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Guest JoelS
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Guest JoelS

Hi All,

 

A study of the great corrections tends to lead towards a theory that holding quality stocks late into a bull market is a reasonable strategy. Some would say, buy cheap, hold and let reversion to value happen without interference - but.. as Graham advised, "The chief losses to investors come from purchases of low quality securities at times of favourable business conditions."

 

I do not want to say in 5 years, I wish I had not held so and so stock... So I am looking to eliminate low quality and progressively shift up the quality curve.

 

Wouldn't it have been nice to own McDonalds in 2008, or Fairfax for that matter. I put forward that some companies (prior to GFC) offered an investor downside protection without compromising too much on upside.. just the knowledge that your company would make it out the other side of the Great Recession would, I think, give one a huge advantage, emotionally and financially.

 

With this background in mind, are there any companies you hold or think of as having equally defensible characteristics today? Looking for a combination of fair price and quality. 

 

I will offer three (and admit that I am not 100% sure on any of them):

 

Brown-Forman: lovers of whiskey cannot do without their Jack Daniels.

 

Charter Communications: most people today cannot go without the Internet.

 

Berkshire: for reasons we are all probably familiar with.

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CVS is an interesting option. In 2008 and 2009, the company grew EPS 14% and 20%. Still, the PE multiple collapsed from 22x too 11x. So it didn't work as a defensive stock.

 

But today, you can buy this defensive stock for 13x.

 

I'm tempted...

 

I bought ESRX & am perfectly happy owning it.

 

Am I right in thinking that CVS & ESRX offer inverse corollaries to biotech/pharma?

 

I figure if drug prices go down, NVO & BBH suffer but ESRX & CVS do well...

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I would include AOBC (gun maker) to the list.  It is not exactly defensive in the sense of stability but it's performance shouldn't be as heavily impacted by market valuations.  Basically it is super cheap and how it performs is a matter of how well gun sales do.  Even if the market loses 1/3 it's value, it will still be cheap if sales hold up.

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CVS is an interesting option. In 2008 and 2009, the company grew EPS 14% and 20%. Still, the PE multiple collapsed from 22x too 11x. So it didn't work as a defensive stock.

 

But today, you can buy this defensive stock for 13x.

 

I'm tempted...

 

I bought ESRX & am perfectly happy owning it.

 

Am I right in thinking that CVS & ESRX offer inverse corollaries to biotech/pharma?

 

I figure if drug prices go down, NVO & BBH suffer but ESRX & CVS do well...

 

I really like your thinking here, DooDiligence - and you know why.

 

Thanks for your help so far. I haven't reached any conclusion for myself so far.

 

To me, there is no doubt, that the value generation in the pharma value chain will stay at about almost intact in a severe downturn going forward, all depending on political risks, some how related to the state of the affairs, on overall level.

 

Please take a look at the share price of NVO, that I know you own, for the period, say - beginning of 2006 to end 2010. It did not get dragged down in the GFC as much as almost other things.

 

- - - o 0 o - - -

 

The point here is, that this is about stocks, not about anything else [Nothing mentioned here by purpose] . Otherwise you would likely be considered a hethen by somebody.

 

The point here is also, that you, when trying to make long picks to avoid the drag in  the next serious downturn, you also end up exposing your self to some other risks, that you have to evaluate - correlated to your "original" risk [the risk, that you wanted to avoid, circumvent, mitigate, whatever], or not.

 

There is no free lunch. That - however - does not change, that I'm personally attracted to you line of thinking., and I'll pursue it in my work going forward.

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Guest JoelS

CVS is an interesting option. In 2008 and 2009, the company grew EPS 14% and 20%. Still, the PE multiple collapsed from 22x too 11x. So it didn't work as a defensive stock.

 

But today, you can buy this defensive stock for 13x.

 

Thanks KCLarkin. I read the thread on CVS and although I don't yet understand the industry, this is the kind of business I'm looking for. Something good that's a little beaten down.

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I think that what you're looking for are your compounders unless you're afraid of mark to market losses.

