Torre Financial began as an idea; one that became a reality through action. Ramping up has not been without challenges. I've had to learn and understand the principles and pitfalls of the industry. In a continual effort to do so, I've adapted my investment strategy multiple times. In this letter I'll walk you through the journey that has led us to where we stand today.
Learn from the Best
I was driven to understand how financial markets worked; specifically, how people make money through investing. I had decided passive investing was not for me; there must be an active way to yield better results. The financial industry as a whole seems to be purposefully obscure. Looking for answers, I started reading. I found invaluable insights studying texts from successful investors, including Seth Klarman, Benjamin Graham, Warren Buffet, Peter Lynch, and Howard Marks. Many of these texts have passed the test of time; they continue to be just as relevant today, as the day they were written.
I found all the texts to have one principle in common: fundamentals drive value creation. Although this concept seemed straightforward to me at the time, putting it into practice proved to be a bit more difficult.
Focusing on Earnings
Fundamentals. The most direct manifestation of fundamentals is earnings. Does a company have earnings, and will those earnings continue to grow?
My initial approach to investing focused exclusively on a company's earnings-per-share (EPS). I held a concentrated portfolio of 10-20 companies with a solid earnings. I looked for a history of increasing EPS combined with projected EPS growth over the next few years. Using the EPS and stock price, I analyzed the average price-to-earnings (PE) multiple, over various time periods. This gives insight into the relative valuation of the company. When the current PE is lower than the normal PE, this could signal that a particular stock is undervalued.
Using this approach, I bought in to quality companies at prices below the fair-value. If the price were to drop further, the company would become further undervalued. As long as nothing changed relative to the earnings, the shares would become more attractive. The premise of the investment strategy called for a reversion to the mean. At some unknown time in the future, the shares would return to their normal multiple (or, conversely, the multiple could come down to the price).
A few positions did just that; they dropped. As they continued to drop, I continued to add to those over-concentrated positions. After a reasonable two years, I began to question this approach. Although the overall portfolio performed well, I was not happy with the results. The portfolio had become heavily skewed in certain underperforming stocks. Why had they dropped so precipitously? Will they continue to drop? It was apparent to me that I had missed something in these positions. Earnings is not the only metric for determining quality.
Focusing on Quality
The acquisition of a new client shifted me to a more conservative approach. I decided to focus on only the highest quality companies: those labeled as Dividend Champions, Challengers, and Contenders. These are companies that have consistently paid and raised their dividends for 25+, 10+, 5+ years. Their consistency paid tribute to the solidity of the business. With dividend-paying stocks, the portfolio will be producing income of its own.
Using this reduced universe of stocks, I performed a similar earnings-multiple analysis to identify under-to-fairly valued stocks.
To further diversify and business specific risk, I opened the number of positions. Instead of a concentrated 10-20 positions, I opened up the portfolios to have up to 75 positions. This way, any single position will not weigh down the portfolio.
This approach to investing is much more on the conservative side. No one position moves the needle. But as downside risk is contained, so is the upside. Outperformance becomes more difficult to achieve. The portfolio will more closely track the index.
I found myself questioning the idea of active investing. Taking into account all the extra analysis and effort, the comparative outperformance versus the index may be insignificant. Why not just buy a SP500 ETF?
I can't lie - I did enjoy the stability. However, after a year, I decided to keep iterating. With so many positions, one is inherently investing in mediocre options. Why not only invest in the best 10 of the 75?
In my personal life, I don't like to take on debt. I don't like paying interest. I prefer to produce excess cash and invest, or spend, it as I wish. This basic idea drove the next iteration of portfolio equity selection.
Understanding a company's financial position is critical before initiating a position. While EPS does take into account debt interest payments, it does not take into account the company's net debt. As debt matures, part of the retained earnings will be set aside to pay off the principal. This drag is more difficult to measure through earnings alone. Even if earnings are growing and stable, a highly-leveraged company has little room for error. When times get tough, the highly-leverage company may face the risk of default. A company, flush with cash, with healthy balance sheet, has options to maneuver.
