Portfolio

I think there are at least three viable paths to achieving above-average returns over a long period of time using what most would call "value investing" principles. I put "value investing" in quotation marks because, as Mr. Buffett pointed out in his 1992 letter to shareholders:

…we think the very term "value investing" is redundant. What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).

So, semantics aside, I see three viable yet distinct approaches to successful investing.

1. The Coffee Can approach
2. The Non-magic Formula approach
3. The Special Situations approach

I deploy all three. I think of this as an experiment. At the time of writing (January 2025), my objective is to manage three distinct portfolios and see which one over the next 3, 5, 10 year periods delivers above-average results.

Whether I can stick to this three-pronged approach will likely come down to my ability to keep things simple.

Time will tell.

The coffee-can approach

But there is surely some young person in your life whom you can share the wisdom of long-term investing with. Tell them about the coffee-can idea ... .Make them wise to the ways of Wall Street.

Chris Mayer, 100-Baggers, p.21

I came across the coffee-can portfolio concept while reading Chris Mayer's wonderful book, 100-Baggers. According to Mayer, the concept originated with Robert Kirby in 1984. He was a portfolio manager at Capital Group and wrote about the idea in the Journal of Portfolio Management: "'The coffee can portfolio concept harkens back to the Old West, when people put their valuable possessions in a coffee can and kept it under the mattress… The success of the program depends entirely on the wisdom and foresight used to select the objects to be placed in the coffee can to begin with.'" (p.15)

The idea is simple: you find the best stocks you can and let them sit for 10 years. You incur practically no costs with such a portfolio. And it is certainly easy to manage. The biggest benefit….it keeps your worst instincts from hurting you. …[It is] designed to protect you against yourself – the obsession with checking stock prices, the frenetic buying and selling, the hand-wringing over the economy and bad news. It forces you to extend your time horizon. You don't put anything in your coffee-can you don't think is a good 10-year bet.

Chris Mayer, 100-Baggers, p.16

This is the one portfolio (or strategy if you prefer to think about it that way) that I will continue for as long as I'm in the game. It aligns with my personality, and it's the only surefire way I know of to build a low-maintenance compounding machine that has a chance of generating above-average returns over long periods of time.

How the Coffee-Can works:

1. Assemble a concentrated portfolio (< 20) of high quality businesses with lots of room for growth run by Outsider-like management, purchased at "very attractive prices."
2. Plan to hold them for at least a decade.
3. Sell only when the underlying business no longer meets your quality standards.

Why the Coffee-Can works:

1. It's tax efficient.
2. It's cost efficient.
3. It's easy to manage.
4. It's designed to protect you against yourself.
5. It forces you to extend your time horizon.
6. It requires you to think like an owner, not a speculator.
7. It's the opposite of what Wall Street does.

Why the Coffee-Can is difficult:

1. Selecting the right companies can be the hardest part, especially if analyzing companies and investment opportunities isn't your full time job. It takes time to get to know a business, to understand its competitive advantages or lack there of. It takes an ability to imagine a future that's vastly different from the consensus view. You aren't looking for companies that are selling for 10% less than you think they're worth. You're looking for compounding machines that are worth way more than their sticker price. Way more.
2. Holding on can be the hardest part:
   1. Buffett bought Disney stock at a split adjusted price of $0.31 in 1965, and sold it in 1967 at $0.48 cents per share. A 55% gain in only two years…but what a costly sale. Today, the stock is trading around $95, and traded as high as $197 [at time of writing]. p.24
   2. Apple, from its IPO in 1980 through 2012 was a 225-bagger. But, "those who held on had to suffer through a peak-to-trough loss of 80 percent–twice!" p.24
   3. "Netflix, which has been a 60-bagger since 2002 [at time of writing], lost 25 percent of its value in a single day–four times! On its worst day, it fell 41 percent. And there was a four month stretch where it dropped 80 percent." p.24
3. Even the best investors in the world will tell you you need a little bit of luck along the way.

Evidence it works:

1. Buffett & Munger built the ultimate compounding machine in Berkshire Hathaway, compounding returns at 20.1% annually vs ~10.5% for the S&P 500 total return since 1965. Their approach? Buying quality businesses run by able management at "very attractive prices" and holding them for long periods of time. ^[1] Their long-term thinking has yielded a staggering ~3,600,000% return since 1965. A $100 investment in 1965 would be worth over $3.6M today. A (deep breath) "36,000-bagger."
2. Nick Sleep & Qais Zakaria ran the Nomad Investment Partnership and delivered a compound annual growth rate of approximately 20.8% net of fees over its 13-year lifespan. This far outpaced the MSCI World Index, which returned approximately 6.5% CAGR during the same period. Their approach? They referred to their investment style as "destination analysis," emphasizing the long-term potential of businesses rather than short-term market fluctuations. They held a small number of high-conviction investments, often focusing on companies with exceptional business models, strong competitive advantages, and the ability to reinvest capital at high returns. $100 invested with them would have turned into $965 over the 13 year period. A "9-bagger."
3. Alternate Universe Michael: My original Apple investment in 2008 would have been a "64-bagger." A $100 investment would be worth ~$6,400. (Alas, mine was worth $80 when I sold)

