Saturday, January 5, 2013

How I Beat the Market Over the Past Five Years

I don't make a habit of checking my portfolio's performance, but it being a new year and all, I decided to log onto my U.S. broker's website and check on my performance as of the end of 2012.

Over the past 1, 3, and 5 year periods my mutual fund investments were just slightly ahead of the market average. I was okay with that, however, since I own mutual funds (and a few ETFs) primarily as an insurance policy on my stock-picking efforts (if I royally mess up, the thinking goes, at least I'll earn the market return elsewhere) and to fill in any gaps in my portfolio.

Fortunately, the performance of my brokerage (non-fund) holdings was pretty good:

As of Dec. 31, 2012; Personal rate of return via broker's website; S&P data from Reuters
Admittedly, the one year figure is nothing to write home about, but I'm more focused on the five-year returns, which I consider to be a better length of time for evaluating investment performance* as it greatly reduces the effects of chance in results.

As such, I thought this was a good opportunity to review what worked and didn't work for me over the past five years.

What worked

Keeping transaction costs to a minimum: Over the past five years, I made fifty transactions in this account -- most of which were buys. Transaction costs were well below 1%, leaving more money in my pocket and less in my broker's.

Regularly reinvesting dividends: In most cases, I automatically reinvested dividends back into the stocks that paid them. There's some debate about whether you should automatically or manually reinvest dividends, but automatic worked best for me. I might have been able to redirect dividends to better opportunities elsewhere in my portfolio, but I could have also misallocated the money or waited too long. Looking back at my reinvestment prices, I picked up some additional shares at really good prices during the financial crisis, Greece worries, etc. when I might not have otherwise.

Buying from forced sellers: Unsurprisingly, some of my best performing picks came during the financial crisis of late 2008 into 2009 -- among them, Philip Morris International, Home Depot, Kinetic Concepts, and AmTrust Financial. The pickings during that time were, in hindsight, incredible and I wish I had invested more aggressively. I don't think I did anything special during that period other than put money to work in quality names and let them take care of themselves.

That was a rare market, however, and it's not often that we can buy from forced sellers. The key, then, is to always have some cash ready to take advantage of those opportunities. Fortunately, I did have a good amount of cash available during the financial crisis, having sold a few big winners in mid-2008 such as Core Labs and Sun Hydraulics (I own SNHY again today).

Being opportunistic: While forced selling situations don't come around often, I took advantage of a number of opportunities where the market soured on specific names or sectors. In fact, I love it when the market gets down on a competitively advantaged company due to either a temporary setback or another reason outside the company's control.

For example, I picked up shares of Tradestation in August 2010 at a time when the market was down on brokers due to the low rate environment and depressed trading revenue. (Indeed, many broker share prices remain depressed today for the same reason.) However, TRAD had some special assets that the other brokers didn't -- an advanced trading platform that catered to active traders, as well as a deep database of derivatives pricing history. It also had a great balance sheet and was small enough to potentially be a nice bolt-on acquisition for a larger company. Fortunately, TRAD was acquired in 2011 to register a 60% gain in my portfolio.

Focusing on singles and doubles, not home runs: While it's true that a few big winners can make up for a lot of losers, taking flyers on speculative companies just doesn't fit with my investing temperament. If I tried to employ such a strategy, I would have probably made many more mistakes along the way, getting nervous if the investment went against me, etc. and realized more permanent losses of capital.

Instead, I focused on buying companies with substantial competitive advantages that had temporarily fallen out of favor. When the market corrects its mistake, the quality companies may generate a 50-100% return as opposed to being a multi-bagger as a speculative company might, but I also don't lose any sleep in the process.

Not being afraid to take gains: Two of my stocks were acquired at nice premiums over the past five years, but I also made it a practice to sell stocks that shot 15%+ beyond my fair value estimate. It's true that you shouldn't cut your winners and water your weeds, but it's also true that a paper gain is just that until it is sold and turned into cash. Don't be afraid to prune a little where necessary and put the cash to use elsewhere.

What didn't work

Before this spirals too far into becoming a self-congratulatory piece, I did make some significant mistakes along the way that I think diminished my five-year results.

I made some emotional decisions: I bought Home Depot around $24 in 2008 for the right reasons, but sold it for a 30% gain in 2010 after I'd had a bad experience shopping at Home Depot. Though Home Depot may have terrible customer service -- and it certainly does most of the time -- American homeowners don't have much choice when it comes to shopping for home improvement goods, as the scale advantages that HD and Lowes have keep competition at bay. Poor customer service doesn't matter all that much if there aren't many other places to take your business. Had I held on through today, I'd be sitting on at least a 160% gain. Stupid. Whatever I rolled those proceeds into hasn't performed nearly as well.

I didn't invest enough in my high conviction ideas: Great ideas don't come around often, and when they do, it's important to take advantage and invest more capital than you normally would in other stocks. Over the past five years, I missed some opportunities to do just that. While there's surely some hindsight bias there, there were few massive surprises in my portfolio -- my best ideas generally outperformed my good ideas -- and I should have invested more in my best ideas.

I bought some things for the wrong reasons: In early 2009, I was convinced that we were headed for rapid inflation, so I bought the iShares TIPS ETF. Trying to be clever with a macro-call here backfired. While I generated a ~10% return from that investment, I could have done better in just about any stock at the time given it was near the nadir of the bear market.

I also bought shares of Pfizer in 2008 primarily because it had a very high dividend yield and a long track record of making payouts. Unfortunately, the company cut its payout in January 2009 after it acquired Wyeth, quickly souring my investment thesis. Getting burned here did inspire me, however, to dig deeper into why companies cut their dividends and probably saved me from future mistakes. A small price to pay for a good lesson, I guess.

What matters now

Hopefully my results show that a) individual investors can, in fact, beat the market in the longer-term, b) that you don't need a complex algorithm or be a professional trader to do so, and c) that a conservative and patient approach can deliver great results.

That's said, what's done is done. The past is the past. Though I'm very pleased with how my portfolio performed over the past five years, I'm more focused on not repeating the same mistakes over the next five years. If the market teaches us anything it's that past performance is not indicative of future results, so I'm reminded not to get lazy or cocky, but rather to stay focused.

Hello 2013!

I hope everyone had a happy and relaxing holiday season. The Mrs., the hound, and I spent our holiday driving nearly 2,000 miles across seven states to visit friends and family in Virginia and Ohio.

It was close quarters in the rental car, for sure. :)

Backseat driver


Here's to a great start of 2013. As always, please post any comments or questions you might have in the comments section -- or better yet, on our Google + community page on dividend investing.

Best,

Todd
@toddwenning on Twitter

*On the importance of using five-year returns as a means of evaluating investment performance: Diamond Hill Investment Group