We believe the math of common stock investing is pretty simple. When you buy a stock without leverage, you can only lose your original investment. Your gains can be unlimited over the longest term (long duration). Most of the benefit (90%) of diversification is reached by owning a 12-to-18 stock portfolio, if the owners are willing to put up with the relatively random way returns are handed out over time. Valuation matters dearly to portfolio results. Stocks purchased at depressed prices (as a group) outperform those which are more expensive over longer time periods.
Common stock portfolio turnover creates expense and is the enemy of performance. Long-term common stock performance fits on a bell curve. In a portfolio of well-selected common stocks, most of the long-term gains are going to come from 20% of the portfolio. This is only true if the most successful shares are held to a fault.
Every stock that goes up tenfold must have first doubled, tripled and quadrupled. The only good reason to sell shares in a successful common stock of high quality is if its share price gets “maniacal” or if it no longer meets our eight criteria for stock selection. In our view, maniacal pricing is two standard deviations away from a normal price-earnings ratio over the past 20 years.
One hundred percent of the stocks that go to zero fall by 20%, 40% and 60% before ultimately losing 100% of their value. Poor stock price performance among our portfolio holdings requires us to refocus on the fundamentals to preserve capital. Other than maniacal pricing, worrying about the volatility of the stock price of fundamentally strong businesses is damaging to performance and success.
Our observation over 38 years is that no one can consistently predict either the stock market or the U.S. economy. Therefore, breaking any of the mathematical disciplines mentioned above, based on stock market or economic predictions, has the potential to ruin the benefit of common stock investing. Paying someone to make directional stock market or economic predictions automatically reduces portfolio results. Stocks, as measured by Ibbotson and Associates, have outperformed the other major liquid asset classes over long stretches of time (30 to 50 years). However, to get this added return you must accept extreme variability of returns.
Connecting simple math to our discipline
We hold our winners to a fault and, over the years, our goal is to reinvest paper profits into future wealth creation. Remember, in the Bible, love covers a multitude of sins. In common stock ownership, your big multiyear, many times your original investment winners cover a multitude of small losses. These losses are realized on stocks which met our eight criteria, but after our purchase didn’t produce going forward.
Is there any way to avoid corrections in stocks which you have done well on in the past, but are correcting gains from prior years or are being doubted in the marketplace? As we mentioned before, we take great pains to ask if companies are becoming “maniacally” priced and, if they are, we reduce ownership dramatically. Most of the heartaches in common stock investing are the stocks you sold for twice what you paid that ended up tripling in price 10 years later.
Here are some real-life examples. First, we came out of the bear market bottom in 2009 with a 4% position in Starbucks (SBUX, Financial). It rose in value by 2012 to over 8% of the portfolio. The price-earnings ratio had risen from 12 times to 35 times and we began a lengthy trimming exercise, which took us down to a 2% position by 2014. The stock kept rising in value until three years ago. With the price going flat for the last three years and the earnings growing, the price-earnings ratio has dropped to 22 times earnings. We may not be that far away from becoming a buyer of the stock. We like owning a business with cult-like customers, which spells an addictive legal drug.
Currently, we have trimmed our holdings in some big winners over the recent years, our bank stocks and NVR (NVR, Financial), which builds homes under the trade name Ryan Homes. We started our positions in Bank of America (BAC, Financial) and JPMorgan (JPM, Financial) in 2012 at approximately $8 and $34.50 respectively. These three stocks soared last year and have corrected sharply this year. We trimmed them due to temporary popularity, but are keeping most of the positions because we think the U.S. economy will be led by homebuilding and household formation. The velocity of money could rise and the banks could be in a multiyear period of earnings growth, and massive dividend growth in the case of Bank of America.
Therefore, even though we have more than tripled our money from the beginning and collected dividends along the way, we believe these stocks are just as likely to double in the next five years as any stock we might buy brand new. They have strong and expanding moats and their great balance sheets are throwing off copious free cash flow. Even if an economic slowdown hits us temporarily, we like to remind everyone that they don’t ask for a divorce if their spouse’s affection slows down for six to 12 months and they shouldn’t divorce their stocks either.
We ended the month of May with what we believe to be an excellent portfolio of companies meeting our eight criteria for common stock selection. It trades for around 13 times this year’s earnings, it is looking at paying 2% in forward dividends and is extremely inexpensive in relation to lower average quality holdings in the S&P 500 Index and the Russell 1000 Value Index. We like the odds of another good 10 years for our shareholders and we want to thank them for their willingness to invest in long-duration timeframes.
Disclosure:Ă‚ Smead Capital holds SBUX, NVR, BAC and JPM.
The information contained in this missive represents Smead Capital Management's opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.
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