A Model Portfolio for the Value Focused Investor

July 7, 2014

Portfolio

 

Hi Value Focus Readers,

I've been thinking and praying a good bit about how God wants me to go about investing, and helping others to understand investments. It should be obvious from my recent posts that I have felt God leading me in a different direction.

I believe that over the last year or so, I've had to unlearn a lot of what I came to believe during my time as a finance student and investment professional. Specifically, I'm having to rethink diversification. I have held firmly to the view that I can't ever fully understand what's going on with a company or industry, and that even if I did, that still doesn't afford me accurate predictions of the future. Those things are still true. However, I have always used that premise to draw the conclusion that I should practice a very high level of diversification, holding at least 20 stocks at any given time, and as much as 40. I no longer believe that to be the case.

I keep going back to two scriptures that I keyed in on initially, when I was still in the Foundry and decided to perform a study of how the Bible would instruct me on managing investments. The first is this:

"If the ax is dull and its edge unsharpened, more strength is needed, but skill will bring success." Ecclesiastes 10:10, NIV or as the New Living Translation reads: 

"Using a dull ax requires great strength, so sharpen the blade. That's the value of wisdom; it helps you succeed."

Whether it's interpreted as "wisdom" or as "skill" it definitely applies to investment management. Even though no one knows the future, we can still rationally expect skill, effort, and wisdom to help us succeed. Therefore, it doesn't make very much sense that we would be closet indexers in our investing. If we work hard employing all the talents and gifts that God has given us, we shouldn't then dilute the resulting positive effects by practicing excess diversification. In other words, if I invest in only my best ideas, I can dare to be great.

Even while daring to be a great investor, I must remain humble. I must continually ask for God's guidance and blessing in and through my work. Since no one's investment decisions will achieve anything near perfection, I must continue to seek him in the difficult times. I must pray for wisdom, restraint, and self-control. But I must also have confidence in what God has led me to do. I must trust that he is working in and through me to accomplish things that are according to his good purpose. I can't let fear stop me from pursuing my best ideas in a concentrated way. I can't use diversification as a crutch. That brings me to the second scripture that has weighed heavily on my mind of late:

"Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land." Ecclesiastes 11:2, NIV

Up until now, I had been relying more upon the New Living Translation or interpretation of this scripture, which says:

"But divide your investments among many places, for you do not know what risks might lie ahead."

But that's the issue. The NLT version is someone's interpretation of what was written so many years ago. The more literal translation is very clear. It doesn't actually say "many" places. It says seven or eight. That difference is crucial. Elsewhere, God tells us to employ wisdom, planning, and knowledge in our work. There are various ways to go about employing wisdom in our investing activities. But, if I'm going to be an individual stock picker, I'm almost certain to dilute the benefits of my effort and skill by investing in 20-40 different securities. However, 7-8 stocks would provide some diversification benefit while also leaving plenty of room for above average investing success. It also makes the ongoing monitoring workload manageable. I simply don't have enough time and brain power to stay on top of 30 different stocks and continue working diligently to find new, more attractive opportunities for investment. When you think about it in that light, 7-8 investments starts to make all the sense in the world.

I think the main reason I was sticking to the NLT version of that scripture was because it fit with my pre-conceived notions and investment philosophies. The fact is, God knew exactly what he was doing when he wrote through Solomon thousands of years ago to divide your portion among 7. Then he really takes it up a notch and says 8. There's not anything to indicate that he intended that to simply mean "many" or "as many places as possible" or even "as many places as feasible". That's at least my interpretation at this point in time. So, the application I've chosen is to target 7-8 different stocks at any given time.

I can't find 7-8 attractive opportunities all at once. So, we will start with the one I find most attractive today (currently trading at $38.74), and that is Whole Foods Market stock (WFM). Therefore, the model portfolio starts today as:

12.5% WFM

12.5% Cash

75% VOO

VOO is the Vanguard S&P 500 ETF. It has an ongoing expense of .05% per year (incredibly low as far as expenses go).

This portfolio obviously requires some explanation. I generally am seeking to invest in individual stocks that are attractively valued and that pass my moral criteria. For an obvious example, I don't want to buy stock in a company whose primary business is to produce and distribute pornography. However, for me, the moral component to investing is all about making a reasonable effort to avoid ill-gotten gains, and to try to make sure positive things are being accomplished with my investments. It's not about moral legalism or gnat-straining. In this instance, I'm making more than a reasonable effort to find individual stocks that are attractively valued. But that takes time.

