Category: Investment Philosophy

Diversification: A look at Ray Dalio’s All Weather Portfolio and the place for fixed income in the portfolio

After reading Principles, by Ray Dalio, this past winter (which I highly recommend as it gave me many, many things to think about) I have been reconsidering my position on being highly underweight fixed income. Perhaps you are similar to me and kept waiting for rates to move up for an attractive entry point.

Now the ten year treasury is hovering around 3% and as I noted previously, is not that far off from long-term averages. Does it make sense to allocate more of our portfolios to fixed income now?

Perhaps you have heard of Ray Dalio’s “All Weather Portfolio” in which he allocates a surprising amount to fixed income, as shown below. His rationale centers on a few factors. One is that by having weighting your portfolio at 80% stocks / 20% bonds is actually heavily weighting “risk”, given the volatility of stocks vs. bonds and for someone like Ray Dalio who is trying to build wealth over the long, long term, performing well in down markets matters. Bonds should go up when stocks go down due to “flight to quality” impact in a down market. The allocation to gold and commodities provides extra diversification, plus these assets perform well during periods of high inflation, whereas bonds will not perform well.

  • 40% long-term bonds
  • 15% intermediate-term bonds
  • 30% stocks
  • 7.5% gold
  • 7.5% commodities

“The principles behind All Weather relate to answering a deceptively straight-forward
question explored by Ray with co-Chief Investment Officer Bob Prince and other
early colleagues at Bridgewater – what kind of investment portfolio would you hold
that would perform well across all environments, be it a devaluation or something
completely different?”

The results are pretty surprising. Dalio says he’s back-tested the portfolio from the great depression, to the Weimar Republic when hyperinflation set into Germany. If you choose not to read Principles, then I implore you to read the white paper on Bridgewater’s website on the background of the strategy.

Using portfoliovisualizer.com, I decided to see the results for myself and ran different 3 portfolio cases from 1978-2017.

The first is based on Dalio’s All Weather portfolio, though admittedly, I had to do a 15% allocation to gold as a general commodities fund was not available that far back. I then ran a 60% stocks / 40% intermediate treasuries portfolio and then an 80% stocks / 20% intermediate treasuries portfolio.

Let me first say that it shouldn’t be too surprising that the higher stock portfolio wins out. Stocks have been a terrific asset class over this time period. Its higher risk, so higher return makes sense.

But look at the results of portfolio 1, the All Weather Portfolio. Results over this time period are not too shabby, logging a 9.4% CAGR and growing $10K to $380K. But the really interesting thing to me is the worst year and worst drawdown. The worst year was only down ~4%! Compare that to the stock heavy portfolio of -25% and having a near 40% loss in portfolio value during the year. Makes me think of “Slow and steady wins the race”

PV All WeatherPV ALl Weather Chart

This analysis isn’t perfect for a host of reasons. Bonds have been in a bull market for 30 years and were at much higher rates during this time period and subsequently went way down. I do like a quote from the white paper though, in which it states,

“In the US after peaking above 15% in the 1980s, cash rates are now zero. Stocks and bonds price relative to and in excess of cash rates. A 10-year bond yield of 2% is low relative to history but high relative to 0% cash rates. What is unusual about the recent environment is the price of cash, not the pricing of assets relative to cash.”

For further analysis on portfolio outcomes that aren’t tied to back testing, I decided to build a monte carlo spreadsheet analyzing a 50/50 portfolio of stocks and bonds. I then ran 10 random simulations over 40 years to see where the portfolios would shake out. This was pretty simple analysis and I probably should’ve added a component that says, “if stocks are down, then bonds are flat or up”, but decided to keep it random.

Given how high the standard deviation is for bonds, it is no surprise that the highest returning situations are driven by bonds outperforming, but we should also not ignore the simulations where in year 38 out of 40, stocks fall 45%, as shown in scenario 3. Bond provide decent offset to a devastating scenario.

Monte Carlo assumptions

Monte Carlo

I think the takeaway I have is that bonds / fixed income can make sense in the portfolio, depending on what you buy. So far, all I’ve shown is buying treasuries, but think there are solid opportunities in high yield and municipal bonds which are much more stable than stocks, but provide good returns.

