Commentary: Know what you hold
The idea of "knowing what you own" seems like it ought to be a basic threshold for an investor to know about their portfolio. However, we'll explore how not all investments are necessarily what they may appear, and how Basepoint swims against many industry trends when it comes to portfolio management.
Dear Family, Friends, and Clients,
Knowing what you hold seems like a minimum threshold for success in any endeavor. The example of making bets in poker without looking at your cards seems like hyperbole; but a careful look at the average portfolio will show exactly this tendency. In fact, academic research is touting this methodology as the only way to guarantee success. “Why look at individual companies, when you can buy a portfolio of great American businesses with very low cost?”, they rhetorically retort, “You are guaranteed average results without doing any work”. This discussion will attempt to explain in detail why Basepoint swims against the indexing tide, when just buying a portfolio of index funds would be cheaper and easier.
In physics, scale is an important factor in determining whether a system is deterministic (Newton) or probabilistic (Einstein). In determinism, the outcome is known with certainty, in advance; the path of a planet is not capricious. In probabilistic systems, the outcome is stochastic, and a certain level of randomness is present. The combined mass of an object or system determines whether the physics of Newton dominate, or the physics of Einstein. Newton even famously quipped that he could “calculate the motion of heavenly bodies, but not the madness of people.” Our own sun contains 10^57 hydrogen atoms; this is an unfathomable number of individual observations. With this many individual particles clinging together, the results are all but certain, and Newton’s First Law confirms this. It is statistically impossible for a star to simply disappear because all 10^57 atoms would have to conspire simultaneously.
In contrast to large, deterministic systems, Don Lincoln at Fermilab Today wrote: “At the quantum scale, space is a writhing, frantic, ever-changing foam, with particles popping into existence and disappearing in the wink of an eye. This is not just a theoretical idea—it's confirmed.” At the very small scale, nothing is certain. Particles can simply vanish without notice or apparent cause, and atoms can be entangled and send signals to each other faster than the speed of light. It is a terrifying world that lacks certainty, and although there is probably a perfectly reasonable explanation for this behavior, we do not yet understand the underlying mechanism.
So where does that leave those of us clinging to a giant, wet rock hurtling through space around a massive nuclear furnace? Somewhere in the middle. Our scale is not quite large enough to be completely deterministic, and not small enough to be completely random. We have many observations to utilize in decision making, but not quite enough to guarantee certainty. The problem lies in trying to tie the physics of Newton to the actions of people; even Newton lamented the impossibility. Using statistical techniques designed to give reliable results in a system of billions of observations falls short when applied to thousands of data points- especially when friction, in the form of exogenous surprises, is also present. At the human scale neither certainty nor chaos prevail. We must integrate the disciplines of both scales to get reliable results over many decisions.
When a subatomic particle snaps out of existence, it seems completely random to us. There is possibly some sort of unobservable factor missing from our perspective to help us predict when a particle will just cease to exist. It is not quite that random at the level of a company. Usually there are assets, liabilities, revenue, and expenses to help guide us in deciding the probable trajectory of the future. That is not to say that seemingly random events do not occur. If Amazon decides to enter your business, your stock price may plummet and your sales may dry up, but this type of occurrence is uncommon enough that diversification can help to mitigate the impact of this type of random tribulation. It is also possible for us to miss certain fundamental signals that were clear to others. Diversification is insurance against ignorance and bad luck.
So why not just buy every company and transition to the physics of Newton? The simple matter of fact is that determinism does not guarantee success, and inertia does not apply at our scale, especially not in investing. A body in motion does not necessarily stay in motion in the presence of randomness. Over-diversification simply reduces the exposure to risk of returns that deviate from average. There is no law that states that average results will not be significantly negative, especially when the average price of a security is high in relation to the income it produces. If you buy 505 individual companies at 42 times their annual earnings, it will be difficult to achieve higher than a 2.38% annual return without significant economic expansion since you own exposure to the entire economy. Your results are tied to economic growth, interest rates, and investor psychology.
