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Welcome to Special Situation Investing Episode 45.
Today we switch gears to respond to some listener feedback. The listener in question is a friend of mine who asked several questions about the podcast during a recent jog in the nearby mountains. His questions all centered around some version of the following, “you mentioned a stock on your podcast but it declined twenty percent after the episode, so how do you suggest that a person buy something like that?”
The question is a fair one and it gets at two points that are worth clarification. The first point, what is the purpose of your podcast, and the second, how do you buy stocks and structure your portfolio?
Beginning with, what is the purpose of the podcast? I started this podcast to “scratch my own itch” that is to say that I was looking for something as a consumer and couldn’t find it, so I created it myself. I was looking for a podcast that explored specific investment ideas and the thesis behind them in real time and not retrospective interviews featuring great investors.
I’m a huge consumer of audio books, podcasts, and books generally, and many of my favorite podcasts are investing and economics related but for the most part those podcasts don’t discuss real-time investment ideas. There are obvious and good reasons why this might be the case. For starters, putting your own ideas in the public sphere opens you up to criticism as people judge your in-the-moment decisions and thoughts after the fact. Additionally, offering investment advice can make enemies out of friends if those suggestions don’t work out as well as you’d hoped. A further reason to avoid real-time investment advice is the risk of being copied.
It’s difficult to come up with a winning investment thesis and to the extent you share that thesis with others you’re creating your own competition and possibly adding buying pressure to the stocks you’re after. We often discuss stocks on the show with near microscopic market caps that are very thinly traded and any additional buying pressure could raise the price and reduce our returns.
Those reasons aside, however, I still wanted a podcast with real-time investment ideas that could accelerate my own stock research and because that show didn’t exist, I created it. There are thousands of potential investment ideas in US traded stocks alone and no single person can sort and weigh them all, so it seemed beneficial for me to share my ideas and thought process with the world so that others could either study them further or move on to the next thing.
From this perspective the “bad” ideas are as useful to my listeners as the good ones in that they save you the time that you might otherwise have expended in further research. All this to say, I’m doing my own research and then sharing it with you in the hope that it’s helpful to you, but am not making buy recommendations that anyone should follow blindly.
Furthermore, I’m not investing in everything I review, nor am I equally convinced of the merits of each write-up, but I am making my research public in the hope that it will compliment and accelerate your own analysis. Again, this is exactly what I was looking for when I searched for, and didn’t find, a podcast like this one. Within fifteen minutes I wanted to know if xyz company’s spinoff, merger, or rights offering was worth further investigation or if it was a pass and I hope you’ve found the show beneficial in that capacity.
Now on to the second point, how do you build a position in a stock and how do you construct your portfolio? For most stock purchases, I build the position up over time. Sometimes I’ll buy into a company for years just chipping away as the price dips into my range, or as I have the money to invest.
Corporate event driven investments are the exception to this rule. If a spinoff, merger, rights offering or other catalyst is the driver behind your investment thesis, then you may have to purchase a large block of stock in a short period of time, but those events are the exception to my otherwise slow-build-up rule.
The next item — portfolio construction — requires a more extensive review than the previous point. To begin, I recommend Jeremy C. Miller’s excellent book, Warren Buffett’s Ground Rules. In the book, Mr. Miller, breaks Buffet’s early partnership letters into three broad, topical categories. According to the author, Buffett repeatedly referred to “workouts,” “controls,” and “generals slightly undervalued” as the broad categories that his specific investments fell into.
Workouts are investments in companies going through specific, time-bound, corporate events or changes. Spinoffs, restructurings, large share repurchases, rights offerings, and other corporate events fit into this category. Workouts are stocks you intend to hold for months rather than years based on short-term events that will “unlock” value.
Buffett highlighted that workouts perform well in flat or declining markets. This is because the event-driven catalyst insulates the stocks performance from broader market conditions. Outperforming a declining market is as important to long-term out-performance as is beating the market when the indices are up. Because workouts buoy your performance in declining markets, they’re an important tool in your portfolio construction and one that Buffett used to full advantage in down years.
