Image: In late December, we increased the position in Facebook (FB) while shares were in the mid-$130s. The stock is up huge since then.
Order Value Trap here.
Hi everyone,
I’m still enjoying my get-away. It feels like it has been about 8 years since I’ve been able to totally tune out of the markets for a day or two, but here I am writing to you anyway. I really appreciate your being there. I really mean it. Today, I wanted to talk a little about concentration bets.
First, however, I want to emphasize the importance of diversification. I’m not going to go into the quantitative explanation, but rather, keep it really simple: it’s better not to put all your eggs in one basket. I view a diversified equity portfolio as one with at least 15-20 ideas, including a few diversified ETFs in areas that are more homogeneous (e.g. healthcare, energy).
When I’m talking about concentration bets, I’m talking strictly with respect to one’s idea consideration within a very diversified equity portfolio within the context of other assets. For example, besides an equity portfolio, a healthy dose of high-quality corporate bonds and certificates of deposit coupled with private-business exposure and cold hard cash may constitute a very good diversified mix of assets.
That said, as it relates to your equity portion, if you’re starting to get to a 50-stock portfolio, or even higher than that, you’re basically approaching the characteristics of an index, and what some may call “di-worsification.” Very few investment teams can possibly know their 50th-favorite idea better than their top idea. It’s just a matter of resources, and some ideas are just more straightforward than others. Okay–now to a discussion about concentration bets.
Let’s take our top idea in the Best Ideas Newsletter portfolio, Visa (V), for example. As of December 15, 2017, the company was weighted at 8.6% of the Best Ideas Newsletter portfolio at under $113 per share. While the broader markets have practically gone nowhere since then, it has absolutely surged [Visa is up ~50%, while the market is up about 10% over that time.] This is what you call a concentrated bet, and it has paid off. This is a fat-pitch investment, one that members swung at and hit out of the park.
We like to overweight our best ideas and underweight some of our less-favorite ideas to form what we think is a solid portfolio targeting capital appreciation (as in the case of the Best Ideas Newsletter portfolio). Though some value-focused managers may be comfortable with positions that approach 20% of a portfolio, we generally won’t let our favorite ideas expand past the range of 12%-15% of the portfolio, and we’d never start a position at that level. We usually start positions we like a lot in the 5% range. Visa has been a huge home run.
Let’s shift gears a bit. In the summer of 2018, one of our other top-weighted ideas Facebook (FB) had a relatively disappointing quarter, and for some reason, readers became confused as a result of Facebook’s massive decline heading into the end of 2018. Through the entire decline, however, I was saying that Facebook is giving members a gift once the tide turns. Those that sold Facebook on the way down fell into the same trap that are causing so many active fund managers to underperform.
Look – Facebook has a huge net cash position on the books and generates tremendous amounts of free cash flow and is trading far below a reasonable estimate of intrinsic value. You don’t trade this company like Tesla (TSLA) or Netflix (NFLX), for example, where one might jump ship on a large decline. Know the difference. Facebook was trading at ~$178 per share on December 15, 2017. Do you know what that means? Facebook’s stock is up about 6% since we migrated to weighting ranges. Not that bad; our “average cost” is far below the price from December 2017, too.
But here’s where this story gets better, and this is really where we hit the ball way out of the park with Facebook for our members. In December of last year, we took the Best Ideas Newsletter portfolio to “all-cash,” further adding to the position in Facebook in the mid-$130s! The stock is up nearly 40% since that time, to just under $190 per share, and has been one of the best performing companies in the S&P 500 during 2019. You wouldn’t know this if you’re reading the latest news though. The media makes it sound like Facebook is going under.
When your two concentrated bets are doing this well in 2019 (Visa and Facebook), you know you’re doing well. I mean you’re doing great! Look – the market was absolutely just plain silly on Facebook’s shares last year. I simply cannot help it if others want to focus on noise and not on balance sheet analysis and future expected free cash flows. That’s their loss. We perform equity analysis here, not speculate on price movements. Facebook has, is and continues to be a gift to our members.
Here’s what you need to know: An undervalued stock that is declining is worth watching, but only if it has a huge net cash position and is expected to generate gobs of free cash flow, backed by secular revenue growth. Facebook is growing rapidly, and people are going to be using social media for a long time. Increased regulation will only make Facebook stronger as new entrants are shut out, too.
This situation is different than a company like GameStop (GME), for example, which is facing structural issues with respect to its physical used-game business, and whose operations are not growing (revenue dropped more than 13% in its last quarter). Facebook is very healthy with a bright future. GameStop, on the other hand, is dying on the vine with perhaps the only out for investors being private equity. It may seem like a similar situation, but it is vastly different.
I want you to think: undervalued stocks on an enterprise valuation basis whose underlying business is growing fast, benefiting from secular growth trends, with solid free cash flow generation, huge competitive advantages, and whose technicals and momentum indicators are just starting to turn. In addition to waiting for an undervalued stock to turn higher, demanding strong GAAP revenue growth on such undervalued ideas will help separate great undervalued ideas from the value traps.
Most of all, however, stocks aren’t just squiggly lines on a chart or some aggregate factor composition made up of size and B/M ratios, but rather they are real companies that generate real free cash flow and have real cash on the balance sheet. I sincerely hope that you are having one of the best years yet. If performance of our top two ideas is any indication, you are crushing it, and that doesn’t even consider the great idea generation of the Exclusive! Not one dividend cut in the Dividend Growth Newsletter portfolio since inception, too!
Thank you so much for being here. We’re making a huge difference in this industry.
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Brian Nelson, CFA
President, Investment Research
Valuentum Securities, Inc.
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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum‘s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.