The year 2020 marks the first year that I am choosing to calculate and document my investment returns. While I have been investing for a decade it was only near the end of 2019 that I really settled on an investment strategy and process that I believe fits me. I now have an investment process that matches my personality, temperament, and can form the baseline for managing money for clients.
Therefore, 2020 marks the beginning of my investment journey where I am managing my portfolio in a professional manner with a methodical approach that can scale to managing millions of dollars for outside investors. Below, I report my annual returns for 2020 not because I believe they are meaningful, but because they are one data point on what I plan to be a long journey of profitable outperformance over the coming decades. One year is simply too short of a time frame to judge the success (or failure) of an investment or investing process. While 2020 marks both a relative and absolute performance success, I know that true skill is demonstrated over many years, not a single year.
My total gross return in 2020 via a Time-Weighted Return approximation was 22%. (See: Appendix Note #1) This compares favorably to my absolute return hurdle rate of 10%, which I use as my discount rate for intrinsic value calculations. In addition, while I don’t personally care about my performance relative to the S&P 500, I know that potential future clients may insist on such a benchmark. The above comparison is provided purely for informational purposes only as my investing process completely ignores the S&P 500 and I believe it to be highly non-correlated.
My investment portfolio outperformed the S&P 500 by 3.7% (22% personal return compared to the S&P 500 return of 18.25%.) For the purposes of comparison, instead of using the S&P 500 index itself (which you can’t directly purchase), I am using a vanguard index fund which you can: VFINX. While the shown S&P 500 return is inclusive of fees, the fees are low as is common for Vanguard Index Funds. I believe this is much more useful because any potential clients always have the opportunity cost of being able to choose to invest in an index fund as an alternative to investing with me.
Everything I did wrong in 2020
It is common practice in these annual letters to discuss one’s investment decisions, what went well, what went wrong, and a future outlook for the coming year. While each of those areas provides some small value, the disproportionate value to a reader comes from learning from investment mistakes. Likewise, the disproportionate value to me as an investment manager is to recognize, write about, and learn from my personal mistakes. Therefore, considering the following my attempt to outline the lessons I have learned in as clear a manner as possible.
Mistake #1: I let Macro Calls influence my Micro Investment Decisions
During January, I recognized the threat that COVID could play in the world economy and the markets. Although I was ahead of the rest of the market in recognizing the threat of COVID, I drastically misplayed this knowledge. I thought that COVID would lead us potentially into a great depression type scenario.
On the one hand, this should have offered me the opportunity to sell out of stocks prior to the March 2020 crash due to my informational and observational advantage. However, I failed to do so because I was trying to rely on the wisdom of not timing markets.
Yet, when the crash actually began in March 2020, I quickly began to sell some of the stocks that I should have sold 20-30% higher if I truly believed a great depression was on the way. This was a reversal in my prior conviction to not let macro views change my investment portfolio. Fortunately for my performance, I chose to reallocate this capital into other stocks and maintained a 100% stock portfolio and fully invested through the March and April timeframe.
The entire experience during March through May demonstrated that even if you can predict one aspect of a Macroeconomic environment it is impossible to predict exactly how markets will play out. I was correct that Coronavirus would grow from 1 infection in the United States into millions. I was wrong in predicting how governments would shutdown the economy. I was wrong again after seeing how the shutdowns occurred in predicting a 50%+ decline in the stock market.
Although I made many positive investment choices during the crash itself and focused on increasing my attention on high quality stocks, this time was rampant with mental mistakes. Even if I didn’t allow those mental errors to create stock trading errors, it was a mistake to even have forced myself to be exposed to such macroeconomic risks.
Lesson Learned: I plan to focus primarily on higher quality companies going forward. I want to own stocks that are setup to succeed in all macroeconomic environments. Companies with high debt loads or cyclical exposure to the economy are less attractive to me than they were before the year began.
Mistake #2: As volatility spiked in March and April, I began executing a few successful short-term trading strategies
During the last ten years investing, I have studied, researched, and invested in numerous companies over the years. The crash of March 2020 offered entry points into some of those former holdings at extremely attractive prices and I felt that the volatility in the markets would allow me to capture massive short-term gains by trading them through the volatility.