 

The companies that are worth more today than in 2007/2008 (with some exceptions) do so because they were able to continue to grow their business and create value. Whether their profits shrink during a crisis or a recession is doesn't really matter. What matter is whether they can survive a crisis and whether they can return to their previous growth path once the storm passes and sunny skies return.

 

Take Berkshire for example. In the financial crisis BRK market value declined by about 50% from peak to trough. Today its market value is 67% higher than pre financial crisis peak close to the end of 2007. However for 2007 Berkshire's pre-tax income was 20.1 Bn, float was 59 Bn, and BV was 121 Bn. In 2016 pre-tax income was 33.7 Bn, float was 100 Bn, and BV was $286 Bn. That's why Berkshire is worth more today than 9 years ago.

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I think that what you're looking for are your compounders unless you're afraid of mark to market losses.

 

The companies that are worth more today than in 2007/2008 (with some exceptions) do so because they were able to continue to grow their business and create value. Whether their profits shrink during a crisis or a recession is doesn't really matter. What matter is whether they can survive a crisis and whether they can return to their previous growth path once the storm passes and sunny skies return.

 

Take Berkshire for example. In the financial crisis BRK market value declined by about 50% from peak to trough. Today its market value is 67% higher than pre financial crisis peak close to the end of 2007. However for 2007 Berkshire's pre-tax income was 20.1 Bn, float was 59 Bn, and BV was 121 Bn. In 2016 pre-tax income was 33.7 Bn, float was 100 Bn, and BV was $286 Bn. That's why Berkshire is worth more today than 9 years ago.

 

Is 67% over 9-10 years really that good of a return?  I will probably get a lot of heat for saying this.  But I think if you owned BRK, MCD, Fairfax, and other defensive stocks during 2008/2009, you sell them because they only went down 20-30% while the S&P is down 50-60%.  Finding stocks that easily double, triple, or quadruple is fairly easy at that point.  So you rotate into something that has much higher risk/reward.  I feel like there are still opportunity for you to get back into BRK.  BRK was still really cheap in 2011.  I remember Tilson pitching BRK as being extremely undervalued at Omaha. 

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Guest JoelS

I am looking for compounders. Defensive compounders. You make a good point about through the cycle returns.

 

To be more precise, I want to avoid investments that lose intrinsic value through the cycle. To take an example, I recently bought nz media company NZME. Newspapers and radio. In decline but cheap. However, if a recession hits NZ, NZME is unlikely to thrive as it loses ad revenue. I want to shift away from ideas like NZME and into quality assets where safety of capital is as close to assured as possible.

 

Another factor for my personal situation is that I'll have less time to commit to investing later this year so I want to set my portfolio and have it as close to autopilot as possible.

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Guest JoelS

I think that what you're looking for are your compounders unless you're afraid of mark to market losses.

 

The companies that are worth more today than in 2007/2008 (with some exceptions) do so because they were able to continue to grow their business and create value. Whether their profits shrink during a crisis or a recession is doesn't really matter. What matter is whether they can survive a crisis and whether they can return to their previous growth path once the storm passes and sunny skies return.

 

Take Berkshire for example. In the financial crisis BRK market value declined by about 50% from peak to trough. Today its market value is 67% higher than pre financial crisis peak close to the end of 2007. However for 2007 Berkshire's pre-tax income was 20.1 Bn, float was 59 Bn, and BV was 121 Bn. In 2016 pre-tax income was 33.7 Bn, float was 100 Bn, and BV was $286 Bn. That's why Berkshire is worth more today than 9 years ago.

 

Is 67% over 9-10 years really that good of a return?  I will probably get a lot of heat for saying this.  But I think if you owned BRK, MCD, Fairfax, and other defensive stocks during 2008/2009, you sell them because they only went down 20-30% while the S&P is down 50-60%.  Finding stocks that easily double, triple, or quadruple is fairly easy at that point.  So you rotate into something that has much higher risk/reward.  I feel like there are still opportunity for you to get back into BRK.  BRK was still really cheap in 2011.  I remember Tilson pitching BRK as being extremely undervalued at Omaha.

