2015 was a difficult year for most investors and essentially all asset classes. A few of the only ways to make money in 2015 were to either be long the dollar, buy Russian bonds, or buy Japanese stocks. 2015 was also a year when many famous hedge funds and long-term value managers posted double-digit negative returns. You know it is a difficult investing year when Warren Buffet’s Berkshire Hathaway is down more than 10%, and Carl Icahn’s holding company is down more than 30%.
OPCM clients who have been with us through multiple cycles know our investment discipline well. Portfolio holdings in all asset classes (excluding fixed income) cycle through a repeated, methodical process of “Initiation, Full Position, Reduce, Sell”.
In the Initiation stage, the OPCM Investment Team has isolated an investment idea that typically has experienced a shorter-term issue unrelated to a permanent operational deficiency. A company’s business may have experienced a weather issue, regulatory push-out, poor industry sentiment, cyclicality, or may be in between a product cycle. Our Investment Team formulates a thorough thesis through internally created research reports. A thesis will have multiple expected future catalysts.
As the catalysts are closely monitored and begin to come to fruition, we may opt to increase the position to a larger “Full-Position”. If the catalysts and/or thesis do not play out, the team will likely choose to sell the small sized Initiation position, many times at a loss, and move on to analyzing the next idea.
When a Full-Position in the portfolio either becomes overvalued or completes the thesis, the Full-Position eventually enters the Reduce stage. At this stage the holding is reduced from a top portfolio holding to a smaller holding. This may occur after one year, or it may happen after a multi-year holding period. Many well-known investors complain that they “buy early and sell early”. We attempt to combat this issue by initially Reducing instead of completely Selling a holding in case the stock price continues to rise unabated.
Finally, when the holding either achieves an extreme valuation, or the fundamentals begin to deteriorate, we Sell the remaining position. Our Investment Team knows exactly what stage each portfolio position is in during any given day, thus we are following different catalysts, news, and fundamental indicators for each position.
This process repeats itself over and over through market cycles. During some years, our portfolio turnover may be lower as many of our holdings stay in the Full-Position part of the cycle. In other years, our turnover may be higher because many of our more successful positions are now “excessive” – excessively overvalued, an excessively high percentage of the portfolio, excessively popular, and even excessively hyped. At the same time, we may have a number of new investments entering the portfolio in the Initiation stage.
A FASTER INVESTMENT CYCLE MEANS HIGHER TURNOVER IN 2015
2015 has been a higher turnover year, similar to years when more holdings were moving through our investment cycle, such as 2003, 2007 and 2009. These periods can be confusing to clients when they see the most successful, media darlings, and the largest portfolio positions, being reduced or sold by the Investment Team. The replacement positions are holdings entering the portfolio in the Initiation stage, and typically the overall sentiment from the investing public is negative. In 2015, clients have seen a number of holdings, including recently, Novartis, Johnson & Johnson, Lowe’s, Pepsi, and Danaher reduced or sold after many years of strong returns. None of their replacement holdings experienced strong returns prior to our recent purchase.
As the replacements enter the OPCM portfolio, they will start their cycle of hopefully moving from an Initiation position to a Full-Position. A short-term side effect of this methodical process is the Initiation positions may underperform short-term, while the excessively valued and popular Reduce/Sell positions may continue to climb to new valuation highs, as greater fools are found. It is quite easy to buy a good company at a high valuation, or to buy “what’s working” and hope for the best. The more difficult task is selling good companies when the risk/reward is no longer favorable, and has turned deeply negative.
CAPITULATION – A DISCIPLINED INVESTOR’S DREAM
While our investment cycle repeats, occasionally the Investment Team uncovers what we call a “capitulation situation”. Capitulation situations occur when an industry, sector, sub-asset class, or entire asset class experiences a free-fall in price and valuation, usually after a prolonged period of underperformance. Think of the action being the inverse of watching one of these cult-stock bubble investments consistently rise over time, then spike toward the end of their popularity – think internet, biotech, social media, and nouveau hamburger companies.
A capitulation situation can be a disciplined investor’s dream. A company may have underperformed for a lengthy period of time. One by one, the Wall Street analysts downgrade the company. The stock blows through previous record low valuations, and may have gone from being labeled a high-quality growth or cyclical company to a company trading at a fraction of its tangible value. Finally as capitulation sets in, the stock price falls seemingly daily until one day the stock drops 5%, 10% or maybe 15% during a single day on massive volume as the final panic sets in. As the media reports the carnage to the public, a valuation bottom is being put in place under all of the volatility. A disciplined investor, who can separate emotions from analysis and valuation, and has no qualms about being patient as an investor is prepared. The disciplined investor takes advantage of others emotions.
A HIGH MARGIN OF VALUATION SAFETY
The good news is these capitulation situations provide a high margin of valuation safety for a patient investor. This is comforting to an investor who always analyzes risk first. In many cases, these holdings which can be gut-wrenching to buy, turn out to be a diverse portfolio’s strongest performing long-term investments.
The bad news is these capitulation situations sometimes only occur every three to five years, and can involve patience once purchased. Often times we will increase the position size at a lower price, allowing us to take advantage of overly pessimistic sentiment. We are sometimes asked by newer clients, “Why did you trim the best performing investment and buy another company that’s down so much? CNBC hates that investment.” The answer is simple: discipline. One holding is cycling out at a priced-to-perfection valuation with little fundamental room for error, while another is cycling in at a priced-to-capitulation valuation with most of the bad fundamental news in the past.
PRICED TO PERFECTION AND PRICED TO CAPITULATION TODAY
After mentioning the outsized number of holdings that moved from Full-Positions to Reduce or Sell in 2015, it is worth noting that the OPCM Investment Team has not seen this many capitulation situations in over six years. For example, after owning our smallest allowable allocation to natural resources in eight years, we recently Initiated a few new capitulation situations, and are close to initiating additional holdings in natural resources. Outside of the natural resource asset class, our domestic equities Watch List (potential new Initiation holdings) has increased from a few companies over the summer to over ten, many of which are capitulation situations.
THE COMPONENTS OF SUCCESSFUL INVESTING
In the world of investing, there are thousands of very intelligent analysts or investors who can tell you anything about a company or industry from the recent trends, to competition, to how the economy affects them, to the CEO’s golf handicap. There are fewer who can properly value a company on an absolute or relative valuation and equate that to a buy or sell opportunity. Where the field of successful analysts and investors narrows further is in the psychology component of investing. These are individuals or teams who strive to analyze the psychological questions such as when to buy, when to sell, cyclical effects, seasonal effects, consensus expectations for fundamentals, how early or late stock prices trough or peak ahead of fundamentals, what type of investor base owns the investment, where are management’s incentives, and when has sentiment reached schizophrenic extreme? As a team, OPCM attempts to analyze all angles of psychology prior to a purchase or sale. We believe in combining deep fundamental and valuation analysis, with an understanding of the present psychology. With the willingness and ability to be patient, we can manage a growing portfolio with less downside risk over the long-term.
