I began the year with a portfolio which has -20% in cash, i.e. I had debt which was 20% of my net asset value. My portfolio was also quite bloated with more than 40 different stocks. Most of the positions were smaller than $1000.
On top of that, most of my bigger positions, i.e. Credit Suisse (NYSE:CS) (24% of NAV), Bank of America (NYSE:BAC) (12% of NAV), Hewlett-Packard (NYSE:HPQ) (10% of NAV) and Best Buy (NYSE:BBY) (10% of NAV), were a result of dollar cost averaging without understanding the business fundamentals. The amount of research was negligible in comparison to my belief in myself.
In Alexander Pope’s words, “A little knowledge is a dangerous thing.” The books I read in preparation were, "Stocks for the Long Run" by Jeremy Siegel, "The Little Book That Beats the Market" by Joel Greenblatt and "Contrarian Investment Strategies" by David Dreman. All three of these books are terrible in their own way. They are great for making a case for buying equities but are useless for anything else. I can write an article each on why these books are extraordinarily bad as a way to learn investing for individual investors and still have things left to say. So, I will make a few criticism and move on.
All three in their own way give a formula on how to invest with minimum effort and reasonable upside. In particular, they ask you to buy a basket of stocks based on some easy-to-verify conditions. For example, Greenblatt espouses his "Magic Formula" which basically involves buying a basket of well-diversified (say 30) stocks with low price-to-earning ratios and high return on capital.
Similarly, Dreman recommends buying a basket of stocks with low price-to-sales or low price-to-book ratio, i.e. companies that are unloved. Siegel goes farthest by suggesting that you buy a basket of stocks randomly (a monkey throwing darts can pick them up for you)! Or maybe just buy an index and be done with it.
Each of my major positions (Best Buy, Hewlett-Packard, Credit Suisse, Bank of America) was contrarian, and Best Buy and Hewlett-Packard had single-digit P/Es with ROIC greater than 15%. Furthermore, the 40 stocks I bought were all contrarian and with low P/Es and good balance sheets.
One of my major criticisms of the formula-based investing is that it separates you from understanding the business. The magic formula investing (and contrarian investing) may lead you to buy companies which are becoming obsolete, and you are looking at them from the rose-tinted lenses of the past. You can look at the screener run today (above $50 million market cap, 30 stocks). The result is shown below. Some of the stocks that appear are: Herbalife (NYSE:HLF), Apollo Group (NASDAQ:APOL) and Gamestop (NYSE:GME). I would not touch these stocks even with a six-foot-long pole. I do not know about most of the companies below, so I reserve judgement on them.
A second criticism is that the gist of their argument is this: Here is a formula and it has worked amazingly well in the past. Use this formula to look for new companies and they will give you good results. If you do not see the logical jump, here it is: Something that has worked in the past may not work in the future.
In any case, I sold most of my positions this year. I hold 16 companies and more or less the same amount of equities in absolute dollar terms as the beginning of the year. This means that on an average my positions are more than twice as big. Also, I know a lot about the companies I am holding and can sleep at night even when the stock market is tanking. In fact, I look forward to drops as a way to add to my positions. For example, I am hoping that Intel (NASDAQ:INTC) and Teva (NYSE:TEVA) will continue to fall so that I will be able to buy them cheaper. Nearly 30% of my net asset value is in cash, waiting to be deployed when a market weakness offers opportunity.
Even with this underlying change in the way I invest, i.e. taking a loss of $5000 on Credit Suisse, $700 on Best Buy and a lot more, I have managed to achieve a return of 11.8% as opposed to 13.6% for the S&P 500 (SPY).