Some Thoughts from Seattle

I went to the MF One event in Seattle this past weekend, which was a lot of fun. It was a real pleasure meeting so many great Fools and I hope to get opportunities to meet a lot more one day (especially on this board!).

MF One is geared towards a different audience than this board, and I think a lot of what they try to teach is aimed at preventing big mistakes (especially emotional mistakes). The Everlasting Portfolio, for example, has the famous 5-year minimum holding period, which means that you’re going to end up holding onto a handful of real losers instead of reallocating that capital; but it also means you’re not going to sell your winners too soon, which is a big problem a lot of people have when left to their own devices. Right now the EP has 33 companies in it, but the interesting thing is that the top-performing 7 companies make up just under 50% of the portfolio now. The bottom-performing 7 companies make up less than 5% of the portfolio.

Tom Gardner said that his brother David has the best track record at TMF, but he’s still only right half the time: 50% of his picks will go on to underperform. But what makes the difference is that the winners are huge and it’s that disparity between gains and losses that leads to outperformance. But that’s only true if you hold onto your winners (and even add to them over time).

Tom even went so far as to muse that maybe the average investor would be better off holding so many companies they couldn’t keep track of them, because when people are focused on their positions and sitting in the pilot’s seat, many will feel like they have to steer the plane and do something – and, unfortunately, that something may be unproductive for their returns (whether it’s trading in and out, or getting scared out of a great company after a large rise in the stock price).

So Tom’s advice was to work hard at running an emotionally efficient portfolio. Take your emotions out of your decisions. Don’t act just to act, but because you objectively believe it makes the most sense for your long-term returns. In the case of the Everlasting Portfolio, they’ve tried to structure it to help the average investor with that through the 5-year minimum holding period (which obviously has trade-offs – they keep losers too – but likely does more good than harm for many people).

Their second bit of advice was to run a tax-efficient portfolio: let your gains compound for you over time and work for you rather than forfeiting a big chunk of them each year. And again, the EP’s 5-year minimum holding period helps with that.

Morgan Housel gave a talk on bull vs. bear markets. I don’t think anyone who reads his stuff regularly heard anything new: corrections and bear markets are a very natural and healthy part of the market. The worst thing you can do is panic and sell in a bear market, but the second worst thing you can do is miss the bull market for fear of the next bear.

He also talked a bit about Hyman Minsky and the idea that stable periods naturally lead to instable periods as people and companies take on more debt and risk (“success breeds disregard for the possibility of failure”). Then, during times of economic stress, the worst companies are destroyed, refocusing resources on the rest who are forced to refocus, innovate, and improve, all of which leads to future success and stability. So bull markets setup bear markets, and bear markets setup bull markets in a natural cycle.

Morgan pointed out again the paradox that past bear markets look like wonderful times of opportunity while future bear markets look like horrible times of risk. His suggestion for mentally managing future bear markets is to pre-plan a “positive action” that you can take in the next bear market. That might be having a little cash on the side that you can invest, or it might be having a watch-list of great companies that you’d love to own if the market dragged the prices way down. But figure out a way that you can view the next bear market more as the opportunity you’ll see it for in hindsight rather than the risk you see it as today.

Finally, nobody knows when the bull market is going to turn to bear. He showed quotes from smart people and leading financial publications that have called the top every single year since 2010, and of course they’ve all been wrong. But those articles all sounded very reasonable at the time given the current situation. Someday this bull market will end, but nobody can call the top. And even if you believe the current market is unsustainable, “unsustainable” market states can last for a long time – much longer than people think. Unsustainable doesn’t mean it crashes tomorrow.

Saul has obviously spoken a lot about his approach and the ways in which it differs from the boilerplate TMF approach. But my takeaway is that they’re actually pretty similar in many ways that matter, with Saul’s absolutely being more efficient and productive, but also requiring better judgement and decision-making. Saul says don’t trade in and out, don’t price anchor, let your winners run (and add to them), and sell your companies that didn’t work out and reallocate that capital to better companies. I don’t think anyone would argue with that approach, but it requires skill and control. TMF fears that, despite good advice, many people are going to react emotionally and sell the good companies too, or get into the habit of trading, or panic in a downturn and sell everything at the worst possible time. They’re more worried about preventing big mistakes that sabotage market-beating returns. So their simplified approach is to just hold all your companies through thick and thin and let your portfolio naturally balance out over time as the winners grow into the majority and the losers diminish into the minority. Better that than selling those winners too soon, or panicking at the bottom, or trying to trade in and out all the time. And you see that with the EP: 3 years and 33 companies in, the top 7 companies have grown to nearly 50% of the portfolio and the bottom 7 have become less than 5% together.