Each of the trades I executed in this area was extremely profitable, but I now feel they were a mistake. They were a distraction.
One example was a trade I executed at the beginning of April. As I don’t advocate buying this company to anyone and no longer own it, the company will remain nameless as I don’t want to encourage any buyers. On April 3rd, I was able to buy a large position in a company at a double-digit dividend yield in a REIT. I knew this was unreasonably cheap because the dividend was extremely safe due to tax laws requiring REITs to payout 90% of earnings as dividends. In addition, the REIT had experienced practically zero declines in revenues due to COVID.
By April 13th, I liquidated my entire position for a 30% gain.
Why then was this a mistake? Two reasons:
- I was wrong about the dividend. Shortly after I sold and within weeks, the company managed to slash the dividend significantly. I believe management was 100% in the wrong in this decision based on the facts at hand, but it was definitely something I had never expected. If the timing had been slightly earlier, my margin of safety would have evaporated.
- It encouraged short-term trading behavior. Yes, I made 30% in a week, but I wonder how many long-term holdings I ignored or delayed buying as I focused on short-term trading maneuvers. Many companies are up 3, 4, 5x since the March lows. Perhaps I could have found and owned one of those instead.
Mistake #3: I bought and owned a closed-end fund below Net Asset Value
The first new stock I bought in January of this year was a company called 180 Degree Capital Corporation or $TURN. 180 Degree Capital is a closed-end mutual fund focused exclusively on investing in microcap companies with an activist mindset. When I began purchasing shares, they traded below Net Asset Value and had a lot of optionality due to some private company assets.
The problem was that I lacked conviction in this purchase. I was buying shares simply to reach a 100% invested position. I liked management and I knew that a focus on microcaps offered substantial ability to outperform the market. However, I didn’t like the level of management compensation and I didn’t like some of their primary holdings.
When the market crash began in March, I sold out at a loss. I thought Net Asset Value was my margin of safety, but the companies were largely weak retailers that faced massive COVID risk. Without the ability to directly calculate look through earnings or manage those stocks myself, I realized I no longer had the conviction to hold the stock.
Lesson Learned: I don’t want to own Closed-End Mutual Funds unless I can take a controlling stake and manage their underlying investments myself. Even when trading at below net asset value, your margin of safety is illusionary. It is impossible to understand in real-time the risk exposures you have.
Mistake #4: I wasted time and focus on Large Cap Companies
There is substantial research that, however flawed it may be, indicates a large return premium for small cap and micro cap stocks over large cap stocks. However, I spent much of Q1 and Q2 of this year trading in and around large-cap stock positions like ExxonMobil and Discover Financial.
At the time, each of those decisions made sense. The companies were clearly undervalued and I knew that they would rise in price in the future. Each had a low risk of default due to COVID and a high probability of future positive returns. In other words, these investments offered asymmetric risk and reward.
The problem was that they were simply the most visible opportunities. They were not the best opportunities. While I risk suffering from hindsight bias here, I should have known at the time that my best opportunities existed within Microcaps. While they may have required more work to find, the returns would have likely been substantially higher.
Most of the microcap focused investors that I know substantially outperformed me this year due to their greater positioning in the space prior to the massive runs since March. Could this have been predicted? Not reliably on any sort of specific timeframe. Yet, I knew that when comparing my microcap holdings and my large cap holdings, the microcaps appeared substantially more attractive.
Lesson Learned: Fish where the fish are fatter and where no one else is fishing. Concentrate on your winners.
Mistake #5: Failed to buy a stock I knew was attractive because I wanted a lower price
This mistake will be discussed in more detail in the premium version of this post available exclusively for Patrons. I discuss the specific stock that I now own, but chose to pay up over 200% higher of a price because I failed to buy when I should have.
Basically, in March and April I identified a high-quality company traded at a very cheap price. Yet, my macro predictions made me feel I could get an even better deal 10% lower in price. Since then, the stock has tripled and I find myself buying at much higher prices.
Lesson Learned: Buy when you know you have a good enough deal. Don’t try and bottom tick the price.
Mistake #6: Too Much Diversification
This mistake will be discussed in more detail in the premium version of this post available exclusively for Patrons. I’ll discuss the specific companies I’m referring to in this section.
