Author: Patrick Larkin
Covestor model: All Cap Value
The value of my portfolio fell a little over 8% in May, versus a 6% plus drop in the S&P 500.
Like the Continental Army's victory at Boston in the winter of 1776 (when Henry Knox and his teamsters dragged the big guns from Fort Ticonderoga up Dorchester Heights in the middle of the night to threaten the British fleet in the harbor, forcing the British garrison to withdraw without a fight), the All-Cap Value portfolios' rapid advance in the early months of this year felt a bit too easy.
Unfortunately, the portfolio's performance in May was more reminiscent of the series of debacles suffered by General Washington's army on Long Island and Manhattan and the ignominious retreat across New Jersey in the summer and fall of that fateful year. I highly recommend David McCullough's wonderful book 1776 for those of you who would like to get the full story, though I will provide one spoiler: Washington still had one more card up his sleeve and he would play it and play it well before the year was out.
Those who have an interest in my portfolio deserve an explanation for some of my recent activity. In prior posts, I have made it very clear that I manage the portfolio for long-run returns. I have also made it clear that I will not panic in the face of short-run reverses in the quoted values of my holdings.
Yet I find myself in a position of having made significantly more trades, both in May and since the portfolio's inception, than one would expect from a self-described value investor.
One reason for this is that the tax benefits of my activity outweigh the very modest transactions costs associated with occasional trading of highly liquid stocks in low-cost online brokerage accounts.
The all-cap value portfolio is managed for after-tax returns, and my activity in the year to-date has resulted in a significant amount of net tax losses that can be applied to unrealized gains when the time is right.
This emphasis on after-tax returns is consistent with the interests of potential subscribers, as tax-deferred retirement accounts are not eligible to invest in the portfolio. While under-emphasized by both the investment press and academic studies, taxes represent a near and certain cash cost and are, rightfully, often at the forefront of investor concerns.
Turning to the specifics of my activity for the month, I was neither the first nor the last to notice the deteriorating near to medium-term fundamentals in energy.
Despite that, I am long-term bullish on U.S. domestic energy production. In May, I closed out mostly losing positions in energy giants BP (BP), ConocoPhillips (COP), and Phillips 66 (PSX), and replaced a portion of those holdings with a slightly less than 5% position in domestic driller SandRidge Energy (SD) and a tiny (slightly less than 1%) position in troubled Appalachian coal producer Patriot Coal (PCX).
With large holdings in the very promising Mississippian play in Oklahoma and Kansas, the low-cost Permian Basin in Texas, and offshore in the Gulf of Mexico, Sandridge is one of the best positioned domestic drillers. The company is highly leveraged, but given the high quality of its assets it has numerous financing options, including packaging producing wells into Royalty Trusts.
In contrast, there is nothing good about Patriot's business at the present time, and bankruptcy is a real possibility. The stock tumbled from a high of over $75 in the summer of 2008 to close out May at $2.37. The stock was trading at over $6 on May 1st before collapsing on reports that the firm might not be able to close on a recently announced financing package and that top management was talking to restructuring consultants. Top management has since been replaced.
Lest anyone conclude that I have succumbed to lottery fever, I should explain my rationale for the Patriot investment. I normally prefer high-quality companies with competitive advantages, sustainable cash flow and low leverage. I only take lottery-like risks when I think that there is real potential for lottery-winning payoffs, and I only allocate a small percentage of my portfolio to these types of opportunities.
With Patriot, the lottery-winning payoffs should come if the company can stay alive until world growth takes off again. But what clinched the Patriot case for me was that in addition to the long-run upside, the stock could become a quick double or better with the closing of a financing package that takes bankruptcy off the table.
During May, I also exited my roughly 5% position in Becton Dickinson (BDX) and added roughly equal sized positions in Ebay (EBAY) and Tesco PLC (TSCDY).
Becton Dickinson is a fine company that I still believe to be mildly undervalued. In my view, it is a much better holding than cash for the long-term, but not quite as good as Ebay and Tesco. I view both Ebay and Tesco as Buffett-style investments, and Tesco is actually in the Berkshire portfolio at a significantly higher average purchase price than my $14.21 entry point.
Ebay is a dominant wide-moat company with excellent opportunities for long-run profitable growth, particularly from its PayPal subsidiary. Other than richly valued Amazon (AMZN), Ebay is probably the company best positioned to benefit from the almost inevitable continued long-run growth in e-commerce.
Tesco is the dominant supermarket chain in the U.K and in many high-growth markets in Asia, such as Thailand and Malaysia. The company's exposure to continental Europe is moderate and is limited to Poland, The Czech Republic, Hungary, and Slovakia. The stock is down over 25% from its early January high to its May closing price, and the dividend yield is now above 5%, with no withholding tax for U.S. investors. The company has raised its dividend payout every year for the last 27 years.
Other moves in May included adding to my positions in The Howard Hughes Corporation (HHC) and The Bank of Ireland (IRE), and trimming positions in Microsoft (MSFT), Hewlett Packard (HPQ) and Cisco Systems (CSCO). I still like all three IT giants, but I judged that I needed to moderate my overall exposure to the sector given the slowdown in Europe and in current and likely future government spending. I have made my case for Howard Hughes and Bank of Ireland in prior posts on my personal blog.
As revealing as the moves that I did make in the portfolio in May is a move that I did not make.
My smallest holding LoJack, a roughly $50 million dollar market cap provider of tracking solutions for lost and stolen vehicles, equipment, and cargo, opened the month at $3.81 and then traded down for 11 straight sessions to $2.70 (a loss of 29% over that stretch) before bouncing back a bit to close the month at $3.15. As anyone who has invested in small stocks knows, the rules of the game are a bit different. Prices can stagnate for extended periods, and then move dramatically on news or on a large holder getting in or out. This makes it considerably more costly to move in and out of smaller stocks than it is to trade the larger names.
While I certainly didn't derive any pleasure from the price action in LoJack during the month, my assessment of the company's fundamentals did not change. Had I been prone to panic in a falling market, LoJack would have been the first position I would have exited.
As I write this, the market is plunging on sour news from the U.S. job market, the All-Cap Value portfolio is again trailing the market, and the Dow has gone negative for the year.
While I can't guarantee short-run outperformance, I strongly believe that the moves that I have made have positioned the portfolio for strong gains in the medium and long-run. I don't expect as much activity in future months as I undertook in May, but I won't hesitate to move on any opportunities that might arise going forward, provided that they are compelling enough on an after-tax basis to justify replacing an existing holding in the portfolio.
Disclosures: BP, COP, PSX, SD, PSX, SD, PCX, BDX, EBAY, TSCDY, AMZN, HHC, IRE, MSFT, HPQ, CSCO
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