Math of Returns

I just released the fourth issue of the Oddball Stocks Newsletter and wanted to share a short excerpt from the introduction letter.

The topic is the timing and security selection criteria necessary to achieve market beating returns:

"To demonstrate my thinking here is a simple example.  Let’s consider a hypothetical $1,000,000 portfolio comprised of 10 equal weighted undervalued stocks.  In our portfolio we’ll assume that each stock is trading for 66 2/3% of book value and is worth 100% of book value for a potential 50% return.  Let’s imagine that three positions ($300,000) appreciate 50% to fair value each year, which would be $450,000.  If the rest of the portfolio remained flat for the year the investor’s return would be a quite satisfactory 15%.  Now at this point in time it isn’t as if we’ve lost hope in the other seven names, but they haven’t done much yet.  If an investor sells the appreciated securities and reinvests them in securities selling for 2/3 of BV and repeats this process year after year the portfolio will continue to earn above-market satisfactory returns.


For one to achieve market beating returns only 1/3 of the portfolio needs to appreciate at least 50% a year.  The rest of the portfolio can stagnate or even fall slightly.  The key to this is accepting that different portions of a portfolio are in different stages of value realization. One needs the patience to see ideas through, and the wisdom to minimize losses.  In this imaginary portfolio positions are held for a maximum of three years, if at that point they haven’t appreciated it’s time to sell and find a replacement.  Or if a position appreciated before the three year holding period was realized the position was sold and replaced by a new lower valued position."

When reading investment blogs or message boards I'm struck by how many people are looking for home run investments.  Rather finding investments with at least 50% appreciation potential and not losing money can generate market beating returns.  It's much harder to find stocks that will reliably double, triple, quadruple or more in a few years.

The above example should be a great gut check for what's in your portfolio.  A single loss or two requires gains from the rest of the holdings to be higher.  It's easier to avoid losses rather than finding home run stocks.  A portfolio with market generating returns doesn't need to be comprised of multi-bagger stocks, it needs to be one that avoids losses.

When a portfolio continues to hold losing positions, or invest in positions that consistently drop it's like a paddler trying to navigate a boat against the current.  It's possible to paddle upstream but it's a lot of work.  Avoiding losses is like paddling with the current, a bit of effort combined with the current results in a quick journey.

 

he's looking for cigar butts a la graham, where the downside was theoretically limited because the company is trading below its liquidation value, so if it goes belly up, you still have a positive return. what people don't realize is that things are a bit more complicated than when Graham did it, and you have less to choose from. the way Graham did it was by combing through thousands of pages of financials (I believe S&P) because information was not ubiquitous.

there was an interesting study done by CFA institute (I think) that tracked the number of stocks that passed Graham's screens, and for whatever reason it has declined substantially over time. I like the approach (finding unappreciated value), but I don't think you can consistently generate alpha through screening (as @"ArcherVice" alludes to), you need to have some business acumen.

finally, when Dreman did his studies on PE, PB, PCF, and dividend yield, PB was not as powerful of an indicator as PB, so I would caution putting all of your eggs in a metric that doesn't have the long term viability of something like PE or PCF.

/rant

 

No, I fully get what he's saying. What I was trying to very politely say before is that this is completely worthless information. He might as well have said "Just buy stocks that go up and you'll make money." In fact, when you boil it down, that is exactly what he said. I put that in the 'no shit, Sherlock' category of information.

How to find the stocks that have nothing but upside would be much more useful information. One problem: There is no such thing as an investment that has 50% appreciation potential in one year with no downside risk. If there was, he could just leverage his position to the moon and be a billionaire by the end of next year. Just like that kid the NY Post wrote about the other day.

 
Oddball Stocks:

I'm struck by how many people are looking for home run investments. Rather finding investments with at least 50% appreciation potential and not losing money can generate market beating returns.

I'm struck that you don't find a 50% appreciation stock with 0% downside to be a home run.

Cheers to you to get people to pay $300 bucks for your newsletter- to me that is way more impressive than any of your "analysis".

 
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