Asset Allocation - Owner Managers + Eww Stocks

[Myth465]

When it comes to allocation advice, Taleb's recommendation in The Black Swan is interesting. It consists of an asset allocation plan of 85% in risk free investments (T-bill) and the 15% remainder in buying way out of the money Calls and Puts. By doing so, he positions his portfolio to capture the occasional mispriced Black Swans which delivers outsized returns, but has the bulk of his assets in risk free investments. I like this idea and have decided to augment it for a portfolio built on value investing and Owner Managers.

 

A Value Investor's Take

 

I plan to allocate 50%-70% of my investments into a small, but diversified basket of Owner Managers who have skin in the game and cash on hand. I am hoping that these investors will act as a counter cyclical force during Market crashes. I believe they will have the skills and capital  (FFH, BRK, FUR, Loews) to expand their businesses by making great deals, buying chap assets, and expanding market share during a downturn. They should also do better then cash in up years.

 

I next want to invest 30%-50% of my assets into a diversified basket of deep value high reward securities. These securities should be of decent quality, but should have an attribute that has the potential to lead to outsized returns.  They could be businesses experiencing extreme stress (ATSG with DHL at 11 cents or SFK), be highly leveraged (URI during the market collapse), deep discounts to book value (CNA and FFH (with CDS) due to misunderstanding), or could be Leaps with a catalyst (FFH, ORH, Ensco Leaps). This capital is riskier then the owner managers, but should deliver outsized higher returns.

 

Finally I want to have up to 20% of my total portfolio in cash on hand for downturns. This cash could be invested in bonds or held in cash. I will go all in when I have more options then cash, but the options have to be of the highest quality. When I do go all in I will deploy the capital into either Work Horse Owner Manager positions or deep value high return positions. I will also hold no short term debt related to stocks. I would like to hold cash in the following percentages / market conditions - 2%  (Market Undervalued), 5-10% (Market Fairly Valued), 10-20% ( Market Overvalued).

 

----

 

What do you guys think and what are some Eww stocks. Right now I hold AI, ATSG, and SFK. They all have a slight smell to them, but I think all of them will deliver outsized returns over the long term. FFH has an entire portfolio of these so they may be a good place to start.

[txlaw]

Myth, I like your asset allocation approach, though of course I also believe, like Valuegeek, that the structure of one's portfolio can vary substantially based on one's style.  It should also depend on whether you are managing your own money versus other people's money and on the individual circumstances of your principals.

 

I manage my own money, my parents' money, and my sister's money, and I have different asset allocation approaches for our different portfolios.  My own portfolios tend to be highly concentrated while my parents' and my sister's portfolios are more diversified.  I tend to trade more in my own portfolio, and I only use options in my own portfolio.  I always take into consideration volatility for my parent's portfolio because of their own psychology and because of the potential that they may need to draw down money from their portfolios unexpectedly.

 

My own regular portfolio tend to be highly concentrated with an emphasis on the deep value securities mentioned in your second category of investments.  My parent's portfolios, on the other hand, have more high quality company stocks in them with owner managers at the helm or with great business models that are not dependent on stellar management.  FAIRX makes up a rather large part of my parent's and sister's portfolios, as well as my own retirement portfolio. 

 

One additional category I might add to your portfolio, perhaps in the first bucket, is high quality company securities entered into at great prices that don't necessarily depend on having good managers to generate lots of cash.  Good examples of stocks in these categories would be KO, KFT, or PFE.  (I always remember Peter Lynch's thoughts about assuming that sooner or later, idiots will be running your business.)  These equities tend to be less volatile and can be sold down at times to purchase deep value companies when the opportunities arise.  Of course, that does not necessarily hold true when you get markets that tank like in October 2008 and March 2009.

 

I don't hedge.  I don't short.  And I've learned that it makes a good deal of sense to set up a specified percentage for my cash position because I have a tendency to want to be fully invested, which could potentially deprive me of opportunities to deploy money when Mr. Market provides an outstanding opportunity.  For example, if I didn't have a large amount of cash on hand at this point (close to 20% of my portfolio), I probably wouldn't have been as comfortable adding to my ATSG position last Friday. 