Controls, just like they imply, are investments in which the investor has significant or total control of the businesses operations. A fund manager who holds a majority stake in a public company or an entrepreneur that runs their own company, fit into this category. For my own purposes I consider my rental property a control. I can set the rent, remodel, borrow against it, or sell it with impunity and thus have control of the investment.
Controls, like workouts, offer a degree of protection against flat of falling markets. Because the investors control gives him more “levers” to pull it’s possible for the investor to get ahead even when general stock prices are falling.
Generals slightly undervalued is the third and final category. This category includes public equities with solid long-term prospects that an investor intends to hold for a minimum of several years. In a rising market these stocks tend to out-preform the other two categories.
Because this category includes your longest-term investments it has the added benefit of delaying your tax bill until years or even decades into the future. One hundred percent portfolio turnover each year would subject all of your assets to a significant tax burden. That tax burden is acceptable at a high enough rate of return but finding high performing investments consistently enough to grow your wealth despite an annual tax on all of your assets is a tall order for even the most celebrated investors and a hurdle that can be avoided by investing in generals.
Identifying a long-term compounder and letting it ride for decades without realizing any tax can be a very profitable strategy. Investments that return one hundred or more times your money take time to play out. These investments can take years or even decades to mature and delaying your tax bill until the end of a multi-decade run dramatically increases your final return on investment. These long-term investments fit squarely into the “generals slightly undervalued” category.
Within the three categories just described, I tend to own ten or fewer investments at any given time. If an investment in one category grows to dominate my portfolio I don’t sell it just to “re-balance.” I sell “generals slightly undervalued” only when the company’s value becomes impaired, or I recognize that I was wrong in my original analysis. Workouts can be sold once your original thesis plays out and the value is unlocked. Controls, should only be sold when they’re losing money or locking up capital that could clearly be better employed elsewhere.
Workouts are my highest turnover category as by definition they are time-bound and should be sold once the thesis plays out. I think of these investments as a funding source for the “generals slightly undervalued” category and typically use gains from workouts to fund the generals.
Turnover among the generals is the lowest of the three categories. As I stated before the low turnover allows you to compound money for long periods without tax consequences and is where the 100x returns are generated.
Most retail investors don’t hold investments in the “controls” category, but to the extent that you do, they are an excellent counterbalance to general market conditions and allow you to pull more “levers” than would otherwise be available to you. To the extent leverage is employed, it can often be obtained under favorable conditions in the control category.
Consider, for example, the amount of money an average person can borrow to purchase property as compared to the amount that same person could borrow in a margin account. Broader tax sheltering options are available to investors in the control category as well given that home office, mortgage expenses, and other costs can reduce the investors tax bill in a way that isn’t available when investing in public securities.
In the words of Mohnish Pabrai, “big bets, few bets, infrequent bets.” Remaining concentrated on your highest conviction ideas coupled with a willingness to sit on your hands for years and even decades is the path that most often leads to out-performance. The power of this framework is evident when you invert it to say “small bets, many bets, frequent bets” and imagine the skill that would be required to make that mantra pay off.
Legends in the investment community frequently owe their success to a dozen or so big decisions. It’s very difficult to spot something undervalued and which nobody else sees. And because of that you must really load up on the big ideas. Making hundreds of small bets correctly is far less likely to pay off than are a few well placed big bets.
So in conclusion, use this podcast to augment your own investment research. Build your stock positions slowly except in the case of workouts, and limit yourself to a handful of your best ideas. Use all three of Buffett’s investment categories to structure your portfolio to full advantage and enjoy what you learn along the way.
With that we hope you enjoyed this episode and that you gained a better understanding of both the intent behind the podcast and of portfolio construction. We will see you again soon with another investment write-up.
SUBSTACK ONLY BONUS
Many of the investment strategies followed by both hosts of this show are preached most famously by Warren Buffett and his business partner, Charlie Munger. Far less known than Buffett, Munger is the modern day’s Ben Franklin. The seminal work compiled about Munger — Poor Charlie’s Almanack: The Wit and Wisdom of Charlie Munger — is worth every penny of its $51.89 cost.
Portfolio construction