Is it the most efficient approach? No, especially not compared to Saul. But those following the EP are up 24% over the market over those three years, and it’ll be interesting to see how things go from here now that the portfolio has become naturally weighted towards the winners and away from the losers. I don’t think the EP is trying to be the best, but I think it’s trying to be “good enough” in a way that works for a broad audience, including very inexperienced investors.

So I don’t think the big takeaway is that everyone should shackle themselves to 5-year minimum holding periods. But emotions and biases are a huge problem with investing – by far our worst enemies – and I think it’s to our benefit to be humble enough to admit we’re not perfect investors and devise ways of controlling our own personal weaknesses while we try to better ourselves and grow out of them. The 5-year holding period is simply the EP’s broad compromise for helping its members avoid the worst mistakes.

The thing I love about this board is that we’re all working hard to improve each day, both individually and as a group, and a big part of that includes talking about our weaknesses and what we’re doing to overcome them. So looking back at your own investing history, what patterns of mistakes do you see? And what processes do you have in place to help avoid repeating them again in the future?

Neil

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Neil,

Thanks for recapping the event. I too am a One member and have been with them since the start of the EP portfolio. Before One, I was primarily a Pro/Options user. Before Pro I followed MDP (right in the beginning before the market hit). Before MDP I was a casual follower of Stock Advisor and RuleBreaker picks going back to 2005 (where I got my AAPL, NFLX and NTES that I still hold today).

My biggest observation going through the 2008 period and following MDP is that it was a difficult time to “stay invested”. Yet I did and kept all of those stocks to their greener days. Those holdings account for my positions in INFN and CSCO to name a few.

Since becoming a One member, I’ve used a smattering of ideas from all the services. For a while I was augmenting from Supernova and EP interchangeably, but instead of buying those stocks I applied my knowledge from Jeff Fischer’s option service to use synthetics and covered LEAP strategies. The one thing I’ll say about the Fool service and their track records is even some of the doggard stocks can give you awesome returns if you use option strategies.

I know that options are not the focus of this board, yet they are my preferred mechanism to purchases. I usually buy deep in the money options instead of purchasing the stock outright. This strategy has afforded me to double my gains along the way (as well as double my losses). My year to date paper gains are north of 70% for the year. Previous years have also gone well for me, usually around 50-60%. However, I am using quite a bit of leverage to get those gains. My synthetics are usually at the money, and I’ve used them to augment my positions in NFLX, APPL and other “retail” stocks that still go up, albeit more slowly than the high growth stocks identified here.

My biggest potential mistake I see coming is if/when the market corrects and I am continued to be leveraged, and become over leveraged as a result. Right now I use my base of core, slower moving stocks, like AAPL, CSCO, DIS and others as leverage to purchase synthetics in the higher moving/higher volatility stocks. The strategy has worked so far, but I am starting to reassess what I’m doing and have made some decisions to do the leveraging strategy on stocks that have safer PE ratios (but also with high growth prospects). That is what I love about this board. The fresh ideas and perspectives here are helping me identify exactly those types of “safer” stocks to be in.

I think as investors we all have our own strategies and methods, and we learn from each other to make us better. I for one am glad I found my way to this board.

Best,
–Kevin

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So looking back at your own investing history, what patterns of mistakes do you see? And what processes do you have in place to help avoid repeating them again in the future?

Good question, Neil; I’ll take a swing at this…

With regard to what I’ve learned from Saul and all the other terrific posters on this board, I would say that one of my mistake patterns involves an inability to add to winners, which is a form of price anchoring. I’ve been with The Fool for over fifteen years now and have been fortunate enough to pick up a fair share of the most successful companies recommended in that time–my folly, however, has been finding comfort in seeing those low cost bases from years ago and being unwilling to add, thus bringing those bases up.

Saul has a talent–and incidentally, those with this ability (Saul) think of it simply, as common sense or an easy call, while others without this ability (me) regard it with much more admiration (talent, savvy, uncanny insight)–for cutting the weeds and watering the flowers. My inability to add to winners is my greatest weakness and through reading about this concept from others here, it is my hope to make it a former weakness.

Many thanks to Saul and others for making this such a great board!

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Whoops, correction to my post above. I meant to say COST not CSCO (which I don’t think I ever owned).

