The 3 Pillars of My Investment Strategy To Beat the Market
Published on February 1st, 2020
Whenever I discuss investing and stocks I am always asked if I beat the market with my investment strategy. Of course the expected answer is no because everybody at this point is well informed of the statistics about active managers losing out to passive index funds. But there is a big difference between someone managing a private portfolio and a billion dollar fund.
And of course the answer depends on many things like the time period being measured (3 years? 5 years?) and how is beating it defined (Total return? Sharpe ratio? Sortino ratio?)? What is the appropriate benchmark? If you only have bonds in your portfolio it doesn’t make sense to compare your performance to a 100% equity index like the S&P 500.
But yes, I beat the index. Keep reading.
My Investment Strategy Is Very Different
I own 50 or so stocks and my portfolio looks nothing like any of the major indexes. I describe my portfolio in the next section but there is a lot of concentration in big dividend industries like specialty financials, REITs, and energy, but I also buy a basket of small cap growth companies.
The hardest index to beat over the last ten years has been the Nasdaq with its tech heavy concentration in names like Apple, Amazon, Facebook, Netflix and Google. I usually don’t own tech stocks because they don’t pay much back to the shareholder, but occasionally I will buy a super cheap name like Micron while it was trading with a single digit P/E ratio. I beat the Nasdaq 100 without ever owning a single share of any of these FAANG stocks. No “new green economy” stocks like Tesla either.
Over the last 5 years the S&P 500 has returned about 75%, the Russell 2000 has returned about 50% and the Nasdaq has returned 115%. Over the same time period, my trading portfolio returned 124%. I’m not here to brag and really it’s not my goal to beat an index in the first place, but some people won’t listen to what you have to say unless you pull out a return chart. My real goal is to build an income portfolio that will sustain a ‘retirement’ lifestyle regardless of what the market does.
A professional portfolio manager’s goal might be beating an index every year, but it doesn’t have to be yours. Remember, anyone who only owned a savings account for twelve years starting from the year 2000 beat the S&P500, but nobody that did that became famous for being an investing genius.
The three pillars of my investment strategy are:
- Income: Preferred shares, CEFs, REITs, MLPs
- Growth: Small cap growth stocks
- Speculation: Special strategies that involves occasionally shorting, options combinations, occasionally futures, and technical and sentiment indicators to lighten up to cash.
The bulk of my portfolio and investment strategy is to buy income paying assets. I like having passive income coming into my account year round without having to make a decision to sell an asset. Since I review every investment before adding new funds to it, I would rather have cash going into my account as opposed to blindly reinvesting dividends.
Before buying, I will review the 10-Qs and 10-Ks and make a decision if the dividend is sustainable, how the business is looking, what management is saying about the future of their business and see if anything seems questionable. I review companies in my portfolio about once a year to a year and a half. I am not looking for capital appreciation with these investments, although that is a bonus when it happens.
The dividend checks roll in and even if the stock drops because of a market correction or otherwise, I have more confidence that the stock will maintain its dividend and will eventually make it through the turmoil. Additionally, can feel comfortable buying during a market draw down like we are seeing now, knowing that I can continue to hold and get income, even if the price drops.
Boring companies that sell a product that everyone needs or offers a place to live will always have a solid business creating cash flows for the owners. Dividends don’t lie.
Of course, lots of dividend stocks reduce or eliminate their dividends during rough economic periods, but for the ones that don’t, you get paid to wait. Some companies like AT&T, which I have owned for a number of years, hasn’t had a dividend cut in over 20 years and has, in fact, raised it every year. Some companies treat their dividends very seriously and only cut them under extreme circumstances.
With preferred stocks, there is even more safety since they get paid before common stocks and the dividend is usually cumulative meaning that if they stop paying, they have to pay back what they missed. If a company stops paying its preferred shares, it is usually a sign of dire straits.
Why Not Index Funds?
Why don’t I just own an index fund and call it a day? The goal of financial independence is having enough income to sustain your lifestyle, and it’s much easier to gauge how close you are to your goal if you have a steady amount of money coming in now and you are confident in the operations of the underlying businesses you have reviewed and invested in. It’s much harder to know if you are ready if you just have a big pile of money invested in index funds, yielding around 2%, but don’t really know how much you can sustainably pull from it each year.
With index funds, you probably won’t be paying attention to how overvalued the market is, or what stage of the economic cycle we are in when you take the hands off approach. When you are unable to find stocks yielding a good amount, it is the first sign that the market is overvalued.
Market draw downs of 30-50% happen more often than people realize and selling in a down market can have catastrophic consequences to a portfolio. I guarantee you will have a pretty good grasp on the market and economy if you spend all year reading the 10-Qs and conference call transcripts of various sectors. Boring for most, I get it, but quite informative to hear what CEOs are saying about their industry trends.
