of these businesses. These kinds of people will always prioritize the long term future of the business as opposed to maximizing profits in the short term.

As an investor, being able to think about the next 10 years as opposed to the next 10 months can put you on a different level. The same goes for CEOs and business leaders in general.

Competitive strengths

The competitive strengths are the factors that allow the company to protect the business from the competition. Superior technologies, brand power, scale, and network effects are some notable examples of potential sources of competitive strengths that I keep in mind when buying stocks for the Data Driven Portfolio.

Long term growth opportunities

The companies in the Data Driven Portfolio are generally benefitting from enormous opportunities for growth in areas such as online commerce, software-as-a-service, digital transformation, cloud computing, genomics, Artificial Intelligence, and so forth.

The best companies with the best management teams generally build new growth engines over time and as they are always expanding into new areas.

I generally want to buy the best companies in the best industries and with the best management teams in order to maximize the chances of obtaining exponential returns over the long term.

Quantitative metrics

Some of the companies in the portfolio are making big profit margins, others are starting to operate in a profitable way, and others are still burning lots of money because they are aggressively investing for growth. This depends on each particular company and its position in the growth cycle.

However, I generally focus on companies that can deliver a solid combination of top-line growth and potentially expanding profit margins over time. Most of the companies in the portfolio also have little debt or even no debt at all on the balance sheet.

Happy customers and happy employees

I work as an adviser for some asset managers, and I interact a lot with the typical Wall Street analysts. Most of the time, these analysts are crunching numbers on their spreadsheets and reading the same reports as everyone else is reading. If you want to obtain different results, you have to do things differently.

Let me tell you a little hack: If the company's customers and employees are happy, there is a good chance that investors in this business will be happy too over the long term. You still need to check the financial metrics and other more typical variables. However, companies that can build the best products and attract the best people tend to succeed more often than not.

About valuation

Valuation is always a hot topic, especially when it comes to high growth stocks that trade at elevated valuation ratios. I am going to explain my perspective first and then I am going to provide some explanations for this point of view.

I generally do not sell the complete position because of valuation. If the stock gets too expensive, perhaps trimming the size makes sense, and abstaining from buying more at aggressive prices is a reasonable thing to do. However, it can be a good idea to hold on to at least part of the position. This is assuming that the quality of the business remains intact, of course.

Now let's get into the explanations. We have two variables to consider here, the fair value estimate of the business and the market price. A stock looks expensive or overvalued when the price is high in comparison to some estimate of fair value. However, it is not as simple in real life as in theory.

The fair value of the business depends on the cash flows that such a business will produce over the years and decades ahead. Those cash flows are unknown, they can only be estimated, and those estimates carry a large margin of error.

Besides, the fair value changes over time and it can sometimes have big increases. Amazon (AMZN) had a specific fair value estimate in 1999 as an online bookstore. Then it became the largest online retailer across all categories. After that, Amazon became the world leader in cloud computing infrastructure, and now it is successfully expanding into logistics, digital content, online advertising, and so forth. The fair value of the business has obviously increased exponentially as Amazon successfully expanded into new areas over the years.

The point is that fair value is always just an estimate with a large margin of error, and the fair value estimate of a business can change substantially over time. When dealing with the best growth stocks, this fair value can have huge increases over the years.

When I select stocks in The Data Driven Portfolio, I try to focus on companies that have this potential to substantially outperform expectations over the long term. Maybe the business looks expensive in comparison to current sales and earnings, but current sales and earnings are not reflecting the company's true potential over long periods of time.

I am not saying that valuation should be disregarded, not at all. But when it comes to innovative growth stocks, valuation should be taken with a grain of salt, always acknowledging that fair value estimates carry a large margin of error and that the fair value of a business can increase substantially over time.

On valuation versus quality and strategic vision

The market is often too short-sighted, and the current price of a stock is generally reflecting the market expectations over the short term, meaning several days or months.

If you can focus on the next 5 to 10 years while everyone else is focusing on the next 5 to 10 days, then you can have an edge in this business.

Perhaps a stock looks too expensive when thinking about the next 5 months, but it is actually cheap over the next 5 years and is even a bargain over the next 10 years.

Doing this is not easy because it requires patience, conviction, and character. These virtues are not easy to find nowadays. However, strategic vision and patience can be rewarded with exceptional gains over the long term.

What If The Price Is Too Extended In The Short Term?

Sometimes you really like a stock for the long term but the price is already too extended in the short term. Just to be clear, I am talking about the positions that you want to buy, but you don't like the timing in the short term.

Sooner or later the stock is going to pull back, but it can always pull back from much higher prices, and perhaps it never comes back to the current price. On the other hand, you don't want to build a big position when the price is looking unattractive.

I generally manage these situations by building the position very slowly and in a small size. Let's say that you want to buy 100 shares, you can start by gradually buying 25, 30, or 50 shares at current prices. In this case, it is important to keep some cash on the side to buy more if there are more attractive entry prices in the future.

If the stock keeps running higher without pause, at least you managed to start buying a small position. Conversely, if the stock price makes a big pullback you have plenty of cash to buy more.

This is strategy is obviously not perfect or infallible, but it has worked well for me over the years. You should always do what works for you, of course.

Position Size And Risk

Let's say that you buy a stock and then the price increases substantially. This probably means that the position is now a much larger share of your portfolio than when originally purchased. Trimming the size of the position in order to remain comfortable with your risk exposure is a reasonable thing to do in my opinion.

Personally, I don't worry much about that because I am still in my saving phase and I allocate more cash to the portfolio regularly. Besides, I have a high tolerance for risk, so I am comfortable with letting my winners run.

For many investors, however, trimming the position when it becomes too big is a very reasonable thing to do.

When do you sell?

When management is not executing as expected, when the business fundamentals are deteriorating, when I have other opportunities with better risk and reward ratios, when there are doubts about the company's accounting, and many other possibilities.

I generally focus on fundamental quality as a reason to sell, not so much on valuation. I am more likely to sell a stock that is performing badly than to sell a stock that is performing well.

Reading The Spreadsheet

Here are some explanations for the columns in the spreadsheet beyond the ones that are self-explanatory.

  • Timing - "Buy Now", "Buy On A Pullback to X", or "Hold". This is about the short term timing for a position. "Buy Now" means that the timing is OK to start buying, "Buy on a pullback to X" means that the price is extended and it is better to be patient when building a position, and "Hold" means that I wouldn't buy now because I am thinking about selling in the near term.
  • Priority is the degree of importance for a specific position from a long term perspective. It makes sense for new members to focus on the high priority stocks first if they can't buy all the positions at the same time.
  • Time Horizon: Strategic positions are planned for the long term, ideally many years if the fundamentals remain strong. Tactical positions are more short-term oriented, and I can use some stops to manage risk if the tactical position is not working as expected.
  • COVID-19 risk is the degree to which the company can be hurt by the COVID-19 pandemic and the recession that comes with it.
  • High Target. It is the highest price target among the analysts following the stock. I do not take these price targets or fair value estimates very seriously, but it can be a data point to keep in mind from a valuation perspective.
  • Research Article: The explanations for the different positions
  • Date: The different dates at which the positions were purchased

That is all for now, don't hesitate to ask if you have any questions or you need anything.

Analyst's Disclosure: I am/we are long AMZN.

I replicate the Data Driven Portfolio with my personal money.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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