A further danger inherent in modern day indexing stems from the way indexes are weighted. Every index must have a scheme to allocate capital among the various components. The three most common weighting methodologies are: capitalization-weighted, price-weighted, and equal-weighted.
The composition of capitalization-weighted indexes is based on the total size of each company. Share price is multiplied by total shares outstanding, which equals market capitalization, and this determines each company’s proportional weight in the index. They are structured this way to make it more realistic for all investors to be able to purchase the entire index. Sometimes capitalization-weighted indexes are also float-adjusted, which means that only the shares available to the general public are included in the weighting. For instance, Warren Buffett owns a large percentage of Berkshire Hathaway, so his shares are removed when calculating Berkshire’s proportion of the index.
Price-weighted indexes are composed based on the share price of each holding. The Dow Jones Industrial Average is a well-known price-weighted index. This type of index is much easier to calculate, and before computers it was less labor intensive to just take the average of all the prices (with adjustment factors). The main problem with a price-weighted index is that it punishes stocks that split, and rewards stocks that do not. If a $300 stock splits 3 for 1, the price-weighting of the index will decrease by 2/3. In addition, a price-weighted index pays no attention to the size of a company, so in theory, a company with 1 share at $100,000,000 would become a very large percentage of the index and be inaccessible to investors looking to replicate the index.
An equal-weighted index simply allocates a consistent dollar amount to each stock. An equal-weighted index with 10 holdings at a tracking value of $1,000 each would be a level of $10,000. This type of index over-weights small companies in relation to capitalization-weighted indexes, and it has higher trading costs due to equalizing the positions on a frequent basis. In addition, it is not always possible to buy fractional shares, so replicating the index at smaller levels is very difficult.
Intuition would lead one to believe that the Standard and Poor’s 500 is comprised of 500 stocks in equal weights. This is not the case. The S&P 500 is float-adjusted, and capitalization-weighted, and is comprised of 505 stocks. This means that larger companies are a larger percentage of the index, and that as companies grow larger, they become an ever-larger percentage of the index. This is a built-in momentum mechanism that places higher emphasis on companies as they grow. An unfortunate side effect of this is that during a market mania the most overvalued companies become a larger and larger percentage of your portfolio. This is greatly rewarding as the market screams higher, but equally punishing when these trends reverse. Currently, Apple is the largest component in the S&P 500 at 5.99% of the index. Conversely, News Corp is the smallest position at .008523%. As Apple increases in value it becomes a bigger percentage of the index. Currently, the top 10 positions out of 505 are 27% of the index, and the top 20 positions in the index are 37% of the exposure.
When we evaluate a portfolio of securities, we think in terms of how much value we are getting for each dollar invested, and how much each dollar invested earns. We consider a portfolio a collection of cash flows that can be translated into an asset price, and appreciation comes from the annual earnings the firms produce. We believe it is a mistake to purchase streams of cash flow with the intention of hoping someone else will pay us more for them next week. Furthermore, we try to purchase them at a discount to what they are worth, and only when we are receiving an adequate return. We evaluate how much of the earnings are being paid out in dividends because the retention of earnings is what causes our companies to grow over time. A savings account paying 5% will compound at this rate indefinitely. As our companies retain earnings, they reinvest them in the business, and hopefully produce at least a dollar of asset value for every dollar they retain. While this is not always the case, it is why having “able and competent management” is so important, and why having a business with a “durable competitive advantage” is so important, these factors protect the integrity of our retained earnings.
