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stocks with "temporary problems" in this market


Homestead31
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i'd appreciate some thoughts from the group...

 

a very common approach among value investors is investing in stocks that are suffering from "temporary problems."  In fact, while my portfolio has some special sits and some compounders, most of my positions are what i would consider good businesses with temporary problems.  there is a ton of evidence to suggest that this approach works real well over ~3+ year periods... but in this current market, the stocks with "temporary problems" are getting smashed much harder than the compounders and special sits. 

 

this makes sense to me - after all - there is a tremendous amount of uncertainty out in the world right now, and this macro uncertainty just compounds the uncertainty associated with a business that is dealing with temporary problems...  compared to a special sit that should be some what agnostic toward the market or a compounder that is easy to say, "it'll be fine in the long run" it is no wonder that mr. market is more concerned that the temporary problems will become permanent problems.

 

the other possibility is that i am just plain wrong about these problems being temporary, although I take research very seriously and work hard to understand competitive advantages and moats and i don't think that this is the case.

 

so my question for the group is has anyone else noticed investments that fall into the "temporary problem" box getting hammered more than other investments?  is anyone else struggling here?

 

when you think about portfolio construction, do you think about limiting the amount of "temporary problem" stocks because you realize they can be more volatile in the short run? 

 

when you look at "temporary problem" investments do you just value them off of current problem earnings and look for a low multiple on problem earnings?  or do you look out a year or 3 and value them off "normalized" earnings? (this is what i tend to do)

 

Any other thoughts on the "temporary problem" method of investing appreciated as well... and please refrain from using this as a platform to pat yourself on the back for your great results if you have them... 

 

thanks

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There is a lot to discuss on this, but I would make a few suggestions:

- diversify your problem stocks over time. In other words, try to have a portfolio where you have some with negative momentum, some bottoming, some recovering, and some passing fair value. So if you have a three year holding period you have stocks that you think will recover in 0. 1, 2, 3 years.

- beware of momentum. Value investors buy early and sell early, I try to slow play a bit. Wait awhile after my initial urge to buy and hold on longer than I feel comfortable. I usually want to buy after the stock has been falling for 6 months to a year.

- average into a position and reserve some buying power.

- make sure it is really a temporary problem! Avoid high debt companies. focus on high moat companies. Is this a cyclical? Is there a hidden cycle or fad?

- add some ballast to your portfolio with good, steady companies and compounders.

 

Obviously we are in rough waters with high USD, commodities in freefall... So there might macro headwinds on top of any company specific problems.

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A few thoughts

 

1. As long as the businesses with "temporary problems" have a strong moat and I have conviction in the moat, I find it easy to hold and even add on to the business as price drops. The key really is that moat is real. IMO there are only about a couple of dozen businesses with moats - all others are more riding industry tailwinds or operationally outstanding (which is not a moat). If you have several dozens of businesses then probably your definition of moat might not be stringent enough to give confidence.

 

So I would really be hoping the prices for these businesses to be going down more and more. I would give in general any business 3 years for the "temporary problem" to be fixed. If problem continues it is likely that its moat is impaired in some way.

 

2. As far a limiting problem businesses to a certain % of portfolio, I think it is better to avoid setting such guidelines top down. I used to do that but it never really worked in practice as I always violated the guidelines since opportunities in the market do not fit nicely with our top down preferences.

 

Some times there is an abundance of cheap high quality businesses, sometimes there is an abundance of 'temporary problem" businesses within your circle of competence. So it makes sense to go where opportunities are.

 

Three years ago I was entirely (2x or more notional portfolio exposure) to problem businesses (financials) because they are dead cheap. Now I have moved in a major way to high quality companies. So instead of a "problem business" at 0.6x IV, I would rather own 0.8x IV high quality business. But when I own mostly problem companies, I would have a higher percentage of cash to balance tail risks and/or have some hedges in place.

 

Vinod

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to be clear, i have a concentrated portfolio of ~15 names and i am happy holding these names and in several cases have been adding.  for most of them, i can look at them and make an honest, conservative case for why i think they will be up 100% in the next 3-5 years, although i am re-examining my thesis on one or two of them as well.  i'm sure that i won't be right on all of them, but i think the returns will be more than acceptable.

 

my question is more regarding the different styles of investing, and which is doing better/worse in this market or any other observations anyone might have. 

 

For example, Vinod, your point about owning higher quality companies at less of a discount is well taken.  traditionally i have viewed that approach as having an element of market timing to it and have always more focused on the best values i could find.  of course in hind sight i am thinking that several months ago a few of the names in my portfolio were just a couple of bps away from my sell level, but i didn't really sell much... and now of course i am wishing i had b/c they have retreated significantly - not due to a deterioration in business, but due to multiple compression.  however, i am happy reminding myself that for these companies IV is continuing to grow and multiples will expand once again in the future.

 

another market observation is that there seems to be a clear bias against smaller names - i saw a piece the other day that showed that the bottom market cap decile of the R2000 was on average down 50% from its 52 week high, and each decile up the market cap ladder had incrementally better performance.

 

similarly, the R2000 "value" index is down something like 10% YTD while the growth index is close to flat.  clearly the market is favoring "growthy" stocks at the moment, and by definition stocks with temporary problems are not growthy.

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Homestead, I just look for industry leaders that are out of favour. They may be out of favour for any number of reasons; some reasons are obvious and others are not.

 

A good example are the large US banks. You can buy them right now for about 10 times 2015 earnings (Wells Fargo is 12 times) and 9 times 2016 earnings. Their 'temporary problem' is Mr. Market simply does not like the sector. This will correct itself over time; these stocks will be much higher the next couple of years.

 

Another good example is Apple. A couple of weeks ago it was trading sub $105. The company will earn $9 this fiscal year and likely earn about $10 next fiscal year. The 'temporary problem?' Concerns over iPhone sales. My guess is iPhone sales will be fine and if I'm right the stock will be much higher in the coming years.

 

My point is there are lots of different types of 'temporary problems', not just the type Volkswagon is currently experiencing that provide investors with opportunities to purchase industry leading companies at very good prices. I think Buffett would rather buy a great company at a fair price than a fair company at a great price (when your holding period is many years).

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