Somewhat unique business, very uniqe management, page-31

Mars,

(Enjoyable exchange of views, this. Thank you.)

Your comments on portfolio make-up are interesting, because this is something that has been an ongoing, evolving process over my investing life, which has spanned some 25 years.

By way of some background, when I started investing directly in listed shares, I did what most novice investors seem to do, namely over-trade. And not just high quality stocks. Just about anything that made a squiggle on a chart.

After auditing my performance after a period, it occurred to me that I was adding no value, not just in absolute terms, but against the broader market.

But one thing I did do well from the outset was keep good records (written down in those days on A4 graph paper!). And my records showed me that, while I was making no money, the broker that I was using was in a bit of a different position: he was making a poultice of money out of me (commissions in those days were something like the greater of 1.25% of the trade value, or $100!)

It was at about that time that what I was doing was not investing at all, but was little other than punting my luck.

So thought I had better do some fast learning, lest I end up in the poorhouse.

So I started reading and while I did so, I never bought a share (for about 18 months, I think).

As with all investing textbooks, the array of topics is seemingly endless, and I certainly learnt that "good" investors did things markedly different to the direction that my broker used to clearly steer me, which was to buy lots of things and to buy them often. And to sell other stuff in order to do the buying of new stuff.


Yet some common practices among the "smart"investors of the world included things like:

1.) Identify good-quality businesses capable of increasing their intrinsic value over time, wait for them to become cheap enough, then buy them and hold either until the business model changes or some other adverse structural change takes place, or forever.

2.) Eight or ten stocks will give you almost as much portfolio diversity that 30 stocks will provide, for all intents and purposes, so adding a tail of stocks outside of major holdings is a bit of redundant exercise.


Applying these principles meant much, much lower activity, and therefore less portfolio turnover. Not exactly broker-friendly.

This portfolio passivity was initially quite hard to maintain, because it feels quite unnatural (We humans, probably driven by a fear of missing out, seem to be wired to act, to be doing something, to be fully engaged.)

So, while I slowly learned to do 1) above, achieving 2) remained somewhat elusive.

And the reason this is the case because it ignores the practical realities of the taxation impost levied on capital gains.

In a perfect world, one could cobble together a portfolio of eight stocks representing one's highest conviction investment ideas, wait for them to appreciate from undervalued to fully valued, sell them as they do and then re-deploy the proceeds into the newest best investment opportunity.

The only problem with that theory is that for really good businesses that increase in intrinsic value over time, what constitutes full value?

At what exact point, over the past 15 years, were the "beautiful" companies companies like CBA, CSL, RHC, REH, ARB, DLX, or RMD etc., "overvalued"?

It stands to reason that the answer is never, given that they are all trading at close to record highs (unless they are definitively overvalued today, and I don't know how to make that determination.)

[Closer to home, is ONT fully valued today? You could have said so many times over the past five years, and you would have been wrong.]

The point is that I have, on too many occasions to remember, sold shares in high-quality companies that I was convinced were overvalued, only to see them some years later at materially higher prices, meaning that I have foregone the capital gains, as well as the ensuing dividend stream, all of which I had exchanged - unwisely - for the crystallisation a nice big capital gains tax liability!

Which means that there is a natural bias - assuming one's initial investments were successful, and your starting cluster of shares moves from being undervalued to fully valued - to free investment capital to be used to buying new, undervalued stocks, as opposed to being funded by the sale of existing positions.

Which means there is an inherent drift towards greater stock count in any portfolio.

And - importantly - the longer the portfolio exists, the more pronounced the drift becomes.

For example, I am a great, long-term devotee of ARB Group, and I think the company will keep increasing in intrinsic value for many years to come, but don't think ARB is at all undervalued at current prices (with P/E in the 20's and EV/EBITDA in the mid-teens).

But I don't dare sell it with a view to re-cycling the proceeds into something "cheaper", because the capital gains tax liability would make doing so almost financially prohibitive. At the risk of gloating, my first ARB share was bought at a price below one dollar, and my average entry price is less than $4.

The consequences of this "portfolio maturity", while not immediately observable, are relatively easy to understand. Selling something and incurring a tax liability in doing so means that the return required in the "new" investment needs to be higher than would ordinarily be the case had it not been prefaced by some not-insignificant cash leakage to the Australian Tax Office.

And the longer the ownership period of a group of high-quality businesses, the greater the potential CGT liability, and the greater the required return on a fresh investment, if such an investment is funded by the sale of any "long-owned" companies.

This means that any new, attractive, high-conviction investment ideas that arise tend to be funded by surplus cash (arising from dividends, savings, bonuses, or other cash windfalls), rather than from liquidation of existing positions, even if they appear fairly - or indeed, fully - valued.

In other words, tax implications causes behavioral distortions that result in new stocks inevitably being added to the portfolio.
I've even coined a term for it: "portfolio creep".

This is a problem that I had identified some years ago; almost all the stocks I hold I first bought in excess of 5 years ago, and the contingent capital gains tax liability is substantial in most cases, which obviously a nice thing and a quality problem to have, but it does render optimal portfolio construction a bit challenging.

As a consequence, I have 26 stocks in my portfolio, which is admittedly somewhat of a zoo.

Keeping on top of them all is not really that much of a problem, because I am not employed and while some people do woodwork or collect stamps as their hobby, mine is trawling through the financial statements of publicly-listed companies and building financial models in the hope of identifying good investment opportunities. (Sad, I know.)

[PS. In terms of how ONT came to be a 2.5% position, well that is a function of lack of liquidity in the trade of the stock. At the time I was buying it, it was not possible for me to get fully set, and it has never since been glaringly enough undervalued for me to have had the opportunity to top up. I should have done so during the CDDS debacle, but that coincided with Europe having one of its earlier debt contagion scares, which threw up one or two higher priority opportunities (also, I didn't really know if ONT would really emerge completely unscathed from CDDS).]