Friday, December 28, 2012

Performance Review

It's the end of the month so it’s time to assess portfolio performance. I know readers like articles that have a watchlist of stocks for them to research, so I hope this format is useful. Every month I like to review the quarter and provide a kind of compendium for the articles I wrote on specific stocks in the month leading into the quarter. I use these articles as a way to help formulate views and invest in the stocks I write about. Any constructive suggestions on how these posts can be improved will be gratefully received.

It was a good quarter, ending 24.4% up and taking me up to 73.3% YTD and 78.8% on a trailing year basis. It obviously won’t always be like this, but I’m reasonably pleased with my performance* since I switched to investing in the US from predominantly UK small caps. I typically hold 20-30 equity positions. For the record, I’m leveraged and hedged so expect volatility. I short indices, not stocks, which means that the stock research I do is always with a view to buying the stock, and I’ve made a conscious effort to push harder and find more stocks. That said, I don’t buy everything I research.

Here is the stuff I looked at in August. The hyperlinks go back to the original articles.

Company View + Article Link Performance Since Article
Sirona Dental Systems Positive 25%
Home Depot Positive 23.6%
Cal-Maine Foods Positive 19.8%
Beacon Roofing Supplies Positive 11.1%
Sanofi-Aventis Positive 10.3%
Nice Systems Positive 6.4%
Covidien Positive 5.9%
CVS Positive 4.4%
Intuit Positive 1.9%
Wells Fargo Positive -1.8%
Check Point Positive -9%
Fortinet Positive -18.1%
Colgate-Palmolive Evaluation 2.5
Nordstrom Evaluation -2.5
Perrigo Evaluation -4.6
GameStop Neutral 42.9%
Acme Packet Neutral 18.7%
Harley Davidson Neutral 11.2%
Heico Neutral 8.7%
Autodesk Neutral 6.1%
Church & Dwight Neutral 4.1%
McDonalds Neutral .4%
Cisco Systems Neutral -.2%
Aruba Networks Neutral -1.8%
NetApp Neutral -5%
Coach Caution 5.6%
Joy Global Negative 10%

The statisticians amongst you will note that the ‘positive’ stocks (all of which I bought and hold until they hit my target prices) returned an average of 6.6%, while the ‘neutral’ stocks (which I looked at to buy but rejected for myriad reasons) returned 8.5%. The ‘evaluation’ stocks (I liked but rejected due to evaluation) returned -1.5%. Meanwhile ‘caution’ and ‘negative’ returned 5% and 10% respectively. Go figure! This is the second month in a row that the stocks I rejected outperformed the ones I bought, although the ‘neutral’ stocks would have returned 4.7% without GameStop.

I can’t explain this away with an argument based on risk. In other words, say that the market soared and took the riskier stocks up disproportionately. In fact, the market is up since the start of August and was pretty flat during August itself.

Incidentally with GameStop, I’m under no illusions here. If forced to be long or short GameStop, I would rather have been short, but since I don’t short stocks it's academic. The problem with shorting stocks is that unless you are a dedicated short seller, it’s very hard to re-frame from a long only mindset.

Buy Unfashionable Stocks

I’m particularly please that four of the big contributors were relatively under-researched and unloved stocks with Sirona, Cal-Maine Foods, Beacon Roofing and Nice Systems providing nice returns. There is more to investing than endlessly discussing Apple! I would encourage investors to be willing to go off the beaten track. We see the views for our articles and believe me, they are not launching when I write about Sirona Dental Systems.

Healthcare and Housing

These sectors have been doing well for differing reasons. Housing has done well because there is a structural recovery going on in the US, and health care is a relatively resilient sector which was very low rated at the start of the year. Health care is also somewhat of a high-yield sector acting as a proxy for bond investors tired of paltry rates. As such, I prefer many of the stocks within it to the food sector. In particular, I look at something like drugstore CVS (NYSE: CVS) and see plenty of opportunity for it to grow its private label sales as well as expand generics sales to an aging demographic.  Elsewhere in the portfolio health care and housing has worked.