I’ll follow up in another article on a bond fund that I think makes a lot of sense to buy for a pretty attractive return.

-DD

Recap from Berkshire Hathaway Annual Meeting

I was fortunate enough to attend Berkshire Hathoway’s annual meeting and wanted to provide a recap to readers. I’ll try to skip much of the fluff questions that were asked.

IMG_2825

But to kick it off, I think its important to recap how Buffett started the meeting. He noted that he expects to receive many “macro” questions, such as what the fed will do with interest rates, risks from an unpredictable president, and the tariffs and to put these topics into context, he brought an actual, physical NY times newspaper from March 1942. The Phillipines had just been lost to Japan. The US had been bombed by Japan in the previous December. The outcome of World War II was far from certain.

Despite all this, 11 year old Warren Buffet decided to invest. And although he did not have this much money at the time, he noted if you bought $10,000 in the S&P500, it would be $51 million today. If you had bought productive US assets, they would have compounded at a fantastic rate of return.  At the same time, if you bought gold in fear and left it, it would be worth $400,000, higher than you invested but significantly less than the amount generated by stocks. Also, the yield on bonds at the time was 2.9% and there was encouragement by the government to “support the cause” and buy war bonds. Buffett & Munger did not partake much in this by simple math -> 2.9% minus taxes less 2% inflation leads to a minuscule return.

  • Succession planning:
    • Many questions related to succession planning, which makes sense given Mr. Munger and Mr. Buffett’s age (87 and 94 respectively). However, based on their responses, their ability  to work all day from ~7:30am to ~5:00pm all while eating peanut brittle and coca-cola, made me confident that Buffett and Charlie are in solid mental health at least.
    • “I’ve been semi-retired for decades”, Buffett’s response to succession planning. Ted Weschler and Todd Combs have assumed some investment responsibilities and Ajit Jain and Greg Abel now oversee Berkshire’s operating businesses.
    • However, Ted and Todd manage ~$25BN compared to Berkshire’s $100BN in cash as well as his current investment decisions. Bottom line: Buffett is still in charge
    • That being said, it should give some confidence that Buffett is relinquishing the reins responsibly.
  • Dark clouds on the horizon
    • Buffett was asked about Amex, given there are “dark clouds on the horizon” in payments. By this, he meant changes are happening in the industry and many technologies are trying to disrupt the industry.
    • However, he reiterated that the business is terrific, global payments are increasing, and Amex is a great brand. Over time, through share buybacks, Buffett will increase his stake.
    • In response to dark clouds, Buffett said something along the lines of, we used to buy outright declines (e.g. the textile business Berkshire is named after) so they are improving.
  • Dividends & Share buybacks
    • When asked to clarify why Buffett does not pay a special dividend or conduct buybacks, yet Buffett is favorable on Apple’s massive share buyback plan.
    • For starters, Buffett thinks Apple’s stock is cheap, and recently added 75MM shares to his portfolio. It then would make sense for Apple to buyback its stock if it also thinks it is cheap.
    • Second, it is unlike that Apple can find acquisitions in size “that they can make at remotely sensible price that really become additive to them.”
    • “The reason companies are buying their stocks is that they are smart enough to know it’s better for them than anything else,” Mr. Munger said.
    • Therefore it makes sense for them to acquire shares. Buffett on the other hand, has said he is open to share repurchases if he can’t find a way to deploy it (but he think he can).
  • Cryptocurrencies
    • Much has been said about what Buffett and Charlie said on crypto, but it bears repeating.
    • First, like gold, cryptocurrencies are non-productive assets and therefore depend on a “greater fool” to buy at a higher price than you bought it.
    • Charlie called this idiotic and immoral (given the greater fool piece). However, the BEST PIECE, was when he compared it to turds.
    • “To me, it’s just dementia. It’s like somebody else is trading turds and you decide you can’t be left out.”

What characteristics do you look for in a business? (Part I)

There is no ONE way to approach your investments. Lots of investing processes have been met with success and lots have been met with limited results. This post details how I generally target businesses for investment.

