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One way we intend to achieve this mission is through our publication, Joseph's Portfolio & Commentary, where we publish the investment decisions, results, and commentary related to a real money portfolio owned and managed by Joseph D. Allen.
We believe that results speak for themselves. Since tracking of the portfolio began on January 1, 2008, through December 31, 2014, the portfolio has experienced an overall gain of 221.2% versus 63.4% for the S&P 500 – a cumulative overperformance of 157.8%, or 10.8% per year.
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EXCERPTS FROM OUR 2014 ANNUAL LETTER (CERTAIN SUBSCRIBER-ONLY CONTENT HAS BEEN EXCLUDED)
February 17, 2015
“Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.”
Benjamin Graham in The Intelligent Investor
“In the conduct of investment trusts I am a great believer, not in the theory of ‘don’t put all your eggs in one basket,’ but ‘know good and well in what basket you are putting your eggs into.’”
Paul Cabot in Passion for Reality by Michael R. Yogg
Dear Readers and Fellow Shareholders:
2014 was another bumpy ride for stocks. Gains were modest but steady through mid-September, but all were given back by mid-October. At one point on October 15, the S&P 500 index even crossed into negative territory for the year. In the end however, the S&P 500 index registered an increase of 211 points to end the year at 2,059. Dividends included, the S&P 500 registered a total return on investment of 13.7%.
Over the years, fund managers have found it difficult to outperform the S&P 500 – and this was especially true in 2014. According to Lipper, a provider of mutual fund statistical information, the S&P 500 outperformed every category of diversified U.S. stock funds. The average total return (including dividends) of all U.S. diversified stock funds was a mere 7.6% in 2014, falling well short of the S&P 500’s 13.7%. Combined, these stock funds held over $6 trillion of assets, and I estimate they cost investors roughly 1%, or $6 billion, in fees and expenses.
During 2014, the published portfolio produced a total return (including dividends) of 22.1%, representing an 8.4% overperformance relative to the S&P 500 index of stocks.
Since tracking of the portfolio began on January 1, 2008, the portfolio has experienced an overall gain of 221.2% versus 63.4% for the S&P 500 – a cumulative overperformance of 157.8%, or 10.8% per year. Below is the complete year-by-year account of the portfolio’s and S&P 500’s total returns, including dividends.
From January 1, 2008 through December 31, 2013, the published portfolio consisted of more than one investment account. Starting January 1, 2014, the published portfolio has consisted of only one investment account, established for the purpose of tracking and auditing the portfolio.
The past performance shown above is not a prediction of future results. Any level of overperformance is very difficult and cannot be guaranteed. I am fairly certain that the portfolio cannot sustainably beat the S&P 500 to the degree it has in the past (10.8% average annual overperformance), and I would be satisfied by a much slimmer margin of overperformance.
Successful investment records, just like great businesses, are not established in one year or two, but over decades. In the long run, even a slight performance edge over the market can result in hugely increased profits. For example, beating the market by just 1% a year over a fifty-year period would boost overall returns by around 60%. The law of compounding interest holds enormous power, and it doesn’t take much to realize its effect in a big way. It is for this reason that I am totally focused on long-term results.
My investment objective for the portfolio, taken from the 2011 Annual Letter, is as follows:
My investment objective, simply stated, is to beat the market average. It does not matter if the year ends in a gain or a loss. A loss of 10% when the market falls 20% would be far superior to a year when my portfolio grows 10% versus a gain of 20% for the market. All that matters to me is how my portfolio performs relative to the market average.
One of the key purposes of this Annual Letter is for me, as manager of the portfolio, to report to you, in good years and in bad, my performance against the market average – my proxy for the “market average” being the S&P 500 stock index.
Performance reporting should be consistently and objectively measured against a fair yardstick. Using a market average benchmark, such as the S&P 500, is a good way to distinguish between performances reflecting one’s own abilities versus performances that are due to the “rising tides” effect that “lifts all boats.” I cannot deny that luck also plays a role in performance. Fortunately, luck’s role in portfolio performance tends to diminish as the measurement period grows longer.
