Of course, I couldn’t ask for more out of a lazy man’s portfolio. Being some 17% in cash brings me no joy; but, this portfolio has continued to outperform the S&P 500 Total Return Index (the S&P 500 with dividends reinvested) by 19.7% a year, growing 4.2% annually versus the S&P 500′s -15.5% annual return. That said, the F Wall Street portfolio is going bye-bye. Though I will continue to write about investing and individual companies, I can’t maintain the portfolio in real-time (or even somewhat real-time).

Still, this “value investing” stuff works. And though we’ve only been going two years, if you don’t believe by now that buying good businesses on the cheap and ignoring the markets is the way to go, it will probably never sit right with you. As Buffett says: You either quickly get the concept of buying $0.50 dollars, or you never do. Let’s jump into some interesting questions from visitors, and concepts in intelligent investing.

Did You Miss The Recent Rally?

Two of the great things about intelligent investing are:

• you never “miss the boat” because there’s always going to be another boat, and
• your results, though volatile, will be largely independent of the market’s returns.

Think about that for a second. If you’re lamenting the fact that you weren’t fully invested in March and you missed the rally – that you “missed your chance” – think about who is promoting that idea, and then remember back not only to March, but to the dot-com bubble, burst, and recovery.

When the markets are flying high, they say that you have to get in – you’re missing the action. When the markets are at their lows, you should “keep some powder dry” because they’re going lower. Then, a massive recovery comes and everyone says, “We told you to buy! You missed the action!”

Interestingly enough, it’s the same people that scream, “Get in! Stay in cash! We told you to get in!” They don’t put a guy like me on television because I’ not fast and actionable.

Reporter: Joe, what should investors do today?
Joe: Buy assets for less than they’re worth.
Reporter: But the markets are [up/down] 40% in the last year, and you said that a year ago!
Joe: Yep.
Reporter: Thanks for another scintillating interview.

I won’t name names, but it’s all garbage. When I talk about Rose in the book, I mention some of the crazy markets she saw – up 40% in a year, down 50% in a year. Rose never concerned herself with the markets. She never timed anything. She paid good prices for good businesses, and ended up a wealthy woman.

But It’s Different This Time!

Bull.

The “September Event” that occurred after Lehman Weekend was different that anything we’ve seen in 80 years. But that’s behind us now (it was behind us a while ago). And even still – had the world economy stopped completely, had everything collapsed, your money market, your stocks, your gold ETFs – all worthless. Even those gold bars they’re selling on television – they’d only be as good as the ammo you have to protect them.

If you’re still looking for the end of capitalism and wondering how to profit from it, get in the ammo business. Otherwise, keep looking for good businesses at cheap prices.

At this point, the economy is still ugly. Unemployment is still rising. Foreclosures. Volatility. Inflation or deflation – take your pick. Rates will go up in the future, putting added pressure on stocks. These things – all of these things – we’ve been through them before, in varying degrees.

It’s not different, it’s just scarier because the internet and the media throw it in our faces more often than they could twenty years ago. And our next crisis, whenever that may be, will seem even more dire and hopeless because we’ll have more information from more sources, adding to the fear and confusion.

Is everything we’re seeing now unprecendented? Yes. But it doesn’t change the game. It’s not “different.”

The markets work. Definitely not on a daily basis. Sometimes not even on a yearly basis. But over the long run, an asset purchased on the cheap will usually work out just fine regardless of whether or not we “retest the lows” or hit Dow 10,000 before the end of the year.

Questions from Visitors

Jason asked about the value of goodwill and intangibles. When figuring out “invested capital,” you should ignore the cost of intangibles and goodwill as you try to determine what the business can earn regardless of what management does with the excess cash. For example, Johnson and Johnson makes a lot of acquisitions; but, you shouldn’t bet your retirement on the hope that they’ll continue to make acquisitions to grow. In determining CROIC, you want to know what the business can earn from its operations as a healthcare company, or retailer, or whatever.