To be clear, this is Part I on a rigorous topic. If it were easy, everyone would do it and I honestly believe everyone can do it well with the right skills and determination. I will go further into my investment process in posts to follow.

Let me lay a foundation first: We are investing in businesses. This may sound simple, but is so often missed and that is why it is critical for me to start here. We are buying a business and we want that business to give us the most bang for our buck, to compound earnings in such a way that it pays us dividends, we make multiples of our money and the business never needs another dime from us… right? Well some people do not think that way in the market it seems, or at least it doesn’t look that way by what they buy.

We are not buying a stock in the market just because we think we can sell it higher. That’s like buying someone’s piece of art on the street and asking someone else to buy it for more than what you just paid. That is speculating not investing, so go back a read my post on that topic.

Should we start top down or bottoms up?

Should we find a good business then analyze the industry? Or find a great industry and find a good company? This one is up to you actually — there is no right answer — but from my experience, I tend to try to find great companies operating within their industry. Bottom line: I try not to write off an investment just because the industry may appeal uninteresting or unattractive.

It should be mentioned here that I don’t think I can call the macro well (or even at all). Count all the things you thought would happen any given year in the macro environment and count all of them that actually happened (interest rates are going up, the stock market can’t go up this year, oil will just keep rising, just to name a few). Howard Marks said it best:

 “We don’t know what lies ahead in terms of the macro future. Few people if any know more than the consensus about what’s going to happen to the economy, interest rates and market aggregates. Thus, the investor’s time is better spent trying to gain a knowledge advantage regarding ‘the knowable’: industries, companies and securities. The more micro your focus, the greater the likelihood you can learn things others don’t.” 

“We don’t know what lies ahead in terms of the macro future. Few people if any know more than the consensus about what’s going to happen to the economy, interest rates and market aggregates. Thus, the investor’s time is better spent trying to gain a knowledge advantage regarding ‘the knowable’: industries, companies and securities. The more micro your focus, the greater the likelihood you can learn things others don’t.”

Sometimes you can have a great company, a great industry, but a bad security (i.e. stock). Sometimes you can have a bad industry, a great company and a great security! And sometimes you can even have a bad industry and company, but great security (it is just too cheap to ignore). But all things being equal, I prefer to buy great companies at a discounted price.

That being said, ask yourself questions on the industry such as:

  • How cyclical is it?
  • Is it growing or shrinking?
  • How competitive? Monopolistic?

In investing, I want to target businesses with strong “Porter’s 5 forces” that is, businesses with good economic moats, pricing power, solid competitive position, etc. These businesses can generally ride out the economic cycle well and are able to compound earnings at a quicker rate than businesses that face intense competition with little moat. Warren Buffett said he views companies like he views a castle… surrounded by a moat where each day that moat can get wider or narrower due to competition. Much has been written on this topic, so I won’t belabor the point here.

Ask yourself if the company you’re looking at has a moat. Is it getting larger or narrower? Why? And do you think the market’s view of the moat is too optimistic or pessimistic?

Business Characteristics

Asset-light businesses are terrific. It is the number one thing I look for. And it of course points to businesses with good returns on capital.

Think about investing in a restaurant concept. You invest in the business and then capital is used to lease space, rent kitchen equipment, pay employees, acquire initial ingredients, fund advertising and start cooking up burgers. After some success, a second location can be opened or dividends could be paid, etc.

On the other hand, think about the franchise concept. I can invest in a franchise business instead, which lets the franchisee handle all of that capital and the franchisor just collects a fee. The limited capital requirements involved let franchisors invest in other high return projects, acquisitions, or return cash to shareholders.

Now, this is not a statement that all franchisors are great, and usually the concept must be established well beforehand, but it gets to one of the main things I look for: High conversion of earnings into actual free cash flow (and I define free cash flow as cash flow from operating activities from the cash flow statement less capital expenditures). Remember my post on Nexeo? I like distributors not because they are super high margin, but because they convert a lot of EBITDA into FCF due to their limited capital intensity.