Not All Good News

The standout disappoints are Fortinet (NASDAQ: FTNT) and Check Point Software which hurt performance here and in my portfolio. I was fortunate that Fortinet hit my target price so I exited before the disappointing last results but held Check Point over its lowering of guidance. While not my finest hour, I happen to think both are cheap and bought more Check Point. As for Fortinet, I’m waiting to see what Palo Alto Networks says before thinking about going in again.

Evaluation Still Matters

This is perhaps the most frustrating part of investing and why it helps to write stuff down. Sometimes you find a great stock in a good industry and buoyed with enthusiasm you then sit down and work out an evaluation only to discover that everyone else discovered it too. I love Colgate-Palmolive (NYSE: CL) but I have no intention of paying the current market price. All businesses have risk, and I want a margin of safety for everything, including toothpaste and mouthwash. Yum! Brands recently lowered guidance for sales in China; who is to say Colgate might not do the same?

Loosen Up

Actually I’m not going too. The ‘neutral’ stocks did outperform this quarter but I’m going to stick to my guns. I’m not a value or deep value investor so things like Autodesk (NASDAQ: ADSK), Acme Packet and Heico, which appear to have near term risks but good long term value, will be avoided for now. All three are very attractive though, and I’m intrigued by how Autodesk is shifting to a SaaS based sales model. The trouble is, it is doing so at a time when its end markets are deteriorating.

Similarly, I think there are real signs of a moderation in growth in China, and Coach and Joy Global (NYSE: JOY) do have heavy exposure. With that said, perhaps much of it was in the price and they bounced back as a result of hopes for a stimulus package from China? It’s possible, but overall I would still urge caution. The US housing recession unfolded over years, and I see no reason to expect anything different from China’s fixed asset investment.

The Bottom Line

I’m pleased with how things are going, and the general theme of overweight US housing, health care and assorted secular growth stories is working. Avoiding over-exposure to emerging markets and cyclical stocks has worked too. My selective technology buying hasn’t worked well (unless it's where I added after downgrades) and my avoidance of some of the high-yield-but-also-highly-rated food stocks has also seen me give up gains. No matter, I’m sticking to my guns here.

It’s a tricky macro environment, but if us private investors can carry on sticking our heads together we can continue to beat the index-hugging professionals without too much difficulty.

* just over 33% p.a. since end 2009 with an R^2 of .07 and Sharpe ratio of 1.07


  1. Lee,

    Out of curiosity, how much are you leveraged and how much have you hedged (and what have you hedged against, the S&P 500?) I'm curious at to how you handle the leverage risk as I'm always concerned about worst-case scenarios - I guess your hedging is designed to compensate against these kind of scenarios.

    Also, what led you to move out of UK small caps and in to US large caps? I'd have thought that the UK large cap market would be more efficient on aggregate so finding mispricings would be much harder?

  2. Hi Mark, I'm a bit underleveraged right now because the performance has added sufficient capital. I need to take more leverage in 2013 and am nudging up position size and buying more stocks accordingly. As a rough indicator leverage of 4-8x is reasonable and I'm closer to the low end right now.

    I short the indices for which I have long positions in. As Japan demonstrated a couple of years ago, you can have one off country events so its best to play it safe.

    I allow for a discretionary element with hedging and it ranges from .8-.9x the long side depending, on how I feel. In general I stick to .82 and I find that that (backtested since 2003 with a regressional analysis) gives negligible R^2. So for example with what I am doing now the (monthly) R^2 is only .06

    Leverage. It's hard to get liquidity and leverage with UK small caps. I confess that this worried me a lot so I did backtest performance a lot by isolating the larger cap stuff I had bought over the years. It is imprecise but things appear to be working okay. It's probably safer to do this with large caps anyway because you want correlation between your long side and index short otherwise there is no point in hedging!

    The only thing that I would caution with this sort of thing is the expense of doing it. It costs a small fortune.
    All the best, Lee