The Case For Stock Selection


The performance of our stock portfolios is largely dependent on the performance of the broad stock market.  This is not an accident.  We purposely select stocks that represent the market and diversify by industry and market capitalization.   We do this because modern history tells us that the stock market provides the best and safest return of any asset class over time. 

Every serious investor knows this, but then they too often leave the safety and predictability of the market for portfolios that are concentrated in one or two hot industry groups or strategies based on timing the market.  The result is a portfolio that requires near constant trading to continue to follow the market leadership and returns that have more to do with the trading prowess of the manager than the market’s proven benefits.

On the other end of the spectrum are passive indexes that allow investors to totally ignore stock selection in favor of owning the market as currently constructed.  Index funds and ETFs are great but interestingly, study after study shows that the average investor using indexes does worse than the index over time.  The primary reason being that the temptation to trade the index instead of just holding it appears to be inescapable.  With just a few clicks and with almost no transaction costs an investor can go in and out of the market on the slightest whim.  Inevitably, this leads to buying high when investors are exuberant and selling low when sentiment is poor but the opportunity for gains is greatest.

Even if an investor can suppress the natural urge to follow the crowd, we believe broad indexes can be improved upon.  We diverge from a passive index portfolio for several reasons.  Since most market indexes are weighted by their market capitalizations, the passive index tends to emphasize yesterday’s winners.  We’ve owned our fair share of winners, but we tend to look for value in what is currently overlooked and pare back our winners over time.  In general, that means our portfolios tend to follow the market, but have less volatility.  Tempering volatility means our portfolios usually (but not always) hold up better than the market in down turns, but it also means we don’t fully participate in the last stages of a market mania.  We believe long term investors gladly accept that trade-off.

Index funds and ETFs are also known for their tax efficiency because unlike mutual funds that pass along their profits to unsuspecting investors even if they don’t sell them, profit and losses from ETFs are generally at the discretion of the investor.   Our stock portfolios go one better by allowing us to record tax losses on a portion of the portfolio to offset gains from the winners.   That is true tax efficiency.

Even so, anybody can go about buying individual stocks, so what makes our strategy any different?

Seeing Through the Market’s Buffet

Our main goal as advisors is to match our client’s risk tolerances and income requirements with their portfolios.   For conservative investors, we do this by selecting stocks with lower volatility and higher dividend yields, while for clients that are more comfortable with risk, we emphasize longer-term growth.

We look at the market as a great buffet where investors can select their meal from a nearly unlimited menu.   Some prefer hot and spicy.   They ride the headlines, need constant trading to stay current and take giant risks chasing outsized returns.  In any given year, these investors post astronomical profits, but for every winner there are hundreds of losers, and the winners seldom repeat their feat.

Other investors prefer just the sectors of the market that provide good income, a bland diet that is low on growth but emphasizes stable dividends.   In today’s low interest rate environment, a high yield portfolio is particularly attractive as an alternative to low bond yields, but investors need to be wary of picking income over safety.   Our high-income portfolios still follow our general rules of investing.   They are diversified by industry group to help control risk and based on serious stock analysis to avoid companies that are income traps, meaning dividend income is offset by a declining share price. 

We prefer meat and potatoes for our main course.   We look for large companies in stable industries that have long track records of success, good management, and clean balance sheets.   Surprisingly, we find that such companies are often underpriced relative to their smaller, less seasoned, more volatile peers.   While fast growing companies grab all the headlines, investors often overlook the steady and predictable growth that great large and mid-cap companies can offer.

If we have the choice of company A that grabs all the headlines while going up 50% in a year and then down 26.5% the next, versus company B that is largely ignored but grows 5% for two years, we’ll take option B.  Both stocks give you the same return but slow and steady does it with a lot less fanfare and much fewer sleepless nights.

Building a vALUE Portfolio

The first part of constructing a portfolio is finding companies that are best of breed in their industries.  Next is price.  How much do we have to pay to own the best?   Our answer always is, “not much more than the average company.”  Since we have owned most of these stocks long enough, we know that even the greatest companies go through periods of being loved and then shunned by a fickle market.   Buying them when they are not in favor can add years of better returns instead of waiting for the growth in earnings to catch up to their inflated stock prices.  

That is the definition of being a value investor, but we are value investors with a small v.   We have great admiration for the Big V managers.   Most of them are hedge funds that can build large positions in a select group of companies that have little in common other than that they are cheap.  If they are passive, they build their positions and wait for an event to unlock the value they see in the company.   Their investors understand that these positions may take years to reach fruition and, in the meantime their returns may be spotty.   That is why hedge funds are best suited to play in this arena. 

Then there are the active value players who build positions sufficient to influence management and cause shareholder rebellion.  It seems like an easy game, but it is not.   The first problem is finding companies that are cheap, the next is to find a strategy that will unlock value. That is a tough game and not one we are willing to play. 