Index funds have done great historically, but I worry about crowding now of passive investing when ‘everyone’s doing them.’ P/E expansion was the only thing driving the market higher up until Feb 2020. The 401(k)s just dumped money into the S&P500 indiscriminately every two weeks regardless of valuation.
Most people don’t have any idea about the sector concentration that now makes up the S&P500. Before the Feb 2020 crash, the top 5 stocks were tech stocks and represented 17% of the index, which was a first. Energy stocks represented less than 4% of the index, down from 25% decades earlier, also a first. I know a lot of people will be happy with this allocation (“it’s a new green world”), but one sector is bid up to forward P/Es of 35 and the other is sold down to P/Es of less than 10. With passive indexing, large stocks just continue to get larger and at some point you may have to ask how much larger can trillion dollar companies become?
P/E expansion is only temporary and eventually P/Es revert to the mean and all the hot air comes rushing out.
Small Cap Growth Stocks
The second pillar of my portfolio includes small cap growth stocks. These companies are very small, generally around $75 million to $300 million in market cap range that are growing earnings more than 20% a year. They are also pretty volatile, which is why they are a small slice of the portfolio.
It’s not uncommon for them to move around 5-8% on a single day because they have much less liquidity than megacap stocks. This makes it very hard to place stop loss limit orders. Short sellers know that the dumb money will place stops 5-8% below the current price because this is what all the gurus and trading books tell them to do. Since these stocks have much lower liquidity, they can sometimes sell just 1000 shares of it until they find the stops creating a chain reaction of selling, only to cover later in the day for a nice quick profit.
I’ve encountered cases where the stock drops 15% intraday, but then ends up with a gain by the end of the day. I am not a day trader and I generally don’t use stops for this exact reason. I plan to hold these types of companies for months and hopefully years based on the underlying nature of the business, not for short term small gains. If the stock drops, but the earning reports are still good quarter after quarter, I can feel comfortable holding it.
The gains on these small companies have much more potential than megacap stocks. They have the potential to double or triple in a few months time period. I don’t hold for days, I hold for months and preferably years if the stock keeps running. The small and micro cap market is very inefficient and, frankly, large funds are simply unable to buy a significant stake in them without distorting the price as they are buying. This is where small investors have a major advantage and some of the best deals in the stock market exist.
But I want to clarify that I don’t invest in penny stocks. Penny stocks are speculative gambles that generally don’t have much of any actual business underlying it and only rely on a grand promise of a great business in the future. They usually have market caps below $20 million and most of these companies are straight up scams or Chinese shell companies. The smaller the company is, the less reliable the auditor generally is as well, if they even have one at all (depends on the exchange listing rules).
There are plenty of penny stock promoters that send out buy instructions to their suckers… er um… subscribers which cause a temporary spike in price of a stock, but then it comes crashing down after the operator has sold all their shares and everybody else starts rushing for the exits. It’s known as a pump and dump and you are likely one of the last buyers at the trough.
The definition of a penny stock as defined by the NYSE is any stock priced less than $5 a share. This is a pretty stupid generalization since the valuation of the company does not matter. Companies like Sprint Wireless ($18.5 billion market cap), Ambev ($67 billion), Nokia ($21 billion), Lloyds Banking Group ($51.5 billion) are all considered penny stocks by this definition, while ultra small microcaps like NeuroBo Pharma (< $5.5 milion), Phio Pharma (< $6 million) and Sundance Energy (< $7 million) are not. A better definition considers the market valuation of the company.
Out of the Russell 2000 index, which is the smallest 2000 companies, there are probably around 20 stocks worth buying by my criteria in a given year. It takes a lot of searching year round but the rewards can be amazing.
The third pillar of my portfolio involves special strategies often involving derivatives like futures and options. It’s also where I take views on the direction of the market. For instance, in the middle of January, I bought some put spreads on various high flying names and the S&P500, betting that there would be at least a 7% correction by March and as we now know, that was more than correct. In 2018, I made a single bet on a volatility spike that paid out two weeks later and turned a $500 bet into $10,000 by betting on a collapse of SVXY and XIV.
It doesn’t always work out, of course. When natural gas spiked toward the end of 2018, I shorted the 3x levered UGAZ and that trade went against me by 300%. That’s why it’s called speculation.
It’s a small part of the portfolio but it can add 3-4% return to the portfolio in good years.
With all three pillars I get income, growth and hedge fund like features all wrapped together. I also invest in things outside my portfolio, such as real assets like Platinum metal which I feel is undervalued.
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