One of these days I’ll get to updating my profile to reflect my holdings, but suffice it to say they are being trimmed out near-daily due to the influx of new information and eye openers on how well these old stocks of mine are really growing compared to better alternatives.

Thanks again for reading,
–Kevin

Saul says don’t trade in and out, don’t price anchor, let your winners run (and add to them), and sell your companies that didn’t work out and reallocate that capital to better companies.

For me, by far the hardest part is making the decision that an investment hasn’t worked out (and won’t work out if given a little more time). That’s the difference between reallocating capital to a better investment versus trading in and out.

What’s helping me with that decision is having some objective historical information. Things like the 1YRPEG (even over time), looking at TTM earnings growth over several years, revenue growth over time, P/E multiples over time.

A growth area for me is to look at more things, like debt vs. cash, cash flow, etc. I also want to learn how to understand businesses well enough to have an opinion on whether their growth should be getting faster or slower, and whether there are recent changes in the business that aren’t captured in the historic numbers.

-Mark

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Hi Neil, Your comments on the Motley Fool One and the Everlasting Portfolio were excellent and intriguing, and got me to thinking, but from a different point of view. I see smart people picking stocks, adding to winners, and generally using good principles for investing. So I ask myself why are their results so poor? Beating the S&P by 23.8% since inception is mediocre at best. It averages about 7.3% per year, which isn’t much for a VERY expensive subscription service. And beating the S&P is setting the bar very low as the S&P is just a mixture of 500 good, mediocre and poor companies.

So I was wondering:

Is it because they are restricted by only being able to invest in companies that they can feel good about holding for five years? That would rule out a lot of the smaller companies, that are growing fast but that they can’t yet be sure about.

Is it because they have too many companies in their portfolio? And more coming all the time. But they started with only a few and should have had good results then. And also you pointed out that their top seven have grown into 50% of their portfolio.

Is it possible that from now on, since their portfolio will be dominated by their big seven, that in the future results will be better, since poorer picks and new picks won’t be able to influence results much?

I welcome other suggestions or thoughts.

Best,

Saul

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John Bogle, a man we all admire and respect may be absolutely correct regarding the best way for the average investor to invest.

He became convinced that an Index Fund was by far the best way to invest and started the Vanguard Fund as a result. His low cost funds have successfully beaten 80% of the professional mutual fund managers on Wall Street for many years.

Had I not had the good fortune to run into Saul’s unique investment methodology, I would have wound up placing the bulk of my investments into such funds. Boring, predictable, slow steady returns are not a bad alternative to the uncertainties of the market. And paying high priced fees to market pros for mediocre to poor returns is the sad reality for most investors.

However, the joy of investing with like minded intelligent folks would be lost. Also, the phenomenal ingenuity of entrepneuers free to innovate and create continues to fascinate me after 35 years of investing.

Jim

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John Bogle, a man we all admire and respect may be absolutely correct regarding the best way for the average investor to invest.

He became convinced that an Index Fund was by far the best way to invest and started the Vanguard Fund as a result. His low cost funds have successfully beaten 80% of the professional mutual fund managers on Wall Street for many years.

I do not admire John Bogle. I think he has put chains on a generation due to the quote that you pointed out. I see a lot of my older friends quoting him excessively and causing them to fear to invest on their own. Not even taking the chance to learn. These same people that quote him push that fear on their children. I think he did a lot of damage to those people’s wealth.

I thought about why most fund manager’s can not beat the S&P and I think that some of them could be idiots but most of them are anchored down by the rules they have to invest under and by the people that are invested in their funds. If they can not invest in anything they think would be a good investment that hurts them. The people that invest in their funds, when the market goes down, get scared and pull all their money out. This makes the fund manager have to sell off shares in order to fund their money. Exactly at the time they should be buying. I think this hurts a lot of the funds. I think people that invest in index funds have been conditioned to put their money in and forget it. Which, in that aspect, has been better for their wealth. If only the people that invested in mutual funds could be conditioned the same.

Andy

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I look at it this way. Most people do not want to learn. They just don’t. So I tell people if you don’t want to become a student of the game, then do index funds. If you want to learn and become a student of the game and earn more, then do stocks. I feel there is no wrong answer, everyone is different and as long as they are doing something, I say good for them. As my ole pappy used to say, “There is a butt for every seat.”

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Great discussion, folks!

This stuff leads more to the heart of the issues than many of the official TMF services and writings. As I see it, there are definite places for vehicles like S&P 500 index mutual funds (or ETFs), as well as TMF EP (as described, since I’m not in that one). I was just explaining some things about investing to a friend who is completely investing illiterate. I see things as a spectrum of risk and returns, based on both knowledge and control over investing emotions. They combine to form an overall proficiency that dictates where people should be invested, or how.