 

This is basically my point. This seems to be what separates the good investors from the great investors. They go down less in the corrections and capture more of the upside when it turns.

 

I know Buffett talks about accepting 50% drawdowns and Munger says its a part of life. But Buffett exposing himself to 50% drawdowns during the Partnership days? I don't think so. He did everything he could to insulate his portfolios from large mark to market declines.

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But Buffett exposing himself to 50% drawdowns during the Partnership days? I don't think so. He did everything he could to insulate his portfolios from large mark to market declines.

 

Do you have evidence of this? Curious to know.

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Guest JoelS

But Buffett exposing himself to 50% drawdowns during the Partnership days? I don't think so. He did everything he could to insulate his portfolios from large mark to market declines.

 

Do you have evidence of this? Curious to know.

 

In the 1957 Partnership letter Buffett talks about the level of the general market..

 

"if the general market were to return to an undervalued status our capital might be employed exclusively in general issues and perhaps some borrowed money would be used in this operation at that time.. conversely, if the market should go considerably higher, our policy will be to reduce our general issues as profits present themselves and increase the workout portfolio.. "…

 

Then he talks specifically about workout/general ratio - given the change in the market..

 

"The market decline has created greater opportunity among undervalued situations so that, generally, our portfolio is heavier in undervalued situations relative to workouts… At the end of 1956, we had a ratio of about 70-30 between generals and workouts.. Now it is about 85-15."

 

Buffett didn't create this approach to investing - he closely mirrored Ben Graham's operations in weighting holdings in a sort of sliding scale as the market went up and down.. The higher the market went, the more workouts/special situations so as to insulate the portfolio from a general decline.. and more generals when the market as a whole was undervalued so as to participate in the market rise when it came.

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PepsiCo is a name I'd be comfortable owning into a melt down. I think the junk food/soda crackdown is exaggerated. There's been nothing known to man to be worse for you than cigarettes for decades and those companies are still cash machines. Soda and potato chips will survive.

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Guest JoelS

Seems to me that at this moment there are three broad options for structuring a portfolio within a value framework.

 

(1) Hold cheap things that have some vulnerability to a downturn in an economy but you expect to make it through. $1 for 70c. The problem is if the $1 goes to 70c (or lower). Some investors were caught in 2008 because they did not stress test their portfolio or think through all eventualities.

 

(2) Hold compounders through thick and thin. They go down with the market but they grow intrinsic value and re-establish a premium valuation when things normalise. Your Amazon or Facebook.

 

(3) Hold defensive compounders, and/or a version of Buffett's "workouts" - i.e merger arbitrage, liquidations etc.

 

Objectively there is little difference between (2) and (3) in regard to compounders but 3 forces you to think defensively and focus on the downside.

 

I recognise that some are very good at identifying situations in (1) where $1 of value pre downturn is still $1 of value post downturn - I don't know if I'm one of those people, so I'm trying to ensure that my compounders are as defensive as they should be, at this point in the cycle.

 

 

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I think it makes sense to think of what Taleb calls "antifragility". Sure, some quiet expensive darlings will probably keep growing earnings in a downturn, but I'd like to own stuff for whom it presents an opportunity as well (unfortunately those are difficult to find at reasonable valuations). Anyway, I think that is companies (typically with owner-operator mindsets) that buys back stock opportunistically when it's "cheap" because they have a good handle on its intrinsic value and attractiveness compared to other capital allocation options. But I also prefer companies that know how to prosper from doing M&A - ie buying a struggling competitor in a downturn. Preferably something without too much integration risk (think Auto Nation buying car dealerships). I haven't experienced a major downturn, but I think I'd have an easier time riding it out knowing that my Companies are busy creating value while my screen is showing large losses.