Market Swings and the Three-Year Test
Anyone who has invested in marketable securities such as stocks, knows that the market does not move in a straight line, but tends to jump and slide repeatedly, at times wildly. Occasionally, stocks and other assets will experience bubbles and crashes, and the portfolio is not immune from such volatility.
My expectation, based on historical data, is for the portfolio to follow the general short-term trend of the market most of the time. If the market has a good or a bad day, I expect the portfolio to do likewise. However, from time to time, one or another of the portfolio’s holdings are likely to break away from the market, causing the portfolio’s performance to differ from the market over the long term. Because of this tendency, I mostly ignore short-term performance, preferring instead to focus on long-term results.
How long is “long” when it comes to measuring “long-term” performance? Personally, I tend to think that anything less than three years does not give sufficient time for good ideas to work out, and so my practice has been to review performance on a rolling three-year basis.
I do not expect all three year periods to work out well – in fact, I am fairly certain there will be multi-year stretches when the portfolio I manage fails to beat the market. However, as a general rule I would be disappointed if my results were not satisfactory over most three-year periods.
Price, Value, and a Margin of Safety Between
Two words sum up my investment philosophy: price and value. Often price and value are used interchangeably, but they really have two distinct meanings and should not be confused with each other.
Loosely defined, price is what a buyer pays to a seller in an arms-length transaction. Price is a short-term concept, as an asset trading hands at a given price now, may trade hands at a very different price ten days (or even ten minutes) from now.
Value, on the other hand, refers to all of an asset’s future economic production that will benefit the owners of that asset. Value is a long-term concept, and depends on future events that nobody can predict with perfect certainty.
The two words, while different, are of course related to a degree. Price is often negotiated according to buyers’ and sellers’ opinions as to value. And if we say that someone paid too much for something, we imply that the price paid was greater than the value received.
Neither price nor value can be ignored by the investor. Both are equally important, as it is the relationship between the two that determines whether an investment opportunity is attractive or not. I consider an investment to be attractive when its price is significantly less than its value.
Investing is not an exact science. For while price is knowable with “to the penny” precision, value is an estimate. Valuation methods are imperfect and prone to serious error. And while our world is full of information, I have yet to evaluate a potential investment where I have a perfect and complete set of facts. And even if I did, I still might not conclude correctly. Highly intelligent and rational people sometimes differ strongly as to their opinions of value, even though they often are looking at exactly the same set of facts.
Fortunately, it is not necessary to form a highly precise opinion of value in order to make a profit as an investor. The trick, therefore, is not in fine tuning the valuation model to perfection, but rather in finding opportunities where the gap between value and price is so wide that there is ample room for error. Benjamin Graham, whom many regard as the father of value investing, and later Warren Buffett, referred to this gap between price and value as a “margin of safety.”
On Diversification, and Doing a Few Things Very Well
Diversification of investments is an important and widely discussed topic, and one about which the investment community at large has long held strong convictions. It is also a topic that can easily become divisive, considering the prevalence of conventional views on the matter as covered by investment professionals, professors, and the media. Because it is in my nature to seek common ground, I have until now mostly avoided discussing diversification. However, it seems a few words about diversification are in order, so as to help readers better understand the methods by which I manage the portfolio.
I should mention first off that I consider wide diversification to be quite intelligent in certain circumstances and for certain people. In the 2011 Annual Letter, I wrote that choosing a broadly diversified basket of stocks, such as an index fund tracking the S&P 500, made good sense for investors seeking average returns.
The evidence seems to strongly indicate that diversification, if carried far enough, leads ultimately to average performance. John Bogle, founder of the Vanguard Mutual Fund Group, wrote in his book Common Sense on Mutual Funds, that “in the long run, a well-diversified equity portfolio is a commodity, providing rates of return that are highly likely to resemble closely and finally fall short of those of the stock market as a whole.” Mr. Bogle went on explain that multi-decade performance data of mutual funds pointed to an overwhelming tendency of diversified stock funds to eventually revert toward average performance levels.