If we look at the top 20 holdings of the S&P 500 in proportion to their weighting in the index, and assume we had a million-dollar portfolio holding these positions, which is 37% of the portfolio of an index investor, we find the following data:
The portfolio discount tells us how much value we are getting for each dollar invested. In this example, for every $1 we invest in this portfolio, we are only receiving $0.91 in value. In addition, each dollar is only earning 2.665% per year, which is not significantly more than a 30-year treasury bond. This is illustrated by the Earnings Yield, which is simply the inverse of the Price-to-Earnings Ratio. The Earnings Yield tells us the amount of earnings the company produces for each dollar of investment. It doesn’t seem logical to take on the equity risk of a 50% decline to earn 0.30% more than bonds. If we look at the composition of this portfolio it is over 50% Technology and what they are calling “Communications Services” these days, which is a fancy term for Technology. Finally, you can see the dividend yield, and what percentage of Total Earnings is paid out in dividends. If the payout ratio approaches or surpasses 100%, it means that the companies are self-liquidating because they are earning less than they are paying out, and either earnings will need to increase, or dividends will need to decrease. Be wary of the “company with the big dividend” that is actually paying out 200% of earnings each year.
You may have questions about the growth of the earnings, but since fair value is calculated using discounted cash flow, an estimate of growth is reflected in the fair value, which tells us that this portfolio is overpriced in relation to not only current earnings, but also the current value of future earnings. There are many nuances to earnings and how depreciation and amortization impact them, but in general, for an entire portfolio, earnings are a reasonable way to judge a portfolio over time. There are always “one-time charges” and “non-recurring charges” and “extraordinary events”, but we can adjust for these manually, when necessary.
Contrast the data for the partial index portfolio to our current individual equity portfolio:
The issue with our current portfolio is that only contains 7 stocks, and we like to purchase at least 10-15 to have adequate diversification. Most of the companies we purchased in April of last year have appreciated significantly, and many of those stocks are no longer appropriate for purchase. Keep in mind that there is a different threshold for holding a security vs buying a security. We only sell our securities when the price well exceeds the fair value, or they no longer have positive earnings on a recurring basis. We only buy securities when the fair value exceeds the price. There is a large zone between these targets where securities are held.
Our investment process never includes timing the market, but it does rely heavily on valuing securities. In January 2020 we were having similar difficulty finding securities to purchase. Our portfolio of individual stocks contained 12 companies and the metrics looked like this:
Even at that peak the valuation of the portfolio was significantly more attractive than now. When the stock market dropped significantly in March, we reevaluated our options and the list of potential purchases had expanded to 28 (we will typically buy 10-15 of these stocks) and the metrics were:
By April our “wish list” had expanded to 55 stocks:
This was the point where we put a lot of the cash we had set aside to work. Many of the securities we purchased at this point have more than doubled in less than a year, and for the first time I can remember we had to struggle with short-term capital gains in some accounts. It is also important to look at the spread between the earnings of our portfolio and the yield available on treasury bonds. In April we were getting paid 8 times more to hold equities as opposed to bonds. Right now, the top 20 holdings in the S&P 500 are only earning 13% (.30% nominal) more than a 30-year treasury bond. That is not a good risk-reward payoff. This is the type of discipline we use to protect your assets through good markets and bad, and the reward of having a significant amount of cash at a time like April 2020 is worth the pain of our neighbor outperforming us, even for a couple of years.
Newton formulated no fourth law that guarantees that companies will continue to become more valuable just because they are part of an index. Although there are technical factors that cause this momentum effect to persist for long periods of time, the more over-valued a company becomes, the more severe the correction will be in the absence of economic growth, in periods of rising interest rates, or changes in investor psychology. There is no magic source of returns. Just because a portfolio has averaged 15% annually does not guarantee that inertia will cause this to continue. In fact, the opposite is true, and it is likely that future returns have been pulled forward to the present, and that losses lurk around the corner to equalize the returns over time.
Our process attempts to build portfolios from the ground up and seeks to be in that middle zone between Newton and Einstein. Our mutual funds average 29 holdings per fund. A fund manager and a team of analysts have carefully examined each holding, and your exposure is weighted based on the conviction of each idea instead of simply rewarding increased size. In addition, we focus on company earnings and sustainability of those earnings. While this does not always translate into immediate returns in the form of capital gains, it does cause the value of the holdings to increase as earnings are reinvested into the business. As Benjamin Graham stated, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” What Graham means by this is that over short periods of time popularity is rewarded by higher prices, but over the long-term earnings matter and the prices adjust to companies that become more valuable. This is why our Principles of Margin of Safety, Investing vs Speculating, and Thinking Long-Term are so important. We may underperform for a while but knowing what cards we hold will eventually reward us.