  1. “I’m supposed to be saving?”
  2. Savings account
  3. Broad index funds
  4. Broad index/mutual fund base with selected stocks
  5. Broad portfolio of selected stocks with rules to prevent panic/manic sales/buys
  6. Broad portfolio of selected stocks and understanding not to overreact emotionally
  7. Concentrated portfolio of selected stocks and understanding not to overreact emotionally

It sounds like TMF EP is at #4 on my list. Saul’s approach is #6. I’m at #5. My friend is between #1 and #2. Each step up the hierarchy gives you the possibility of higher returns, but also requires more knowledge and discipline to minimize spectacular failures.

None of the approaches in themselves are wrong. What is wrong is when a person uses an approach that they aren’t suited for and don’t understand. I’ve been on TMF for a very long time, but am relatively new to this board. So far, I really like it because I see conversation that addresses the limitations of the newsletter services and applies some of the decision making process to a real portfolio, rather than as merely an ever-growing list of picks, many of which should have been dumped long ago.

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Justin,

What a great way to look at the levels of investment knowledge and abilities!

It rang true for me, anecdotally at least, since my own friends, family, co-workers all seem to have a “number” in your list. Incidentally, most are at the 0-1-2 level, which is why Bogle’s is the right approach for many.

For those of us willing and able to look at individual companies and make decisions based on their company financials and business prospects, it may become increasingly difficult to understand why everyone else does not see the benefit in a Saul or TMF approach.

I’m also at the 5 level, just graduated from a 4, but would like to eventually reduce my holdings, too, since they seem more and more to approximate a kind of index fund…

Pete

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I thought about why most fund manager’s can not beat the S&P and I think that some of them could be idiots but most of them are anchored down by the rules they have to invest under and by the people that are invested in their funds.

While it is certainly true that those constraints influence the performance of mutual funds relative to the market as a whole, another factor is that underperformance of the majority is expected behavior. The most one can lose is 100%, but there is no ceiling on what one can gain. Losing 50% is doing extremely badly. Gaining 50% is very nice, but certainly not extraordinary. Consequently, we expect a Pareto distribution of success in the market in which something like 80% will underperform the average and 20% outperform it.

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Andy,

Man, I like your screen name (buynholdisdead). Your my kind of person. I enjoyed your thoughts with respect to the Mutual Fund industry. I have never owned nor will ever own a Mutual Fund.

Have owned and trade ETF’s ever since 1993 with SPY as my first.

People always remember there very first car (Blue 1967 442) they ever bought, but, don’t remember the first fund or stock they ever bought and why.

I still own and trade SPY and compound compound the returns into buying more shares at a lower price and sell at a higher price. SPY is part of my 4 Horsemen (SPY, DIA, QQQ (QQQQ)and IWM). Being a Swing Trader, I let the charts tell me what to do and follow our peers with there hard earned money and decisions. Our peers had a reason to buy as well as to sell the stock/s.

Charts don’t lie, people do.

Just another thought within this great topic.

Quillnpenn -

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0. “I’m supposed to be saving?”
1. Savings account
2. Broad index funds
3. Broad index/mutual fund base with selected stocks
4. Broad portfolio of selected stocks with rules to prevent panic/manic sales/buys
5. Broad portfolio of selected stocks and understanding not to overreact emotionally
6. Concentrated portfolio of selected stocks and understanding not to overreact emotionally

Great thoughts Justin. I do not want anyone to think that I am trying to slay any of the heroes. I just wanted to express my thoughts. Bogle has done some great things by providing cheap index funds but I think he held a lot of people from learning. True there are some people that do not want to learn but I think a lot more are just scared.

Andy

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Man, I like your screen name (buynholdisdead). Your my kind of person. I enjoyed your thoughts with respect to the Mutual Fund industry. I have never owned nor will ever own a Mutual Fund.

Quill, thanks for the kind words. I picked the name buynholdisdead because of all the pundits in 2009 that were going around screaming Buy and Hold is dead. I have no problems with the concept of buying and holding but I do think that everything you hold must be evaluated. I thank Saul for teaching me that. I also do not have a problem with the way that anyone wants to invest. People will put down another person’s way of investing only because they do not understand it. I have seen many arguments on the MF boards where people get really upset just because they do not like a certain way of investing. Most of these are due to a lack of understanding. We all have something to learn, and everyone can teach us something.

