Author: Patrick Larkin
Covestor model: All Cap Value
I would like to begin this opening post by thanking Covestor for the opportunity to manage a model on their innovative platform. It has been a pleasure working with Eric and other Covestor staff members in preparing for the launch of my model. I look forward to a long relationship that will be rewarding to all parties involved, particularly Covestor’s clients and my future subscribers.
If you decide to invest with me it is important that you share my objectives and my time horizon. The objective of my All Cap Value model is to earn the highest annualized rate of return possible over a five-year time horizon, without taking reckless risks. To be more specific, my goal is to beat the S&P 500 by at least five percentage points on an annualized basis over the coming five years, and to preserve purchasing power after fees and taxes over that same five year time frame.
The second goal is necessary because I will not be satisfied with beating the S&P 500 by five percentage points if, for example, the market is down 7% annualized over the five year time frame. Subscribers can’t retire or send their kids to college on S&P 500 outperformance. Optimally, I would like to compound at 15, 20, or 25% if those figures are within reach. However, I won’t fall victim to common behavioral pitfalls such as loading up on “lottery” stocks and relaxing my investment criteria in an effort to “get back to even” should I fail to keep pace with my goals for a period of time.
There’s a great deal of discussion right now about how difficult it is to invest in the current equity market environment. Volatility has been high and variable, and the returns on individual stocks have tended to be highly correlated with each other. The only view that I hold on future volatility is that the volatility of changes in market prices will exceed the volatility of intrinsic values, and that this will provide opportunities to investors who focus on intrinsic value.
I hold a long-run view on correlations. In due time, stocks that are selling at low prices relative to the present value of the cash that they can generate for their owners will rise in value, regardless of what the market does. One reason for this is that even if the public markets remain irrational for an extended period of time, private buyers have shown a propensity to step up and take advantage of opportunities to make win-win transactions. And in time, I believe Mr. Market will return again to a state of euphoria, ready to pay top dollar for quality companies.
One of the biggest risks that consumers of investment management services face is agency risk – the risk that your manager’s interests are not well aligned with your own. The best way to minimize this agency risk is to invest with a manager who “eats his own cooking.” I have over 60% of my family’s total wealth invested in an account identical to my Covestor model. The remainder of our assets consist of retirement accounts, home equity and cash equivalents. I don’t anticipate that my personal commitment to my Covestor model will change substantially, but should it change I will alert you in later posts on this forum.
My performance since the model’s inception on Covestor on August 17th, 2011 has been mediocre. The market has so far failed to see things the same way that I do, though I am confident that the future operating performance of the firms in the portfolio will bring the market around in time. The portfolio is currently heavily weighted toward large cap names, but this could very well change over time as quality large caps become more fully valued.
The largest holding in the portfolio is Microsoft (MSFT), a firm that generates boatloads of cash from its effective monopoly in the lucrative PC operating systems and applications markets. The biggest fear with Microsoft is that they will blow their huge cash hoard on overpriced acquisitions. While that is a possibility, I think that is equally possible that they will experience runaway success with other projects such as Kinect for Xbox 360 and their mobile phone partnership with Nokia.
Assuming that Microsoft will generate a net present value of zero from future acquisitions and other investments in growth, the stock appears grossly undervalued based on normalized earnings power value.
My second biggest holding is Berkshire Hathaway (BRK-B), the Warren Buffett’s fortress conglomerate that trades below 1.2x book value. I estimate that Berkshire has between twenty five and fifty percent upside from current levels, with minimal risk of permanent capital loss.
Rounding out my large-cap holdings, I am long two undervalued integrated energy names – Conoco Philips (COP) and BP (BP) – two other beaten down and unloved tech giants with very strong competitive advantages – Hewlett-Packard (HPQ) and Cisco(CSCO) – and formidable medical device and system maker Becton Dickinson (BDX).
Turning to my smaller and less well known holdings, I particularly like home health care provider Almost Family (AFAM). The stock was hit hard in 2011 due to actual cuts in Medicare reimbursement, fears of more drastic cuts, and potential sanctions for gaming the Medicare compensation schedule. However, the firm is a strong cash generator, has a clean balance sheet, and so far appears likely to escape crippling liability in the compensation gaming case, although the investigations continue. We aren’t going to stop caring for the elderly and disabled, and getting patients out of the hospital and into home care as quickly as possible provides the system with substantial savings.
Finally, interested readers can find very detailed write-ups on The Howard Hughes Corporation (HHC), LoJack Corporation (LOJN), and the Bank of Ireland (IRE) on my personal blog.
Happy New Year and health, happiness, and prosperity in 2012.