A prime example – and I hate to keep picking on these guys – is Lucent. Lucent doesn’t seem to have a very good business; so, they constantly try to grow through acquisitions. What happens when the financing runs out and they can’t make any acquisitions for a while? You’re stuck with Lucent’s business, and whatever returns they’ll generate on the existing capital.

ajay asked a few questions. Question 1: Do we include X, Y and Z in shareholder equity, and is it the same as net worth, book value, etc.? Shareholder Equity is all of the assets minus all of the liabilities. There is a difference between Shareholder Equity and book value in that book value is often considered the tangible book value – the net value of the tangible assets minus all of the liabilities. Book value excludes certain accounting “assets” such as goodwill or the value of trademarks. That distinction is critical when investing in break-ups, bankruptcies, and net-nets. (More on net-nets in another post.)

He also brought up Pfizer, a topic discussed recently at a book signing I did. Is it a good investment? My two cents on pharmaceutical companies is that they’re generally only as good as the drugs coming out of their pipeline. They have to invest massive amounts in research and development, and often seek growth through acquisitions. Every product they make generally has a very limited revenue stream, as opposed to a Coca-Cola. If you can predict the value of their pipeline, you can invest in a pharmaceutical company…but you have to have a thesis on the pipeline, just as you have to have a thesis on where oil is going before you buy a company that makes money on oil.

Joie asked about whether or not goodwill should be included in shareholder equity, and the answer is: it depends. If the goodwill is truly valuable, then it should be included. If not, ditch some or all of it. When I wrote about Adobe Systems, I talked about their goodwill from their purchase of Macromedia. The goodwill was the difference between the purchase price of Macromedia and the value of its actual, tangible assets. I felt that Macromedia was so integrated in Adobe’s business that the goodwill carried was much too high relative to the ongoing, resale value of Macromedia in the event of a sale; so, I reduced the goodwill somewhat.

Joie also asked about capital expenditures. Some companies break down their capital expenditures for you so you can easily deduce which ones are required and which are temporary; some don’t, and you have to use some math and logic to work it out. (See this post on Wal-Mart.) When looking through annual reports, look at the notes to the financial statements. And don’t be afraid to skip it if it’s too hard to figure out!

Ari Greenberg also asked about capital expenditures, but more specifically: Does depreciation equal maintenance capital expenditures. Answer: No. Over the course of the business’ lifetime, depreciation will equal capital expenditures because that’s how the accounting works. Depreciation allows a company to spread out an expense over a certain period of time, and that depreciation works out to the purchase price minus the sale or scrap price of that asset. There will also be costs in upgrading the equipment, maintaining it, etc. which may be significant. The fact that the accounting regulations allow the company to write off a piece of equipment over a number of years doesn’t mean that the ongoing expense of maintaining, upgrading, and repairing that equipment can be ignored – and that’s the number you want to figure out as well.

Avishek asked about moats and Morningstar. The “moat” you want is that key ingredient that virtually ensures that the business will be profitable in the future. I wouldn’t rely on anyone but my own research, because most people get it wrong which is why you have the opportunity to buy a great asset on the cheap. If you’re not comfortable reading annual reports and identifying moats, you can learn over time by continuing to look and read. Start with big companies and work down the line. And on that note: It won’t all be in the annual report. Avishek mentioned “switching costs.” You don’t necessarily learn that in the company’s filings, but in learning about the industry, how it works, and who the customers are.

Finally, Ron asked why I thought that Harley Davidson had high capital expenditures versus a Wal-Mart. Make sure you check out this post about Wal-Mart to understand the growth vs. maintenance capital expenditures. HOG, like most auto manufacturers, airlines, and heavy steel/iron operators, have to rely on massive, old, clunky machines to build their products. These machines require constant maintenance, upgrades, and repairs. This leads to large capital expenditures. Wal-Mart, on the other hand, merely needs to buy a building and set up shop. The massive jumps in capital expenditures over the past few years was largely due to growth capex (including expansion into China) and, perhaps moreso, due to their revamping and building out of their massive distribution center – a cost that isn’t likely to occur indefinitely in the future. When looking at two similar businesses at similar prices, you’ll likely be better off with the company that doesn’t have to spend huge amounts just to keep the doors open.