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I think it makes sense to think of what Taleb calls "antifragility". Sure, some quiet expensive darlings will probably keep growing earnings in a downturn, but I'd like to own stuff for whom it presents an opportunity as well (unfortunately those are difficult to find at reasonable valuations). Anyway, I think that is companies (typically with owner-operator mindsets) that buys back stock opportunistically when it's "cheap" because they have a good handle on its intrinsic value and attractiveness compared to other capital allocation options. But I also prefer companies that know how to prosper from doing M&A - ie buying a struggling competitor in a downturn. Preferably something without too much integration risk (think Auto Nation buying car dealerships). I haven't experienced a major downturn, but I think I'd have an easier time riding it out knowing that my Companies are busy creating value while my screen is showing large losses.

 

This is a good idea. If you read some of the old Arlington Value letters, he seems to use this strategy. As an example, MSM is an industrial distributor. During the recent manufacturing downturn, they took market share from local competitors, cut operating expenses, released substantial working capital, and tendered for 8% of the outstanding shares. They even did some minor M&A.

 

In this case, MSM is actually pretty cyclical. But also very defensive.

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Well his approach has changed a lot since then. Do you make room for the fact that maybe the man has learned a thing or two in the intervening 60 years?

 

His returns were better in the partnership days. That's not to say he was a "better" investor as he probably couldn't have deployed tens of billions of dollars in that strategy, but none of us have that problem.

 

His early days are probably the best one for aspiring managers to emulate and leave the Berkshire model as the road map to corporate investments.

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Well his approach has changed a lot since then. Do you make room for the fact that maybe the man has learned a thing or two in the intervening 60 years?

 

His returns were better in the partnership days. That's not to say he was a "better" investor as he probably couldn't have deployed tens of billions of dollars in that strategy, but none of us have that problem.

 

His early days are probably the best one for aspiring managers to emulate and leave the Berkshire model as the road map to corporate investments.

 

His strategy had to fundamentally change.  If memory serves during the partnership days he categorized holdings into three categories: generals, control situations and arbitrage.  My guess is he changed the % of each based on the environment he was in.  However at this point, the overwhelming majority of holdings are subsidiaries with some generals.  At this point arbitrage is probably no longer a relevant part of Berkshire's strategy. 

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Well his approach has changed a lot since then. Do you make room for the fact that maybe the man has learned a thing or two in the intervening 60 years?

 

His returns were better in the partnership days. That's not to say he was a "better" investor as he probably couldn't have deployed tens of billions of dollars in that strategy, but none of us have that problem.

 

His early days are probably the best one for aspiring managers to emulate and leave the Berkshire model as the road map to corporate investments.

 

His strategy had to fundamentally change.  If memory serves during the partnership days he categorized holdings into three categories: generals, control situations and arbitrage.  My guess is he changed the % of each based on the environment he was in.  However at this point, the overwhelming majority of holdings are subsidiaries with some generals.  At this point arbitrage is probably no longer a relevant part of Berkshire's strategy.

 

I don't think that was necessarily true. I think he saw the writing on the wall for high turnover necessary to invest hundreds of millions of dollars in cigar butt strategies and that there were likely to few opportunities to do it consistently with an capital growing at an exponential rate. He recognized that his strategy was better suited for smaller sums of money and to scale he'd need to change - not because the strategy was bad, but because he was going to outgrow it.

 

When he wound down the partnership he specifically stated that the new "strategy" was to buy quality companies and hold them. He also said that he expected returns from this strategy to be lower without an actual reduction in risk.

 

He recognized that the strategy would underperform what he had been doing (and it has), BUT you can't manage hundreds of millions, or billions, of dollars the way he was investing. Takes too much work, too much turnover, too much lost to taxes and brokerages, and too few opportunities for you to find to put $10-15 billion to work in any given quarter. It was easier and deleveraging to move to a strategy better suited for investing large sums of money with reasonable returns (i.e. strategically buying quality companies and holding forever).

 

The only thing that forced him to change strategy was the scale he envisioned achieving through Berkshire. Not because anything was fundamentally flawed with the original approach.

 

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Well his approach has changed a lot since then. Do you make room for the fact that maybe the man has learned a thing or two in the intervening 60 years?

