Portfolio Rule Three

One side benefit of deciding to start up Aleph Investments, LLC, is that it is forcing me to write out articles on my rules.  When I was writing for RealMoney.com, I wrote a number of articles about my eight rules, but I only wrote about four out of the eight rules.

Before I write about rule number three this evening, I would like to bring you up to date on what I am doing with Aleph Investments, LLC.  This past week I incorporated the business, and in this coming week.  I will be registering as an investment advisor.  I will be managing equity money, on both a long only and hedged basis.  I have yet to choose a custodian and clearing broker, but I am working on this.  Given the state that I am domiciled in, Maryland, there may be delays but I suspect I’ll be up and running by late November or early December.

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Let me give you a little history of how the eight rules came to be.  In 2000, I had an e-mail discussion with Kenneth Fisher.  I explained to him what I had been doing with small-cap value, and how I had done well with it in the 90s.  He told me to forget everything that I’ve learned, especially the CFA syllabus, and look for the things that I can do better than anyone else.  We exchanged about five or so e-mails; I appreciate the time he spent on me.

So I sat back and thought about what investments had worked best for me in the past.  I noticed that when I got the call right on cyclical industries, the results were spectacular.  I also noticed that I lost most when investing in companies that didn’t have good balance sheets, no matter how “cheap” they were in terms of valuation.

I came to the conclusion that size and value/growth were not the major determinants of my investing success.  Instead, industry selection played a large role in what went right and wrong with my investment decisions.  So, I decided to formalize that.  I would rotate industries with a value bias.  But that would have other impacts on how I invested.  One of those impacts is rule number three.

I formalized the first seven of the rules in 2002, when the strategy was two years old and seemingly performing quite well.  I began doing what rule number eight states sometime in 2004, and reluctantly added it to the seven rules sometime in 2006.

With that, on to rule number three:

Stick with higher quality companies for a given industry.

There are three simple reasons for why rule number three works:

  • First, companies with lower debt levels within a given industry tend to be more profitable than companies with higher debt levels that industry, contrary to what the Modigliani-Miller theorems state.
  • Second, many investors, both retail and professional, have a bias toward what we might call “lottery ticket stocks.”  Many people swing for the fences in the stocks that they buy and accept high risks in order to achieve a high return.  On average, this strategy does not work.  In general, buying high beta, high volatility stocks is a recipe for disaster and buying low beta, low volatility stocks tends to earn money better than the market averages.
  • Third, if you are rotating industries, there are two ways to do it.  These two ways are not mutually exclusive, you can have part of your portfolio in one strategy and part of your portfolio in the other.  Method one is to look for trends that are clearly going on, but that the market has not fully discounted.  In this case, one can buy companies with excellent or good balance sheets because the trend will carry you along.  Method two is to look for industries that are sick but not dead.  In that case, you only select companies with excellent balance sheets.  This is how it works: if the industry remains sick, weaker competitors will be destroyed, capacity will exit, and pricing power will return to the survivors.  If the industry’s pricing power suddenly improves, then all of the companies industry will do well.  The one with the excellent balance sheet will outperform the market as a whole.  That the ones with poor balance sheets do even better is not a concern.  The idea is to avoid losing money; don’t take the risk by buying the “lottery ticket stock.”

For what it is worth, this same idea not only works with stocks but it works with bonds as well.  If you read the book Finding Alpha, the author has an extensive discussion on why high quality bonds outperform low-quality bonds over the long haul.  In general, corporate bond investors underestimate the costs of default risk.  BBB bonds do best, followed by AAA bonds, and then other investment grade bonds.  After that, the lower the rating of the bond the worse they do.

The same is true of stocks, which is why it pays to look at where the market is in its liquidity cycle.  In November of 2008 through March of 2009, it made a lot of sense to buy junk bonds, and I did so for my church building fund.  Though I didn’t say it at the time and did not act on it, it was also in hindsight the right time to buy junk stocks.  Oh well, that’s water under the bridge.  I tend not to take the risk of buying junk stocks because I don’t want to lose money.  I did well enough by adding to more cyclical names that had strong balance sheets.

