Classic: Investing Is About the Whole Portfolio

Classic: Investing Is About the Whole Portfolio

I wrote the following article for RealMoney in August 2005.  I don’t like handing out individual stock ideas.  I would rather teach people how to think about stocks and other assets, because my individual ideas will be wrong 30% of the time, and I will garner a lot of complaints from them.  I will get few thanks from the 70% I got right.  The ratio corresponds to that which Jesus had healing the lepers.

That said, those that invested in this portfolio for two years did well.  Okay, read on:


Klarman: Baupost’s Core Principles Have Helped The Fund Outperform

Seth KlarmanWhen Baupost, the $30 billion Boston-based hedge fund now managed by Seth Klarman, was founded in 1982, it was launched with a core set of aims. Q4 2021 hedge fund letters, conferences and more Established by Harvard professor William Poorvu and a group of four other founding families, including Klarman, the group aimed to compound Read More

I’m not crazy about giving individual stock ideas on RealMoney because all investing is best viewed in a portfolio context. Individual stock ideas are important, but I believe portfolio construction and management are more important.

Too many investors are looking for the next hot company when they should really be looking for a consistent theory of how to produce reliable returns while minimizing downside risk.

In my column Evolution of an Investment Style, I tried to describe how I achieve above-average returns while trying to squeeze out risk. This is not an easy process, but it is achievable if you think about investing in the same way an intelligent businessman thinks about his own firm.

That’s what my seven rules from that column are all about.

One of the first things you’ll notice is that there doesn’t seem to be any rhyme or reason to the order in which the stocks are listed. There is a logic here, but the order is based on the timing of initial purchases. Stocks that I have held the longest are on top, and stocks that I have bought for the first time most recently are at the bottom.

This helps me see on a day-to-day and week-to-week basis, which group of ideas are doing well. If my newest are doing well, there may be some mean-reversion happening in valuations.

If my oldest are doing well, there may be a bit of momentum happening for those that have already reverted to the mean. Because I tend to make shifts to the portfolio quarterly in groups of four or so stocks, I can see themes working out as I look at performance in the order that stocks were purchased.

The Current Portfolio

Listed below are the stocks in my portfolio. They are roughly equal-weighted.

Value With a Twist
David Merkel’s current holdings
Name Aug. 10 Close P/E Yield Market Cap P/E (This Year) P/B P/S
Cemex (CX:NYSE) 46.94 6.99 2.51 16.80 8.98 1.83 1.45
Dycom (DY:NYSE) 23.50 21.08 1.15 20.98 2.01 1.13
Cytec (CYT:NYSE) 48.25 14.87 0.83 2.22 14.26 1.81 1.18
Ameron (AMN:NYSE) 37.25 21.08 2.14 0.32 10.35 1.14 0.49
Allstate (ALL:NYSE) 58.04 11.62 2.04 38.79 9.33 1.74 1.13
Unilever PLC (UL:NYSE) 41.19 19.40 3.51 66.36 13.18 6.90 1.32
Liz Claiborne (LIZ:NYSE) 41.80 14.18 0.54 4.57 13.71 2.43 0.94
Fresh Del Monte (FDP:NYSE) 25.46 10.80 3.91 1.47 10.97 1.37 0.46
Montpelier (MRH:NYSE) 34.27 11.12 4.08 2.17 7.53 1.49 2.36
PartnerRe (PRE:NYSE) 62.92 7.43 2.26 3.47 8.84 1.00 0.84
ConocoPhillips (COP:NYSE) 65.64 9.66 2.07 91.39 8.42 2.00 0.71
SPX Corp. (SPW:NYSE) 45.36 3.75 2.22 3.41 17.43 1.21 0.76
Canadian National Railway (CNI:NYSE) 67.44 16.43 1.26 18.57 15.36 2.44 3.23
Petro Canada (PCZ:NYSE) 79.42 18.95 0.74 20.83 12.13 2.78 1.67
Stone Energy (SGY:NYSE) 53.71 9.63 1.44 7.86 1.51 2.34
Barclays PLC (BCS:NYSE ADR) 42.39 12.67 4.22 68.39 11.54 2.20 2.85
Valero Energy (VLO:NYSE) 90.77 10.74 0.49 23.30 10.14 2.92 0.37
Toyota (TM:NYSE ADS) 78.42 11.93 1.24 128.10 11.12 1.53 0.75
Sappi (SPP:NYSE ADS) 10.88 51.92 2.78 2.46 90.00 1.13 0.50
Apache (APA:NYSE) 71.93 11.09 0.46 23.61 9.46 2.48 3.60
Premcor (PCO:NYSE) 81.05 9.80 0.08 7.24 9.91 2.75 0.38
Ryerson Tull (RT:NYSE) 19.37 6.05 1.28 0.49 5.13 1.05 0.10
Jones Apparel (JNY:NYSE) 29.03 13.14 1.79 3.44 12.10 1.31 0.70
Neenah Paper (NP:NYSE) 31.45 20.09 0.93 0.46 20.09 2.40 0.63
Johnson Controls (JCI:NYSE) 57.46 12.39 1.70 11.03 12.83 1.91 0.39
Japan Smaller Capitalization Fund (JOF:NYSE) 11.81 5.20 0.19 50.00 0.98 108.19
Pfizer (PFE:NYSE) 26.39 20.04 3.43 196.20 13.39 2.92 3.70
Sara Lee (SLE:NYSE) 20.02 13.31 3.83 15.76 13.51 4.61 0.80
Repsol (REP:NYSE) 29.61 14.95 2.19 36.15 8.98 2.00 0.80
Premium Standard (PORK:Nasdaq) 14.76 6.70 0.41 0.46 9.07 1.10 0.40
Anglo American (AAUK:Nasdaq ADR) 26.72 11.68 2.62 39.62 10.32 1.59 1.53
ABN AMRO (ABN:NYSE) 24.73 11.54 7.52 41.28 10.25 1.78 1.61
Gold Kist (GKIS:Nasdaq) 18.93 8.60 0.97 7.86 2.46 0.90
Dana (DCN:NYSE) 15.01 11.73 3.12 2.26 12.92 0.98 0.24
SABESP (SBS:NYSE) 17.14 8.00 4.52 1.95 10.05 0.54 0.98
11.68 2.04 4.57 10.97 1.81 0.90
Source: David Merkel, Yahoo!