We buy companies that are expected with a high degree of certainty to become more valuable over time, not companies that are expected to appreciate in price regardless of company performance. While this discipline can be frustrating when Tesla rises from 800 times earnings to 1600 times earnings, that price increase is untethered from any measurable reality, and if a company can double in price regardless of improving financial results, it can just as easily be cut in half. It is said that stocks take the stairs up and the elevator down.
There is still the matter of how it is possible to minimize the risk of permanent loss of capital through less diversification. The answer lies in the fact that we are not making even money bets on individual companies. If each decision were a coin flip, we might be better served making more bets so that we could get very close to that coveted average result of 50/50. If we only made 20 flips it would be entirely possible to lose 17 of them. However, our methodology attempts to make each decision much more favorable than 50% odds. We are looking for situations that are more than 80% likely to be successful by buying based on both earnings and valuation, buying companies with durable competitive advantages, buying companies with able and competent management, and maintaining adequate liquidity to take advantage of market declines. By making a smaller number of decisions with much higher odds of success, our chances of increased returns are more certain. There are not an infinite number of situations available in the market with 80% certainty of success. The more expensive the overall market, the less common high probability of success ideas are. We add more positions when the market declines in price because when the odds are in our favor, we should make more bets. An American Roulette game pays 37-1 on a single number, but there are 38 numbers. If you bet on every number, you would lose on every spin. But if you found a game that paid 39-1, the proper bet would be on every number, every spin, and you would be guaranteed to win. We take a similar approach in investing. When the odds are in our favor, we make more bets, and when the odds are not in our favor, we make fewer bets.
The problem with indexing lies in not knowing what you hold, the odds varying over time based on valuation and composition, and with the momentum factor working for you during an increase and against you during a decrease. In addition, these factors evolve over decades and fundamentally change the systems and processes of investment firms with short memories. Academic research does show that it is impossible for all investors to beat the index in any single year; however, we do not measure success on an annual basis, our strategy and discipline are very uncommon, and we maintain large amounts of cash when stocks are expensive, and we put that cash to work when stocks are cheap.
The average portfolio we see from competing firms has a dozen different funds, each with over 100 stock holdings. But when we run a stock overlap analysis, we find that the top 10 holdings are owned by half of the funds, and those stocks comprise up to 30% of portfolio. Even worse, sometimes they also have those individual stocks added in addition to the mutual funds for even more concentration. We see portfolios with exposure to thousands of stocks, but with 30% of the assets in the top 10 holdings. This makes the portfolio almost guaranteed to underperform an index over time, and it is physically impossible for any individual to have knowledge of every holding. The management fee becomes insurmountable with exposure to that many different contingencies because the majority of the fee is allocated toward replicating what you would get almost for free in an index.
Our commitment is to focus your equity holdings in the best ideas of able and competent asset management teams. Our own individual stock selections will always be purchased based on our principles, will favor earnings over short-term capital appreciation, and we will default to cash when we can find nothing to buy. This may drag on performance during periods of wild market appreciation, but during declines we are flexible and ready to put capital to work. This is how we manage your assets for a lifetime, instead for a quarter. We will know what you own, why you own it, and the risks and rewards we are likely to face over time.
Thank you for the trust you put in our team. We never take for granted that you have chosen us to be stewards of your life savings over many other options available. It is our hope that our disciplined and logical process helps you both eat better and sleep better. As the firm grows, it is exciting to see the principles we have established taking hold and being lived every day by our team members. Basepoint is a pleasure to walk into every morning. As always, your wealth advisor is available to answer any questions, and I am too. We look forward to helping you define and reach your goals, both financial and otherwise.
Allen Wallace, CFA, CPA/PFS, CFP®
Chief Investment Officer
Basepoint Wealth, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.