 

His returns were better in the partnership days. That's not to say he was a "better" investor as he probably couldn't have deployed tens of billions of dollars in that strategy, but none of us have that problem.

 

His early days are probably the best one for aspiring managers to emulate and leave the Berkshire model as the road map to corporate investments.

 

His strategy had to fundamentally change.  If memory serves during the partnership days he categorized holdings into three categories: generals, control situations and arbitrage.  My guess is he changed the % of each based on the environment he was in.  However at this point, the overwhelming majority of holdings are subsidiaries with some generals.  At this point arbitrage is probably no longer a relevant part of Berkshire's strategy.

 

I don't think that was necessarily true. I think he saw the writing on the wall for high turnover necessary to invest hundreds of millions of dollars in cigar butt strategies and that there were likely to few opportunities to do it consistently with an capital growing at an exponential rate. He recognized that his strategy was better suited for smaller sums of money and to scale he'd need to change - not because the strategy was bad, but because he was going to outgrow it.

 

When he wound down the partnership he specifically stated that the new "strategy" was to buy quality companies and hold them. He also said that he expected returns from this strategy to be lower without an actual reduction in risk.

 

He recognized that the strategy would underperform what he had been doing (and it has), BUT you can't manage hundreds of millions, or billions, of dollars the way he was investing. Takes too much work, too much turnover, too much lost to taxes and brokerages, and too few opportunities for you to find to put $10-15 billion to work in any given quarter. It was easier and deleveraging to move to a strategy better suited for investing large sums of money with reasonable returns (i.e. strategically buying quality companies and holding forever).

 

The only thing that forced him to change strategy was the scale he envisioned achieving through Berkshire. Not because anything was fundamentally flawed with the original approach.

 

Yep

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I think it makes sense to think of what Taleb calls "antifragility". Sure, some quiet expensive darlings will probably keep growing earnings in a downturn, but I'd like to own stuff for whom it presents an opportunity as well (unfortunately those are difficult to find at reasonable valuations). Anyway, I think that is companies (typically with owner-operator mindsets) that buys back stock opportunistically when it's "cheap" because they have a good handle on its intrinsic value and attractiveness compared to other capital allocation options. But I also prefer companies that know how to prosper from doing M&A - ie buying a struggling competitor in a downturn. Preferably something without too much integration risk (think Auto Nation buying car dealerships). I haven't experienced a major downturn, but I think I'd have an easier time riding it out knowing that my Companies are busy creating value while my screen is showing large losses.

 

Thank you for an excellent post here, kab60.

 

Mr. Taleb defines an antifragile thing as a thing, that gains strength, when it is subject to disorder, stress, headwind and punches from some direction, perhaps several.

 

I have had severe second thoughts going forward in recent months with an intention to buy more of long term positions, and I have been struggling with getting some structure on my thinking.

 

Here is what I have started to do - position by position:

 

1. I go back to the '08 financials of the company and study it, trying to find answers to the following questions:

 

1a. What was the financial position and overall condition of the company then [in most cases - just around early spring '09 - thereby near the buttom].

1b. What did the management then express of expectations going forward - short term, mid term and long term.

1c. What did the management express in the spring '09 that it would do short term, based on 1a combined with 1b.

 

2. Then I look at the '09 and '10 financials from the same angle , as mentioned under bullet 1 - including specifically looking for hindsight bias in the management and chairman letters for those years.

 

3. Then I take a look at "now" - the '16 financials, and ask my self the questions while reading:

 

3a. What is the financial position of the company now?

3b. What changes has been made to management, investment strategy etc. since '08 - '09?

 

We all now know in clear hindsight, that the worst action  - then - was to panic near the buttom and go on the side line for a period of some extent.

 

So far, I have looked at BRK, INVE A.STO, LUND B.STO, INDU C.STO and SCHO.CPH this way. What has been really striking to me, is that they have all been overall faithfull to their investment process, investment policy, policies about use of leverage etc., all actions based on expressed expections near the button in the spring of '09.

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