Basically, I spent the year holding companies in my portfolio that were substantial losers primarily to increase the diversification of the portfolio. I wanted to own 5 stocks because I felt like 5 companies were needed to provide diversification. Yet, I don’t have 5 equally good ideas. I currently only 3 companies that I truly believe in for the long-term future. Why do I own 5 stocks? Why do I still own those 5 stocks?
My returns would have been astronomically better if I simply concentrated only on the companies that met literally every box on my checklist. This has nothing to do with the actual results here and everything to do with the process. My process failed me. I had/have a mental block keeping me from concentrating my portfolio to match my current opportunity set. That is an area for improvement in 2021.
Lesson Learned: I need to work on not settling. Charlie Munger was comfortable owning only 3 stocks and I should work towards being more comfortable with a lower number of companies. Not as a target. I prefer holding 5 stocks today, but if I have to choose between 3 great companies and 2 good companies, perhaps I should simply own the 3 great companies.
Mistake #7: Too Slow at Deciding to Sell
When 2020 began I knew that continuing to own Pipestone Energy (BKBEF) was probably a mistake. They’re a small-cap oil exploration and production company in Canada. They have all sorts of growth opportunities, but they don’t really have any margin of safety.
The initial investment in the company was a mistake and I was down a lot on my position. I’m talking about somewhere around down -50 to -60% to start the year. When COVID hits the position only deteriorates further and in March I decide to ADD to my position instead of sell. The company was just “too cheap” based on future potential.
This was a mistake I shouldn’t have made. I should have known better. The company ended up dropping an additional 50% before I liquidated the position in April.
While the actual dollars involved were small relative to the rest of my portfolio, Pipestone Energy took on the greatest mind share in my portfolio from January through April until the day I sold it. This sell decision was perhaps the best decision I made all year. It has nothing to do with the dollars involved and everything to do with the freedom to think and find new positions.
Lesson Learned: Sell your losers as soon as you know they are losers. Don’t hold on hoping for a rebound. If you’ve lost conviction in a company don’t double down simply because the company is so much lower than you bought it at.
Mistake #8: Focusing solely on the downside (Ignoring the upside)
As a value investor, I have spent my investing career with a supreme focus on downside protection. I want cash on the balance sheet, I want earnings, and I want growth. All good things. However, a supreme focus on margin of safety can cause you to ignore potential upside in each stock.
There is a substantial difference in the risk / reward for a company if you have 100% upside or 1,000% upside. Even if both companies trade at similar P/E ratios or have similar margins of safety, too often I have ignored the value of growth and the optionality of good capital allocation by management.
I no longer want to make this mistake. For 2021, my primary focus will be making sure that I always evaluate the upside as a critical part of my investing process.
My best investment in 2020 was made when I clearly built a thesis for massive upside. Discussion of that specific stock and the rest of my portfolio is available only on the premium version of the letter for Patrons.
My Current Investment Portfolio, Thoughts on each Holding, and 2021 Outlook
The remainder of my 2020 Annual Letter discusses my personal investment portfolio, my current holdings, and how I plan to execute my strategy over the course of 2021. I am excited about my potential return prospects in 2021 and am optimistic about beating my 2020 performance of 22%.
However, the rest of the letter will be available exclusively to my premium subscribers. Interested investors can read my full letter here if you’re a $25/month Patron member. You’ll also gain access to my other private investment research published on this site behind a paywall.
Appendix
- My investment calculation is an approximation of a true Time-Weighted-Return because I lack sufficient data to calculate an exact time-weighted-return. Since I only have monthly data (Starting Balance, Ending Balance, Portfolio Change, and Net Contributions), I have to approximate the return on a monthly basis. I have chosen the Bernstein Formula that originates in the “The Four Pillars of Investing” book by Bernstein. This methodology takes into account that contributions take place at various parts of the month by splitting half of the net addition at the beginning of the month and the remaining half at the end of the month. Monthly return = (Ending Balance – Net Additions/2) / (Beginning Balance + Net Additions/2)-1. The final step is for each month’s return to be geometrically linked to determine the full-year annual return.