So, while diversification can be a good strategy, it may not work well for those who seek above-average returns. On the other hand, a strategy involving less diversification makes it possible (but by no means guaranteed) to achieve above-average performance.
I would further argue that the diversification technique can at best offer only average portfolio safety, whereas a more concentrated approach can result in above-average safety. By safety, I refer to the avoidance of permanent loss of value, as opposed to mere temporary fluctuations in price quotations.
How is it possible that both performance and safety can be improved beyond average levels through an approach that diversifies less, not more? This seems quite contrary to modern portfolio theory. The answer to this question is not nearly as simple as holding fewer investments. Four additional requirements must be met.
First, the investor must practice sound methods. Because poor methods, whether applied to a small or large number of holdings, cannot be expected to produce superior long-term results. The investor’s methods must do a proper job of weeding out unsafe opportunities. They must give the investor a way to rank opportunities. And finally, the investor’s methods must produce new worthwhile ideas in all market cycles.
Second, the investor must possess a certain degree of knowledge. It is not possible, nor is it necessary, to know everything, but it is very important to obtain and understand the key facts. The investor must seek and interpret these facts with an open mind, for it is very easy for biases to influence decisions. Paul Cabot, who in 1924 co-founded the nation’s first mutual fund and went on to a very distinguished investment career, including seventeen years as Harvard University’s treasurer, had it just right when he stated, “First you’ve got to get the facts. Then you’ve got to face the facts.”
Third, the investor must not restrict too narrowly the universe in which he or she searches for investment opportunities. The eyes must be wide open at all times, to catch attractive opportunities when and where they come along. If an investor’s focus is too specialized, sooner or later he or she will succumb to choosing only the best from a poor lot. I am not suggesting that the investor choose opportunities he or she knows little about – this would reflect amateurism. On the contrary, the investor can only expand into new areas when he or she is sufficiently competent. Therefore, the investor must forever be learning and growing, moving to where the opportunities are. This forms both the challenge and the excitement of managing an investment portfolio.
Fourth and finally – once armed with the proper methods, key facts, and wide universe of opportunities – still something more is required if the investor would hope to find above-average safety and performance simultaneously. The investor must be disciplined, sticking close to what he or she knows best, never stooping to compromise on safety, and only allowing investments into the portfolio that offer significantly greater-than-average performance potential. The investor must be a vicious “guard dog,” resisting the temptation to let ideas through the gate that, although seeming to offer great rewards, do not meet his or her established criteria.
The natural result of applying discipline as discussed above, will be that the investor says “no” far more often than he or she says “yes.” Portfolio resources will tend to be concentrated into fewer – and hopefully higher quality – investment holdings. For while many attractive opportunities may exist, it is not likely that one person can be sufficiently informed to take advantage of more than a few of them at any given time.
Even if the investor were in a position to take advantage of many ideas, there is still the important matter of continuous monitoring of the portfolio. Only by limiting the number of holdings in the portfolio, is the investor able to pay proper attention to each investment. Paul Cabot, who was mentioned above and who was instrumental in growing the Harvard endowment from $177 million in 1948 to more than $1 billion in 1965, explained the benefits of concentration in this way, “In the conduct of investment trusts I am a great believer, not in the theory of ‘don’t put all your eggs in one basket,’ but ‘know good and well in what basket you are putting your eggs into.’”
There is obvious wisdom and truth in the old proverb, “don’t put all your eggs in one basket.” However, history has shown that great success in any venture is not to be had through indecision and sprinkling of one’s resources over many areas. But rather, the most successful people have reached the pinnacle through concentration and focus.
A.P. Giannini, founder of the Bank of America, when asked about the secret to his terrific success, said, “It’s no trick to run any business if a man has the intelligence and industry to concentrate on the job. The great trouble with most men is that they scatter too much. A few men can go into many things and succeed, but they are very few.”
Thus, over the years I have grown to accept a philosophy of doing only a few things, and trying to do them very well. Being an outsider in the companies I invest in, I realize that some diversity is called for, as I will always be shut off from a considerable amount of information that is available only to those on the inside. However, notwithstanding this informational shortfall, I do not attempt to run the portfolio in a manner that will provide significant diversification, for by doing so I believe I would be sacrificing both safety and performance. That would be both unacceptable and undesirable.