For example of another company, take a look at B&G foods (ticker: BGS). This company is generally a low growth, consumer staples business. Boring business that you’d expect to grow 2-3% per year. But you can see below that EBITDA has expanded significantly. The company generates a significant amount of FCF due to its high margins / limited capex and therefore, management has used that capital for acquisitions. Due to its high FCF, it also can support more debt for these acquisitions, which generates a higher IRR for its shareholders. Finally, B&G also offers a 5.3% dividend yield today, so you can start to see why asset light business models are attractive for equity holders and why this is a good case study.

ScreenHunter 03.png

Asset light businesses can weather economic cycles better

Have you ever heard of the best way to win at investing is by not losing? It almost sounds like a Yogi Berra quote, but it has some wisdom. Warren Buffett didn’t build his empire on one or even a couple high flying, successful stock picks. He picked a portfolio of good businesses bought at good prices.

I like asset light businesses as they usually are better insulated in downturns. Take a look at Company A below. It has 15% EBITDA margins and will likely perform OK in an expanding cycle. However, in a recession we can see the business becomes barely break-even since it cannot pull on its cost structure. Businesses like these include auto companies, airlines, steel producers, grocery stores, gyms, and so forth. And it makes intuitive sense – an auto company must maintain massive production facilities while also maintaining a global distribution platform in addition to its sales, marketing and other staff. It cannot cut some of these costs quickly enough and expect to revamp in time when the cycle does recover, so it eats the cost in the meantime. This just shows EBITDA, which of course is earnings before even interest and capex are taken out, which implies the business would likely burn cash (without cash flow from working capital).

ScreenHunter 05.pngScreenHunter 06.png

Now look at Company B with less fixed costs. It weathers the storm much better. We would also expect that it would have lower capex needs given low fixed costs so if I were to compare FCF of these 2 businesses (i.e. EBITDA – Capex – Interest – Taxes and change in working capital), it would advocate Company B even more.

I do want to caveat what I am saying here with what I said before about “bad industry, but great company or great stock” etc. Sometimes there I times I want businesses that are high fixed costs. That time is when we are at the depths of a business cycle. High fixed costs translate into higher operating leverage into a rebound as well. On the rebound, you can see how those fixed costs can translate into faster earnings growth and margin expansion on the way out. As such, I typically like to buy them when others think the cycle will be terrible for much longer and cast the businesses out right when things may inflect.

To again quote Howard Marks, always remember that although I am quickly detailing a couple things I like to look for in general, “high quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them.”

That’s all for now.

-Diligent Dollar

Are you speculating or investing?

I think when most people begin to invest in stocks, they buy companies that make a product that they really like or that they think will be beneficiaries of major trends. This seems completely reasonable, but is simple speculation until cash flow enters the equation. Before I get into how I approach investing in companies, I’ll first break down the significant differences between the two, as I think it’s an important distinction and provides a valuable backdrop before we put money to work.

Back in the 1990’s, the commercial internet had just dawned. What was clear was that it would change the way we live forever; what was not clear was how. One new service was going to offer grocery delivery ordered online. It would deliver groceries to customers during a 30-minute period of their choosing. This presumably would change the way we shop for groceries forever (sound familiar?). Their plan was simple; they would raise cash from an IPO to fund investments in warehouses and expand to new cities. Clearly, THIS was the future. The company raised $375MM in an IPO to fund expansion and the company at peak was valued at $1.2BN. Moreover, they had an uber experienced and already successful founder, Louis Borders (of Borders bookstore fame), in addition to top-of-the-line VC money and guidance.

The company was growing too. It achieved 750,000 users, had 3,500 employees, and for the 3 months ended Dec-31-2000, the company did $84MM of revenue compared to $9MM in the 3 month period in the prior year (+833%!). However, the company’s losses expanded to $173MM from $49MM (and cash flow was a similar story) as it tried to expand quickly and needed to invest back in the business. In the end, the company was running out of cash, capital dried up (the tech bubble burst, closing the public equity markets), and it declared bankruptcy in 2001. The name of this company was Webvan if you want to study it further.