The conservative way to be a value investor begins with diversification to reduce risk and provide more consistent returns.  Then, pick stocks that are representative of their industries but are better, cheaper, and more predictable than their peers.  That may mean buying tech stocks at stratospheric multiples, that no true value investor would ever touch.  It will also mean buying great companies at bargain prices in industries the market temporarily has little use for.  Invariably, it’s uncomfortable going against the consensus, but it’s the most consistent way to add long-term value to a portfolio. 

The Value in Being Contrarian

Buying what other people are throwing away is easy enough if you have a contrarian streak that lets you move against the crowd, but what if the sellers are right?   What if what looks like a temporary problem with the stock or industry is just the beginning of a long-term decline?  We’d like to say we have a special formula to avoid mistaking a temporary problem for long term impairment, but we don’t.   It is really a matter of knowing that it can happen and not being afraid to ask the question; has something fundamental happened to the company or the industry that no longer makes it a good investment?  

In the eighties and most of the nineties we owned Intel and other companies tied to personal computers.   Then in the late nineties it became clear that PCs were giving way to the internet and companies like Intel and IBM would be unable to transition from PCs to smart phones and main frames to the web.  We needed to replace the old technology with new investments that better represented the future of the industry.  Today, we wonder if a similar change is happening in the energy sector as oil and gas get replaced by wind, solar, and green hydrogen. 

While occasionally there are changes so profound they alter an industry forever, more often industries are subject to recurring economic or market cycles. This is most obvious in cyclical stocks or companies subject to the ups and downs in the economy.  Big ticket consumer items like cars and homes go from feast to famine with the overall economy.  Generally, energy and natural resource stocks follow a similar pattern.  The true value investor waits until the economy is in recession, loads up on these names and sells as the economy recovers.   The problem is that this is a game only played once or twice a decade and if the recession turns into a depression, you can be wiped out.  We prefer to always have some exposure to these stocks, but to add or subtract them as the economy gives us opportunities.

There are a lot of other cycles the market is subject to beyond just the economic cycle.  Other industry groups tend to fall in and out of favor based on investor’s risk appetite and investment preferences. The past few years have been prime examples of this.  The FAANG stocks dominated the market until this year.  When market pundits described the mood as risk on or risk off it simply meant that the handful of mega cap stocks that were dominating the market were going up or down.

The same thing happened in the eighties with small cap tech stocks, the nifty fifty big caps stocks after that, commodity stocks in the days of hyperinflation, the conglomerate stocks, growth stocks, internet stocks, and tech stocks.  We like to look at industries and leading stocks in each group over ten-to-fifteen-year periods.  Some of them are so well managed and have such strong moats around their businesses that we want to hold them forever; but when they come too much in favor, we will pare them down and wait for the inevitable fall from grace to add to positions.

Building a Portfolio Over Time

Owning Procter & Gamble or JP Morgan for decades may not seem like the most exciting thing in the world until you look at the tax advantaged compounded rates of return for that period.  We try to enhance core positions like these with less known companies that we believe represent outstanding value.   These are often smaller companies off the radar screen of indexers and big cap growth investors.  

Finding these hidden gems is difficult and tracking their progress or lack thereof is hard work, but it is one of the most rewarding parts of our jobs.  There were times when we were one of a handful of people on the Fly Leasing conference call, but we stuck with it even in the worse aviation crisis ever, because they were selling at a big discount to book value, even if it was slightly impaired. Eventually a large investor agreed and took the company private.  When we started buying a little company called American Tower it was a low margin business that took the cell phone towers the majors were glad to unload.   It turns out that operating the towers was more cash flow positive than running a cell phone company because as cell service grew, the need for space on the towers multiplied several times.

We would be remiss if we didn’t admit that both in core holdings and special situations, we haven’t made mistakes.   We thought that Community Health Care with a long history of great acquisitions could manage one more, until they couldn’t.  We thought that NCR could prosper making ATM machines, but it turned out the cashless society overwhelmed them.   Turns out if you are going to play this game there will be some losses, but fortunately a legendary investor once said, pick a bad stock it can lose 100%, pick a great stock and it can return 500% or more. 

To summarize, this is how we select stocks.  First, we want stocks that are diversified by industry to represent the entire market.  Second, we want to select stocks that represent better value than their peers.   We define value as superior companies at a reasonable price.  We look for prudent managers of balance sheets and those that avoided risky acquisitions and creative accounting to mask a lack of organic growth.  Adding to this, we may be able to find special situations in overlooked stocks that we believe offer superior appreciation potential.

Perhaps what we are most proud of is that this investment philosophy had been proven effective for over fifty years, in all kinds of markets and in boom times and recessions.   During this time, markets have changed dramatically, but the basics of how we select stocks and manage portfolios has not.  If it had, we would have little confidence in it.  We are always amused to see a new system touted as the market beater based on few years of success. What nonsense!  We believe investors deserve to have the confidence that comes with an investment philosophy they understand and has been time tested.

Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.

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