In a recent appearance on CNBC, we were asked about what we do with stocks we own which have run-up recently. They asked us how we plan to handle Disney (DIS), JPMorgan (JPM) and Target (TGT) after those stocks enjoyed strong price increases this year. This is an extremely important question to overall portfolio management success. How can stock pickers overcome the inherent cost advantages of the S&P 500 Index over long stretches of time when the index holds so many successful companies?
Our answer to this question comes from explaining the mathematics of common stock investing. If you pay cash to buy a stock for $30 per share and it is a total disaster, your loss is limited to $30. When you are right about a $30 stock, there is no limit on how much it can go up. In the Bible, love covers a multitude of sins. In portfolio management, big multi-decade winners cover a multitude of stock performance duds.
We are indebted to The Wall Street Journal writer, Jason Zweig, for summarizing this in his Intelligent Investor column called “How You Can Get Big Gains That Wall Street Can’t?” In the column, Zweig discloses that many of the best performing stocks of the last 30 years started small and had “bone-crunching” declines many times over those thirty years. In fact, Zweig argues that individual investors have an advantage over stock pickers in this regard, because they don’t have to worry about investors bailing out on them when long-time favorites go through those bone-crunching corrections and drag down performance temporarily.
We have gone through this several times in the last ten years. Our healthcare stocks like Amgen (AMGN), Merck (MRK) and Pfizer (PFE) corrected sharply in 2016 and helped us underperform the index by the most in the last 12 years operating our U.S. large cap value strategy. Homebuilders soared in 2017, dove in 2018 and soared again this year. The fact that we underperformed in 2016 led to outflows from our strategy. The only way around that would be to sell recently strong performers to avoid their natural corrections.
In meetings with clients over the last two months, the same question comes up over and over again: “How did your strategy outperform the S&P 500 Index over the last ten years when the market was so heavily tilted towards growth/tech stocks in the index?” Our answer is “We held our winners to a fault.” Here is how Zweig explains the importance of holding long-time winners to wealth creation:
That’s because, to earn such superior long-term results, you have to withstand bone-cracking short-term downdrafts along the way—something most fund managers can’t do.
He went on:
Surely only a professional investor can withstand that kind of pain? Au contraire, says Mr. Salem: “It’s potentially career-ending for a manager to hold such big interim losers. I wonder if any manager has ever been able to stay the entire course with stocks like these.
A dirty secret of the investment business is that fund managers don’t buy and hold—not because they don’t want to, but because they can’t.”
Fortunately, for us, we are steeped in the discipline promoted by the great Fidelity Magellan manager, Peter Lynch and Berkshire Hathaway’s Warren Buffett. Lynch set out looking for stocks which could go up ten-fold or more but had characteristics about them which caused investors to never fully embrace them. He owned Phillip Morris, the tobacco company, for decades as it stomped the S&P 500 and was despised the whole time. He bought Fannie Mae while it was misunderstood and held it during his 1977-1992 run of spectacular performance.
We have owned eBay (EBAY) for 12 years. It has been hated constantly and treated like an ugly step child since we bought the shares. Since November of 2008, when it traded at $11 per share, it has grown to be one share of eBay at $35.55 and one share of PayPal (PYPL) at $109.60. This means that we have made 13.19 times our money since then. We will reiterate how hated eBay is. They recently sold StubHub for 13 times what they paid for it and the media painted a negative picture of eBay that day for not being Amazon (AMZN) during that same time period.
This is at the heart of what Lynch and Buffett taught us! We are not geniuses at figuring out who the best growth companies will be in a stock market that craves growth companies. However, we can buy stocks like eBay, American Express (AXP) and Target when they get deep in the investor doghouse and hope they don’t ever get extremely popular to the point of requiring being sold. We call that popularity “maniacal pricing.”
Buffett has said his favorite holding period is forever and he has owned many of his holdings for decades. He also is happy to share that his biggest mistake was selling 5% of Disney at a 50% gain in 1966. Disney has gone up about 2,500 times its price of 7 cents per share in 1962 with dividends reinvested. Disney is the most expensive it has been since we bought it 12 years ago and we believe it will probably correct sharply when this growth-oriented market gets a big comeuppance. Remember, you don’t get rich paying the capital gains tax and long holding periods enhance taxation.
JPMorgan is still very reasonable due to the hatred for banks (Occupy Wall Street and Occupy Senator Warren’s office) that developed ten years ago in the aftermath of the financial crisis. Target trades at a huge price-to-earnings discount to Costco (COST) and we feel has as bright a future!
We will stick to our stock picking discipline and continue to hold winners to a fault. In today’s environment, this means the stock Occidental Petroleum (OXY) looks very attractive. In a world of ESG investing, even if they do well the next ten years, they will probably never get into favor because they produce hydro-carbons. For value investors like us, having a multi-decade winner that you can sit through the corrections with is a Godsend.
The information contained in this missive represents Smead Capital Management's opinions and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.
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