I have owned Mutual Funds in the past because the companies I worked for would not let people invest in single stocks in their 401k. The company I work for now though lets us invest in anything within our 401k so I am only invested in single stocks.

Andy

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Hi Neil, Your comments on the Motley Fool One and the Everlasting Portfolio were excellent and intriguing, and got me to thinking, but from a different point of view. I see smart people picking stocks, adding to winners, and generally using good principles for investing. So I ask myself why are their results so poor? Beating the S&P by 23.8% since inception is mediocre at best. It averages about 7.3% per year, which isn’t much for a VERY expensive subscription service. And beating the S&P is setting the bar very low as the S&P is just a mixture of 500 good, mediocre and poor companies.

Saul, I think after all these years you may have lost perspective on how good your performance really is. It’s possibly the best I’ve ever come across. And your record is only matched by your generosity with regards to your investment practices.

I think if you look around, at mutual fund managers, at hedge funds, at most individual investors, at newsletters, at TV shows like Mad Money, etc., you will be very hard pressed to find for than a handful (at most!) with results that match yours. There are a lot of very smart people on the various boards across Fooldom, and I would be willing to bet that your long-term results (not for a year or two, but for decades!) are in the top 1%, if not the top .1%, of every individual investor here.

When I read your words above, the next image in my mind is LeBron James wondering why the rest of the NBA can’t be as good as him. LeBron James averaged 30 points per game this season, the second highest in the league. LaMarcus Aldridge of my Portland Trailblazers averaged 22 points per game, the tenth highest in the league. The vast majority of all the players in the NBA would be extremely happy to have Aldridge’s numbers. But LeBron sits back and asks, “Why are his results so poor? Who would be happy with that kind of underperformance compared to my numbers?”

This is bit tongue in cheek of course, and the analogy is not a great one for many reasons, but my overall point remains. I’m not sure if you understand how amazing, and rare, your compounded annual results are. I think other services and/or styles that have produced good results, though not as good as your own, are sometimes unfairly dismissed on this board. 22 points per game is not 30 points per game, but it’s still a lot better than many people would be able to do on their own. And thanks again for bringing us along for the ride, as I’m definitely shooting for 30 myself, and you’re helping me make it happen.

Fletch

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Saul, I think after all these years you may have lost perspective on how good your performance really is. It’s possibly the best I’ve ever come across. And your record is only matched by your generosity with regards to your investment practices.

That should have read: “…after all these years of outperformance you may have lost perspective on how good your performance really is.”

I think if you look around, at mutual fund managers, at hedge funds, at most individual investors, at newsletters, at TV shows like Mad Money, etc., you will be very hard pressed to find for than a handful (at most!) with results that match yours.

Hi Fletch, Thanks so much for your very kind words!
Saul

Saul,

I’m not sure, but I think are your performance metrics were for a tax-differed account (IRA acount?). If my assumption is correct, it allows you to trim positions from a slower performing stock and move funds around without the tax consequences.

My question is, in a taxed account would you apply the same strategy of going into and out of positions, since real returns in a taxable account need to take the short term and long term capital gains into account, right?

Not critiquing your methodology, but trying to learn. I have both kind of accounts, taxable and IRA accounts.

Kris

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I’m not sure, but I think are your performance metrics were for a tax-differed account (IRA acount?). If my assumption is correct, it allows you to trim positions from a slower performing stock and move funds around without the tax consequences. My question is, in a taxed account would you apply the same strategy of going into and out of positions, since real returns in a taxable account need to take the short term and long term capital gains into account, right?

Hi Kris, Your assumption is wrong. My results are for my entire portfolio which includes numerous family accounts, some taxable, some not, some large, some tiny.

Most things I’d get out of short term would be losses or small gains. If a stock was really doing well I’d be more likely to add to it. If, for some reason, like a major change in the fortunes of a company, I had to get out of a position with a significant gain, I would do it in all my accounts, taxable or not.

Look, normally, if it’s a big gain it would mean I’ve held it for a year at least. It would be rare that I would be selling out of a stock with a significant short term gain. So let’s say I do sell $120 worth of stock on which I have a $20 short term profit. The key is that the tax is not on the whole $120, it’s just on the $20 profit. The difference in the short term tax on that $20 profit and the long term tax might be about $4.00. Should I risk the entire $120, keeping it in a stock I’m worried about, because I’m worried about $4 in taxes? When the stock could easily drop more than that in a week? When I could redeploy the money in something I prefer? I don’t think so.

Saul

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