That leads me to the second part of his question: What is a good inventory turn rate to profit margin? It depends on what you consider a good profit margin. A business with one inventory turn a year and a 20% profit margin is no better or worse (at least from a profit margin standpoint) than a company with two turns and a 10% margin, or four turns and a five percent margin. Don’t rule out a company solely because of profit margins. Wal-Mart’s margin is about 3.5%, but it is wildly profitable because it turns its inventory seven or eight times a year, for a “true” profit margin of 26% or so.

Think of it this way: If you buy a rock for $100 and sell it for $102, you’ve made one inventory turn and a 2% profit margin. If you’re doing that once a year, close up shop because your shareholders are better served if you stop buying rocks and invest solely in U.S. Treasuries. But, if you’re buying and selling these rocks twice a month – twenty four times a year – you’re laying out $100 to earn $48 a year. Though your profit margin would still be 2%, your “true” margin would be 48%. That’s one heck of a business.

And of course, don’t take it all at face value. Two companies with “true” profit margins of 40% won’t necessarily grow rapidly. The one that has to lay out more in capital expenditures is going to grow more slowly (all else being equal).

Keep On Trucking

There are values out there. I recently purchased a stock around $7.80, even though it was up some 92% from its March low. Think we’ve “come too far too fast”? I don’t know. What if we fell too far to fast?

There is no way to know what the markets will do next week or next month. The nice thing is: So long as you keep investing intelligently, you’ll never have to worry about it.

Since our launch, we saw the S&P 500 climb to an all-time high in October of 2007, only to watch it plummet nearly 58% to a level first seen in May of 1996. Some of the causes of the drop were highly predictable. Some of the events, such as the September 2008 disaster, were completely unpredictable. And through it all, we were largely, if not entirely, invested in individual stocks.

Let’s see how we did.

Portfolio Performance

If you recall, I started the F Wall Street portfolio with $100,000, and compare it to the Diamond Trust Series (DIA) – an ETF that tracks the Dow – and the Vanguard S&P 500 index fund (VFINX). I compare to these two funds because investors can’t invest directly in an index; so, these are two of the broad “index-type” investments.

In the roughly two years since F Wall Street was launched, $100,000 in the F Wall Street portfolio grew to $103,224 (+3.2%) while $100,000 invested in the DIA and VFINX fell to $68,246 (-31.8%) and $63,225 (-36.8%), respectively. On an annualized basis, we have outperformed the better of the two investments (the DIA) by 19.6% per year.

What’s In Our Portfolio?

The portfolio snapshot below is as of yesterday’s close. This morning, I sold DBB because it didn’t work out as planned. I will discuss it in a later post.

Thoughts on Our Portfolio and Performance

Had I been able to spend more time and energy on the blog, I am certain that our results would have been much better. As the markets plummeted, I found myself with less and less time to post, as is indicated by my lack of activity here over the past year. I first mentioned this problem in March of 2008 in this post:

When the markets were flying high, I had all the time in the world to write posts for an hour or two a day. Trying to maintain that pace in this market would be detrimental to our future returns.

It is important to remember that I am not a professional blogger, living off advertising revenue and blogging for dollars. Nor am I a professional author, living off book royalties. (Trust me – there’s no money in writing books unless you’re Steven King.)