Ok, so how is that different than investing? Both investing and speculation involve taking risk. As Ben Graham said, investing inevitably has “substantial possibilities of both profit and loss.” However, in speculation the risk vs. reward is often miscalculated. You believe, since the price of something has gone up in the past, you can anticipate these movements and gain profitably from them. And maybe this strategy works for a little while, but see how similar that sounds to a roulette wheel? “It hit black 3 times in a row… it must be red next time.”

Think about today’s market. Infrastructure spending, tax reform, the next tech event… nothing has actually even been laid out yet, which has allowed investors to write their own narrative. This has led to speculation and driving stocks higher.  

When investing, we must take a calculated, fundamental approach to what we are buying, while also being realistic. We are buying an asset that we want to produce cash flows in the future to grow our capital or pay us back. However, we can’t pay any price for it if we want our capital to appreciate at a fast rate – which should be our goal! That philosophy alone also eliminates some “investments” out there, such as art, popular crypto currencies, etc. – to wit, anything that is not a producer of cash.

We must understand the industry, the company’s position, management, and cash flow. Unfortunately, this is harder than speculating, but also can create more significant wealth with much less risk. There is no free lunch, so it does require challenging work, but it can be well worth it and will be the subject of future posts here.

Think about it; is something in your portfolio right now that you’d equate to Webvan? Good concept, excellent product, or immense potential, all they need to do is… make a great leap? Or you’ve seen this stock rise so much in the past, you don’t want to miss the opportunity. This is all speculation and yes, sometimes there is a place for it in our broader portfolios and yes, it can be hard to draw the line between investing and speculating.

In future posts, I will delve further into my investing approach. But for now, I want to leave you with the following; if you have a large speculative position in a company, consider taking some risk off the table in favor of a real investment.

– Diligent Dollar

What’s your investment philosophy?

Right after high school and through college, I used to buy & sell cars. I would pour over classified ads looking for cars at discounted prices. Most of the time they were fixer uppers, but I knew that after some work I could sell it for a similar price to recent transactions of similar cars.

I bought my first car for a few hundred dollars, fixed some small parts, cleaned it up, listed an ad, and sold at a higher few hundred dollars higher than were I bought it. Given the return on my investment, I was hooked. I went on to sell more cars and eventually got my dealers license, moving up to bigger auctions where you’re given a couple of hours to actually test the cars, weigh your input costs, while keeping in mind what you think can sell it for in a reasonable amount of time.

There were some great investments and there were some losers.

I once bought a Honda based on a few pictures. I know what you are thinking, but it looked great and Honda’s are always so reliable, right? I thought I could buy it for a couple thousand and sell it for a few hundred-dollar profit quickly thereafter. Wrong. The transmission slipped. Turns out that part failed in this particular model of Honda made in a particular year range. That made supply low and demand high and the transmission itself would cost a couple thousand dollars. Welp. I debated my options (fixing it or maybe parting out the car), but in the end took it to an auction and sold it for a loss.

There was also a Jeep I found at auction that wouldn’t drive. On top of that, it was a complete mess inside (I’m talking nasty). No one would touch it. Since it was listed as immobile, they didn’t even drive it through the auction, only had it sitting in the parking lot. However, I noted a simple piece wasn’t actually hooked up that was making the car immobile. Most people probably quickly assumed a fix would cost what they could sell it for (much like my Honda experience), and so no one bid. I bid $300, fixed the part, and sold it for a few thousand in a short period of time.

The point of this story is you have to do your homework. Oftentimes you think you know something well, skip steps in your diligence process, and it goes against you. It’s through hard work and diligence where you find a left-for-dead investment that ends up being your best winner.

Investing can be an emotional game (which is why its good I didn’t buy and sell muscle cars!), but in the end you have to stay grounded. That’s one reason why I personally stay away from investments where valuations imply astronomical growth for the foreseeable future. It’s too easy to overestimate what you think will happen in the future and lose sight of fair value.

In sum, I’ve always been a value investor. I try to find investments that people have left behind, don’t want to do their homework on, or are hidden gems.

What is your philosophy or approach?

-Diligent Dollar