There are plenty of great companies out there. There are a lot of stocks I like. WFM is the only one I would be buying today (and in fact did buy more of today for the family member's account that I manage). I still have the general sentiment that markets are very highly valued, and perhaps somewhat overvalued at the moment. This sentiment grows stronger when I see consumer staples such as Colgate-Palmolive (CL) trading with a PE of 30, or electric utilities such as Southern Company (SO) trading with a PE of 20+. I still like names such as Kinder Morgan (KMI, KMR), Chevron (CVX) and AT&T (T), but they are trading at a higher price right now than where I recently bought them. Barrett Business Services (BBSI) was a name I was working diligently on of late. I was even able to buy a small amount at $46.81, but by the time I had finished my full report on them, the stock had already had a nice run (currently at $54.96). If it drops back down below $50 in the near future, I'll probably be adding them to this portfolio. Intel (INTC) is still a great company, but at $31.02, it's not nearly as attractive as when I first recommended it at $23.70.

The point of all this is to say, it takes time to build a portfolio. So, in the meantime, I will hold the Vanguard S&P 500 ETF (VOO) in place of individual stocks. The reason for the 12.5% cash is not for market timing. It's actually to avoid any "freeriding" concerns. Hopefully it will be deployed rather quickly. I have no moral concerns about holding the S&P 500 ETF because I'm actively working (making more than a reasonable effort) to find individual stocks to hold. Further, I'm not trying to time the market. So, this is the strategy that makes the most sense to me today. It requires patience and diligence to acquire stocks of great companies at attractive prices.

I am also mindful of special situations, deep value, or contrarian situations that offer a good chance at strong excess returns. That's how I would classify the BBSI situation actually (a special situation that made for somewhat of a contrarian opportunity in the near term, and a GARP opportunity in the long term). But a full report will come on that if/when the risk/reward profile improves a little more. I don't want to get anyone too interested in that situation unless and until the risk reward profile becomes extraordinarily attractive again.

As for the previous strategy of trying to find good relative, or even attractive, value each month, I think it led to some less than optimal results. Intuitively, forcing one's self to make stock picks each month will lead to some poor results at times. Looking back, American Eagle (AEO) stock was probably the idea that I like the least. That's not because it dropped in price after I highlighted it. The near term price fluctuation is actually somewhat meaningless to the overall investment thesis. It's just that as I thought more and more about the total picture of that company, it seemed less and less attractive to me. The operating lease liabilities are huge. The company says that at least a portion of those liabilities have early termination options, but they don't say how many and they don't say what the terms are. I suspect the lack of disclosure is because the percentage of leases with such options are low, and/or even on the ones which do carry such options, the terms of them are not very favorable. It appears, looking back now, as though American Eagle did whatever it had to do to secure for the very long term, the retail spots that it greatly coveted (i.e. that it found most attractive at that point in time). Whereas that was probably viewed as a wise strategy at the time, it does not appear so wise now with the decline of shopping malls that is upon us. In short, they overpaid for many of these "top" retail spots, given the decline in the value of such locations. The resulting total picture is one of huge off balance sheet liabilities, a fickle consumer base, major shifts in consumer behavior and preferences among its target market, and lack of focus, or at least the lack of a clearly communicated strategy, among the company's leadership. I still see a lot of potential value in the brand. But unless and until there is new leadership, and that new leadership communicates a clear strategy for capitalizing fully on the value of the American Eagle brand (or the price of the stock drops a lot more without further deterioration of fundamentals) I will now remain on the sidelines. I sold my position in AEO for a 10.8% loss this morning. That was hard for me to do, as I generally always think of stocks as something I plan to hold for many years. However, it is important to recognize mistakes or potential mistakes early on. It's even more important to admit them, and deal with them appropriately. AEO's business may very well turn around and offer great returns from this point on. But the value proposition just isn't that compelling right now. The contrarian in me remains interested in AEO, but not at today's price.

I'm also not very fond of the Lindsay Corp (LNN) pick I made in January. Long term, there is still a compelling story intact. But the cash flows of this company are a little weak for my taste. I never actually purchased that particular stock. But if I had, I'd probably sell out of it today. Fortunately, it is still trading slightly higher ($85.99) than where it was when I recommended it ($84.28).

Going forward, there probably won't be any more updates on any of the stocks I highlighted or reported on under the previous format. That is, unless/until any of them make it into the new format.

Thank you for your patience with the changing formats and strategies. I am simply trying to follow where I believe God is leading me in terms of my investment style, and in terms of writing a newsletter that readers will find to be helpful. I value any feedback you all might be able to provide!

Thank you so much for reading, and best wishes in your investing!

Best Regards,

Chris McKinney

Full Disclosure: Long BBSI, CVX, KMI, KMR, T, WFM