Looking back at previous picks, I identified a pattern. The majority of the underperforming stocks were effectively highly-leveraged. It was the high debt and weak balance sheet, coupled with rising interest rates, that appears to have been driving those companies down. Many of those continue to drift lower today, 3-4 years later.
As the PE drifted lower from the normal PE, I had mistakenly interpreted that as an undervalued opportunity. In reality, value was deteriorating due to increasing debt loads. The market was adjusting to correctly price the risk.
High leverage can be intoxicating and can ultimately cause a business to default. A strong balance sheet, on the other hand, gives a business options to graciously handle any unforeseen challenges. I now rigorously analyze balance sheets and cash flow statements, considering it a critical part of my due diligence.
Bringing It All Together
I consider myself to be risk-averse. I take a defensive approach. My goal is to protect capital from any permanent loss, limiting any long-term downside risk. If I do that well, I believe the upside will take care of itself.
I focus mainly on equities. Equities tend to be a more volatile asset; they also are the asset with best performance over the long term. The best defense I can think of is investing intelligently in great companies at a great valuation. Defense through valuation. Buying a great company at a high price is risky; if things change, it could lead to permanent loss of capital. Conversely, investing in a great company at a low valuation can provide upside. As long as the intrinsic value of the company is higher than the purchase price, you can rest assuredly that over time, the market will value it at it's true value. Intrinsic value is difficult to measure exactly; that is why we rely on a sufficient margin of error, or margin of safety. This may require patience; the stock may dip lower as the trend continues. But with conviction through evidence, we can wait for it to bounce back. It is only a matter of time.
The best way I can do that is to closely analyze companies and make sure to invest in only the best opportunities. The question becomes how can we identify those opportunities.
These market inefficiencies occur because investors are human beings. Investors tend to overreact. Buying a high-flying stock at nose-bleed prices due to fear of missing out happens just as likely as losing hope and selling the last bit of a deeply undervalued stock. Machines can also lead to erratic behavior, and can present opportunities of their own.
We have already mentioned the major components of our due diligence: we need companies with healthy balance sheets, healthy cash flow, and growing earnings. We look for companies that fit our requirements and are undervalued. In addition to these, I have also added company size and subtle technical analysis to the process.
Large companies have more investors. Large companies publish more news. Because of the dynamics, large companies are more likely to be priced correctly by the market. Small and mid-cap companies are more likely to present mispriced, high-quality opportunities. Significant value can be captured be identifying and investing in these before the large institutional investors begin participating.
Although fundamentals drive results in the long-term, the short-term plays by a different game. Financial markets tend to move with momentum. Trends tend to stay in motion until otherwise acted upon. Technical analysis can be useful in navigating those waters. We do not invest purely on technical analysis. Rather, we leverage it to find appropriate entry points. Technical analysis is only applied after an attractive opportunity has been identified.
Torre Financial in 2018
There are many strategies to manage a portfolio. Some are happy with passive investing. Others use strategic asset allocation. Others try to time the market. Hedge funds look for absolute returns, hedging every position. Others look for arbitrage opportunities. Some use high leverage.
This letter gives insight into my investment methodology. The underlying theme is to buy great businesses, at great valuations, to yield great investment results. In that aspect, I manage every portfolio similarly. Nevertheless, each portfolio is managed independently and appropriately as to the client’s needs.
Torre Financial manages over US$800,000. The funds are split between two custodians: Interactive Brokers and Charles Schwab. I manage all of my personal funds in the exact same way I manage client funds. Under a family-and-friends' advisor structure, we have kept the client list small and have not implemented any fee structure as of yet. We plan on registering as an Independent Adviser firm in the first half of 2018. This will allow us to formalize Torre Financial as a business and expand operations.
I would like to thank my clients for trusting me, at such an early stage, with their capital.
Returning to the original question: how do the markets work? Unfortunately, there is no succinct answer. Rather, it is the combined understanding of many moving parts that yields investment acumen. A majority of the understanding can be achieved through experience alone.