The non-magic formula approach

There is no magic in investing…but there is a common sense way to filter the universe and build a portfolio that seems (if it works) magical. Inspired by Joel Greenblatt's 'magic formula' presented in The Little Book that Beats the Market, I'm constructing a concentrated portfolio of public equities selected using simple, quantitative criteria. Mainly. I'm still fine-tuning my own 'magic formula' so, for now, I reserve the right to tinker (likely to my detriment, but that's where I am at the moment).

In his book, Greenblatt sets out to find a purely objective way to find good companies at bargain prices. That seems to me a reasonable approach. And his results, at least at time of publishing, seem to legitimize the approach.

Greenblatt's magic formula screens for companies that are capital efficient (high return on capital) and selling at a reasonable price (low Enterprise Value to Operating Income ratio). He then ranks them accordingly, aggregates their rankings, and buys from the top.

He recommends a basket of at least 20 securities that are rotated in and out on an annual basis.

Others have followed, attempting to improve on Greenblatt's simple approach by substituting his two-variable formula with a more sophisticated (i.e., complicated) method of objectively filtering the universe and homing in on the best opportunities (see Quantitative Value, Gray & Carlisle). Their logic is sound and I'm sure their math is too. The risk is overcomplicating things.

I've tried to incorporate some of the 'safety-first' filters that Gray & Carlisle propose, like scrubbing businesses whose financial statements show potential signs of manipulation, or those showing real signs of financial distress, but getting the data is a challenge. Still a work in progress.

How it works, in theory:

1. Once a quarter, filter the universe using simple, objective criteria. Example criteria might be:
   1. Safety filter: e.g., Market Cap >$100M
   2. Quality filter: e.g., Minimum Return on Assets (ROA) of 25%
   3. Bargain filter: e.g., Earnings Yield >10%
   4. Exclude certain sectors or industries (e.g., Financials and Utilities)
2. Rank the results based on your Quality and Bargain filters.
3. Combine their scores (the lowest score any company can have is 2: Ranked 1st for Quality + Ranked 1st for Bargain)
4. Buy the Top 5
5. Sell the 5 companies you bought 12 months ago (note: There's some fine tuning to do here if you're running this in a taxable account. You'll likely want to sell winners after a year has passed to lock in long-term gain tax treatment, and sell losers before a year has passed to lock in short-term taxable income offsets).
6. Rinse. Repeat.

Why this formulaic strategy works

1. It focuses on quality businesses selling at reasonable prices.
2. It reduces the odds of making irrational snap decisions.
3. It is designed to take advantage of Mr. Market's mood swings.
4. It's tax efficient (if you pay attention).

Why it's difficult

1. Data: You have to find a source of data that makes it easy to filter the universe using high quality data. You'd be surprised what kind of challenges even the largest data providers wrestle with (at least I was). To give yourself the best chance, make sure your data source is either first hand (e.g., SEC filings) or from a reputable vendor. If you're using Greenblatt's free screen provided at (magicformulainvesting.com) then this is less of an issue although it's more opaque.
2. It's tempting to tinker with the formula endlessly. Tinkering is just as likely to harm your results as it is to improve them.
3. It's tempting to cherry pick, to allow subjectivity to enter the equation rather than let the objectivity of the formula do the work.
4. You won't know for a few years whether it's actually delivering above-average returns over extended periods. Nothing works year in and year out, but it needs to work over rolling 5 and 10 year periods in my book.

Evidence this approach (probably) works:^[2]

1. Joel Greenblatt's Magic Formula achieved a 19.7% compound annual growth rate (CAGR) from 1988 to 2009 compared to a 9.5% growth rate for the S&P 500. Better still, when he included companies with Market Caps less than $1B (over $50m), the annual rate of return was 23.8%. At that rate, you'd have 100 times your money in about 20 years.
2. Wesley Gray, PhD & Tobias Carlisle dubbed their model "Quantitative Value" and, according to their backtest, that model would have achieved a CAGR of 17.68% from 1974 to 2011, compared to the S&P 500 Total Return of 10.46%.

Special situations

Successful investing requires you to find mispriced assets hiding in plain sight. Everyone else can see, if they look, more or less what you see. Sometimes it's simply the person who does the legwork, who pays attention to the facts instead of the talking heads, who finds a lopsided bet just waiting to be placed.

I'll be writing more on this topic and providing more details about the type of Special Situations I look for in the future.