Instead, I try to find a happy medium – diversifying into new areas when doing so seems appropriate, while always bearing in mind the dangers of too much diversification.
Present Market Conditions
At February 17, the last business day before publishing, the level of the S&P 500 was 2,100 points. The price-to-book ratio for the S&P 500 is approximately 2.8.
For five out of the past six years, the S&P 500 has produced double-digit returns, including dividends. In the past 50 years, the market has managed this feat only one other time. During the “boom” years of 1993 through 1999, the S&P 500 total returns exceeded 10% in six of those seven years. And what happened after 1999? Investors endured three straight years of losses, and it would take more than seven years for the market to reach its pre-crash heights again.
Am I suggesting that, due to the recent stretch of good years for stocks, we are due for a downward correction? No – I have no idea whether investors will push stocks higher or lower in the near term. But what I am saying is that boom often comes before bust, feast before famine, pride before humility, etc. It is important, especially during periods of heightened stock market valuations, that careful investors exercise caution when evaluating investment opportunities.
In theory, as market prices move higher, investor expectations should moderate, keeping a lid on prices. However, history has proven that the opposite often occurs in reality. As stock charts grow steadily higher year after year, investors begin to forget the past and form unrealistic expectations about the future.
In spite of their recent impressive returns, stocks still seem more attractive than long-term government bonds. I am absolutely shocked by the interest rates that investors in bonds are accepting these days.
Bond rates are particularly bad in Europe. Recently, the Wall Street Journal reported that the Swiss government sold a bond yielding a mere 0.065% annually for ten years. Let me put that in perspective. If you were to invest a whopping $1,000,000 in such a bond, your interest income would amount to a paltry $650 per year. Investing in this manner, to quote the great investor Walter Schloss, “is no way to live.”
Persistent low interest rates on high-quality bonds may actually boost stock prices in the short term, since the prices of all income-producing assets tend to move higher as interest rates fall. However, it seems to me that excessively-low interest rates will eventually encourage risky behavior by a great many investors in bonds, stocks, and other asset classes.
In the long run, if a lot of people and institutions make unwise and risky choices for an extended period of time, markets are likely to become unstable and ultimately crash. Let us hope some sensibility returns to interest rates before too long.
Reasonable Expectations for Average Stock Returns over the Next Decade
Considering the current level of stock prices today, as well as other factors, it seems reasonable to me to expect the S&P 500 to produce total returns, including dividends, of between 3.6% and 6.5% over the next decade.
Obviously I cannot know what is to come in the future, and my expectation is at best an educated but crude guess based on limited and imperfect information. Nevertheless, it is important to me that you understand my long-term expectations concerning future returns from stocks, and compare them to your own. It is not easy to outperform the market. It can be downright impossible to outperform excessively inflated expectations.
It is essential to have a good approach in judging the future returns from any asset considered to be an investment, and to be disciplined in its application. This way, investors with realistic expectations will avoid making costly mistakes in the way they allocate their savings. It will also give them confidence when (not if, but when) prices fall.
[Some content - for example a section entitled "Portfolio Analysis and Commentary" - is provided to subscribers only and has been excluded from these excerpts.]
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Our mission at Joseph & Company, LLC is to develop a better way to invest for the average investor. That means investing should be less costly, take less time, and produce great results. I take our mission very seriously, and am constantly working to find an even better way to invest. I am encouraged by our progress, and know that there is much more work to be done.
To those of you who have the faith to invest alongside me, I thank you for your belief. It is a heavy burden to know that my decisions affect not only myself and my family, but others whom I care about. Your confidence drives me to work harder, and to be more careful. I will continue striving, in order that one day your trust is justly rewarded.
Any questions or comments you might have are more than welcome. I always enjoy hearing from readers, so please do not hesitate to contact me.
Most respectfully yours,
Joseph D. Allen
[END OF 2014 ANNUAL LETTER EXCERPTS]