Since the launch of the Independent Value (IV) Portfolio on 24 October 2013, common stocks have returned approximately 2% – 5% over the near-six month period to today, as measured by my preferred benchmarks of the Euro Stoxx 600 (+1.9%) and the S&P 500 (+5.0% ). By contrast, the IV Portfolio has generated a nil return over the same period, by virtue of a 100% allocation of capital to cash until Friday, 11April, when I made the first investment for the portfolio, initiating a position in Weight Watchers International (WTW). Based on the current stock price and conservative estimates of future earnings power, I believe WTW offers upside of 60%+ with a very low probability of permanent capital impairment over a medium term investment horizon. Please refer to my most recent post, Weight Watchers International – Is the Fat Lady singing? for a detailed appraisal of the business and my investment rationale.
The last six months have been a frustrating period in which I have felt like the guest that arrives to the party too late, as I watched the S&P 500 deliver a return of 30%+ by the end of 2013. As I launched my portfolio in October, the stock market appeared to be at best fairly valued on new peak earnings, and at worst, extremely overvalued based on realistic forward earnings expectations. I believe this remains the case. In such an expensive market, identifying attractive investment opportunities continues to prove challenging, with numerous potential “leads” turning out to be most likely overvalued when subjected to rigorous analysis and appraisal. By resisting the urge to invest my capital in a rising market, I have felt the “pain” of holding cash, as I watched the market assign even higher prices to both excellent and average businesses that I believed to be already fairly or overvalued. However, I have found solace in the following words of wisdom from Seth Klarman’s 2004 letter to Baupost Group investors:
“… remain liquid, defy the steady drumbeat of performance pressures, and wait for the prices of at least some securities to drop. (One doesn’t need the entire market to become inexpensive to put significant money to work, just a limited number of securities).”
I believe WTW to be one of those limited number of inexpensive securities.
Later in the letter, Klarman explains that “by holding expensive securities with low prospective returns, people choose to risk actual loss. We prefer the risk of lost opportunity to that of lost capital.” Similarly, the opportunity cost of missing out on the 5% that I may have earned from simply investing in an S&P 500 index ETF last October is one I am willing to bear. Such a return would have been earned by the assumption of heightened risk (permanent capital loss) and without any consideration of the margin of safety principle, given the already lofty price levels of common stocks at that point in time.
My appraisal of Western Digital Corporation (WDC) as posted on this blog on 11 November 2013 serves as a useful case study for just how expensive the opportunity cost can be however. Priced at $71 at the time of posting, I determined an intrinsic value range of $86 – $106 per share for WDC common stock. Today WDC is priced at $90, comfortably within my estimated intrinsic value range, and approx. 27% above the $71 price in November. And yet my conclusion at the time was “that WDC is a Buy at $63 or less per share, being a 33% discount to the mid-point of my estimated range for intrinsic value” as this would afford me a satisfactory margin of safety. My analysis and conclusion was sound, yet my two-thirds intrinsic value rule (based on Benjamin Graham’s rule) cost me a 27% return over 6 months, of 54% on an annualised basis! Perhaps the lesson here is that while it is important to have rules and checklists as an investor, rigidly sticking to those rules in an academic fashion can sometimes be costly (after all Warren Buffett decided that due diligence was not necessary when he acquired Nebraska Furniture Mart from Mrs. B, and that purchase worked out well!)
Looking ahead to new potential investments for the IV portfolio, I currently have an “ideas bench” of 4 – 5 investment ideas that may offer some promise. While I feel no great rush to initiate new positions for fear of missing out on the next possible market upswing, I intend working rationally through these ideas while also scouting for new prospective investments. As with the first IV portfolio investment, WTW, independent thinking, rigorous analysis and a focus on value will be the guiding lights in this search.