This Portfolio Is Weird

Even though I manage this portfolio the same way that a “long-only” mutual fund manager would, because my portfolio is diversified by country and capitalization, it doesn’t fit any of the neat classifications common to mutual funds. I’m not running a mutual fund for which I’m anxious to gather assets, so this doesn’t bother me. Given that, I will now describe the way the portfolio breaks down by country, capitalization, sector and industry.

A notable characteristic of the portfolio is that 34% of it is non-U.S. Even adding back the two Bermuda reinsurers (which only trade in the U.S.), the percentage foreign is 29%. This is high enough that it would be hard to call this a domestic fund, but low enough that it can’t be an international or global fund. Why do it this way? Because I believe it offers the best returns to a U.S. investor. I try to buy stocks that operate in stable parts of the world, with reasonable legal systems. I consider information, war and expropriation risks. When something outside the U.S. seems too cheap, I buy it, but I don’t force myself to stay inside or outside of the U.S.

My approach to market capitalization is not as idiosyncratic. I am “all capitalization,” which is done by a number of mutual funds. I am probably more large-cap now than I have been in years. Small-caps generally don’t offer the valuation discount that I like to see when buying something off of the beaten path. Mid-caps I normally like best, because they typically have the stability of large-caps, but still have enough potential to grow, like some small-caps do. At present, many large-caps seem quite cheap, so I have more of them than normal.

The most important thing to look for in market capitalization is rule No. 4 from the column I mentioned above: “Purchase companies appropriately sized to serve their market niches.” Some businesses need scale in order to be profitable. Other businesses favor the entrance of smaller competitors following a niche strategy. “Is the business the right size in order to prosper?” is a question that intelligent investors ask.

Sector/Industry Mix

Looking at both the sector and industry mix, Jim Cramer would probably gong me in his radio show’s “Am I Diversified?” segment. Well, no, I’m not diversified, at least not by sector and industry. I can hear the comments: Where’s the tech and telecom? Pfizer is not enough for health care. Only one utility, and that one’s in an emerging market? You’re too overweight in materials and energy. Agriculture has been a loser for years. You’re joking, right?

I’ve always run an undiversified portfolio, because intelligent sector rotation can add value. Industries tend to trend in the short run and revert to the mean over the intermediate term. I try to analyze where the pricing power of industries is as I evaluate companies for investment. There are two things that get me primed for purchase:

  • Things are abysmal and no one wants to invest there. (Think of auto parts.)
  • Or, stock prices have not caught up to the industry pricing cycle. (Think of energy.)

That’s how I view it. I want to be in industries that are underrated, whether that’s due to a bruising bear market in an industry, or because of an abundance of skepticism in the face of improving fundamentals.

Valuation Parameters

The summary statistics of my portfolio are shown in the table below.

The Numbers at a Glance
Category Median Value
P/E last year 11.7x
P/E this year 11.0x
P/E next year 10.4x
P/Book 1.8x
P/Sales 0.9x
Yield 2.00%
Range 72%
ROE 18%
Source: David Merkel

You can tell that my portfolio broadly fits into the “traditional value” style. I like my modified form of Graham and Dodd, with tweaks from Marty Whitman and a number of other notable value investors. That said, it’s my unique synthesis, and it has paid off for me in performance. Buying them cheap is critical to both good performance and risk control.

You might adopt my style or you might not; it takes some effort to do well with it. But the important thing is thinking through your portfolio management process to make sure that it’s fundamentally sound, businesslike, intelligently contrarian and something that fits into the way you live your life. Life is broader than investing, and management techniques must be small enough in time use for them to be a part of a broader, well-balanced life. You have my best wishes as you work out your own investment management style.

Full disclosure: still long VLO, IBA, JOF

By David Merkel, CFA of alephblog

Updated on

David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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