 

----

 

Your "eww" stocks question is also very interesting.  I've been reading some of Michael Burry's posts and letters, and he mentions that he is often interested in "ick" stocks.  I'm also quite interested in getting into "eww" stocks, though I often wait until I'm absolutely sure that the sky is clearing up.  I tend to miss monster runs associated with severely distressed companies, but I also sleep well at night.  Also, it's sort of surprising how often prices will stay irrationally low even after the "kill the company" risk gets taken off the table.

 

Some of my own "ick" stocks: ATSG, C, ETFC, SFK (very small position)

[Myth465]

valuegeek and txlaw you guys both brought up a very important note. I am managing my own money. I wouldnt know where to start when it comes to managing other peoples money. I have a hard time just recommending a mutual fund for them. I am still training myself to ignore volatility, and unless you have good clients dealing with them during market downturns can be a nightmare.

 

I view cash as insurance. But Micheal Burry and Prem definitely have me thinking about better forms of insurance to manage risks. Another problem I see is the importance of the catalyst. Pershing creates thier own catalyst and Berkowitz is great at going in towards the beginning of the catalyst.

 

With regard to eww/ick stocks. I choose the name due to reading Burry but have been investing in them for the better part of 2 years. I noticed that most of my returns come from out of favor Owner Managers - FFH Leaps, ORH, ORH Leaps, FUR or eww stocks ATSG and SFK. If you put just 1-2% of your portfolio in the ick stocks at the right time then they really juice the returns. I currently have 2-3 of them, but would like to have a basket of 7 or so of these stocks.

 

I know ATSG very well and am getting comfortable with SFK Pulp. I think the trick is to buy a small position to get to know the company. As the knowledge increases and the price decreases you can average down. If I had more excess cash I could have picked up more shares of ATSG and would be up an easy 10% today.

 

You also bring up a good point regarding solid earnings. I think I will add a bucket for those. Many have done well with JNJ, Kraft, and Wells Fargo over the last year or so.

[Sea Island]

I believe that one of the most interesting aspects of modern portfolio theory and asset allocation, is that when combined with investor physcology it will not create wealth. It might maintain wealth or preserve vs. an index, not on an absolute basis, but it will not create wealth over the long term. As asset allocation is applied in the retail financial industry, it is designed to limit blow ups on an absolute basis(its ok if a "well allocated" portfolio declines 40% with the market). Taleb's strategy is a highly concentrated one that you would never be allowed to implement at a retail financial service firm for a private client or institutional client. Nor would any "responsible" investor choose to place 100% of their financial assets with a hedge fund manager that was pursuing a strategy like this. I don't think compliance departments like it when you begin an investment with the likelihood of a 100% as is the case with leaps etc. However the Taleb strategy is beautiful and would create far more wealth than a "traditional" asset allocation strategy.

[twacowfca]

Taleb's strategy is hard to maintain in a rising, low volatility market.  His Empirica Kurtosis fund struggled in the last bull market until he closed it in the mid noughties.  His new fund launched at just the right time when the market was about to roll over, and they hit a grand slam home run during the market meltdown.

[Myth465]

I like Talebs basic concept. Safety. Having most of your money in low risks investments and shoot for the moon with a small bit. I dont think you can look much at his funds because they would be the small bit shooting for the moon.

 

Similar to Sea Island. I think its tough building wealth and most strategies focus on maintaining it vs building it up.

 

 

[Sea Island]

Taleb's strategy may not work as well in a product environment such as a hedge fund which has to serve  many masters. If your yield on your treasuries is 3% and the volatility is not working in your favor and you have a standard hedge fund fee arrangement it won't be a wonderfully long experiment. However for a personal strategy I believe it has exceptional merit, if you have a large enough pot, small income demands and/or long time horizon. If you had a $20 MM portfolio with 90% earning 3% in treasuries and you could live on half of that income(after tax) and reinvest the balance along with the remaining $2 MM in out of the money leaps, you could do quite nicely. Its not a very good model for most as not many investors would accept a 1.5% yield with 100% safety(define safety?) and the chance for extremely lumpy but extremely positive returns. The beauty is of course that you need relatively small investments paying off relatively infrequently to make it all work quite nicely.

 

Buy some gold and guns out of the 1.5% and maybe a naturally fortified mountain lair for additional safety