Two notes before I close: first, industries tend to have preferred habitats.  In other words, typically the difference between the company with the best balance sheet the industry and the company with the worst balance sheet industry is not all that great.  Why is that?  If you’re in the same industry, typically you have similar levels of fixed costs versus variable costs, and you face the same levels of variability in sales.  These two factors together will lead an industry to a preferred level of financial leverage.  But even though the difference might not be that much between the company with the best balance sheet and the worst balance sheet within the industry, when pricing power is weak that small difference is significant.

Second, I am a proponent of “good enough” investing.  What I am saying here is that it is very difficult to achieve optimal results, and that if you try too hard to achieve optimal results, it is likely that you will do worse than good enough results.  The demands of perfection kill.  Size your goals to what is humanly possible.  My methods allow me to sleep at night.  My methods allow me to step away from my computer, and spend time analyzing what really might matter.  I can go visit clients and not worry that something is going to blow up on me.

This is not laziness on my part.  It is my view that most investors can do well enough in investing at low to moderate levels of risk.  But at high levels of risk, you have to get too many things right too much of the time in order to succeed.

That’s all for now.  Back next week when I write about rule number four.

3 Comments

  • I really like your mention of Falkenstein’s book, although I would have personally linked to his paper on SSRN, since it includes the meat of his thesis regarding the negative skew of of most equities and the myth of the risk premium.

    Additionally, I think your rules–so far, at least–jive with both Faber’s study about unloved industries and Falkenstein’s latest work on the minimum variance portfolio, both strategies that make sense to me and make a lot of sense.

    As far as your clearing broker… I will repeat myself and say that Interactive Brokers has a great platform, on costs as flexibility for advisers and product selection. They are definitely bare-bones on a lot of things, but not a lot of platforms for RIAs offer futures (which I believe you mentioned for your hedged strategy), especially on retirement accounts.

    Otherwise, I’d like to say that I’ve found Pershing’s and Fidelity’s RIA platforms to be real stand-outs. Fidelity has a great inventory of fixed-income instruments (if you later choose to use it) and, as a tech guy, I’ve found Pershing’s not only incredibly capable, but willing to go the extra mile for smaller clients. I worked extensively with Fidelity in the past and while they have great people they get very tied up in bureaucracy and sometimes simple projects take a long time to get to production. they also have such large clients that sometimes the smaller guys don’t get that much attention. Pershing seems to be aggressively investing in the future of the platform, something that I can’t say for Fidelity’s team (which is actually National Financial’s). Fidelity and NFS are so big that some of the work is diminutive in comparison to their other work, but Pershing has constantly floored me with their aggressive approach to getting things done. They are a great company that seems to have taken the conscious choice of taking the risk of making heavy far-sighted investments with the idea that they’ll end up paying off, and philosophically that is a company that–to me, at least–is committed to progress. They seem to really have that “we’re in this together” mentality, which is not only valuable for their offerings–which you might not use–but speaks volumes to me about their commitment to advisers and culture in general.

    I look hearing more about your selection of a broker since I’m also in the process of helping someone find one. I will hopefully be able to post a series on the operational details of opening an RIA (which I am also in the process of) and would love it if I was able to link to your experiences so that, in the future, people facing similar situations can have a clearer idea of what to expect. It hasn’t been easy so far, and I sincerely believe having access to someone else’s first-hand experiences will help make life easier for people in the future. It always makes me happy to share knowledge to decrease unnecessary friction in life for others.

  • bbarberayr says:

    Nice writeup Dave. Seems so obvious when you read it, but I agree, a lot of people chase the low quality “lottery tickets” with much weaker risk / reward profiles.

  • matt says:

    Given that you are not trying to hit home-runs, do you tend to overwrite a lot of positions with covered calls to grab extra yield? Or do you miss too much upside that way?

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