Some opportunities that were missed in the F Wall Street portfolio:

• Graham Corporation, which was discussed ex post facto and never included in our results.
• The InBev acquisition of Anheuser-Busch workout which, at one point, offered a substantial premium.
• As I mentioned in this interview on First Business and back in November to my friend Barry Pasikov, Managing Partner at Hazelton Capital Partners, Sears Holding Company was an amazing opportunity in November, when it was trading at just $30 and less.
• And, of course, Wells Fargo which, in February, fell to just $7.80 a share. In response to Dan’s question whether or not WFC was a screaming buy, I responded: “Screaming,” but didn’t have the time to post more about it.

These investments would have had a significant impact on our results. The total impact of these investments, as of June 1, 2009, would have added another 33% or so to our returns, broken down as follows:

• about 2.5% from Graham, in which a 5% investment would have doubled,
• about 0.5% from the InBev workout, in which a 10% investment would have grown about 5%,
• 10% from Sears Holding Company, in which a 10% investment would have doubled, and
• 20% from Wells Fargo, in which an additional 10% investment would have tripled.

And that’s net of some of my more boneheaded moves, like overpaying for American Eagle or getting my butt kicked in the Landry’s workout-gone-bad.

The point here is not that I’m backward looking or playing with the numbers, but that the market presented investors with some amazing opportunities over the past year, if, of course, you were looking at the business and not the media or stock markets.

On a relative basis, I’m bubbling over with joy at how we continue to outperform the markets and at the amount of safety our portfolio enjoys. On an absolute basis, I am upset that I didn’t have more time to discuss some of these amazing opportunities in greater detail and include them in the F Wall Street portfolio.

Still, we own some wonderful businesses at great prices. While my primary responsibility is to manage money for our clients, I will continue to run the F Wall Street portfolio on this part-time basis because, as I discuss in the book, casual investors can invest conservatively, confidently, and at satisfactory rates of return without taking a lot of risks. This portfolio will continue to be run “casually,” unlike the portfolios we manage at Ponzio Capital.

Thoughts on Diversification and Buy-and-Hold

Clearly, and once again proven over time, broad diversification just doesn’t cut it. Having extremely small positions (1% of the portfolio, or broadly diversified mutual funds) doesn’t allow your best ideas to have a meaningful impact on your returns. And though the losses have a greater impact (and we’ve had a few), a 5% loss in the portfolio due to a 50% loss on a 10% position is not impossible to overcome, so long as you can remove emotion and media hype from the equation and focus on making smart business decisions.

The number of positions an investor should hold is inversely correlated to the predictability and discount one receives in any investment. You could put your entire net worth into a single U.S. Government bond, and never diversify outside of that one bond because you have absolute certainty and predictability. Conversely, if you’re going to invest in a highly speculative, debt-laden, poorly run company, you wouldn’t want to risk too much of your savings.

That, of course, is one of the problems with mutual funds, and particularly index funds. Both the DIA and VFINX held General Motors as it fell from $90 to bankrupt and worthless over the past ten years. From a value standpoint, it was as worthless at $90 as it is today; however, if you have to own a GM (like when you invest in index funds), you certainly want it to be a very small portion of your portfolio.

This, of course, leads us to the constantly-asked-and-wrongly-answered question: Is buy-and-hold investing dead? The short answer is an emphatic “no.”

Whether stocks are rising, falling, or hanging flat, Wall Street wants you to believe that “it’s a trader’s market.” When the markets are rising, it’s a trader’s market because easy profits are aplenty. When the markets are falling, it’s a trader’s market because you need to be nimble and liquid. When the markets are flat, it’s a trader’s market because “buy and hold ain’t working” and you have to do something to make money.

The truth is that it’s always a trader’s market on Wall Street because Wall Street gets paid when you’re buying and selling. The broker handling the F Wall Street portfolio couldn’t buy an iPhone with the money he would have made from us.

Buy-and-hold is a poor strategy if you’re buying anything at any price, and holding it no matter what. If, however, you are buying great businesses at great prices, the overwhelming majority of active traders won’t be able to match your results over the long-term.

I had written the following to clients a few weeks back about this exact topic. Though it’s not an exact comparison, I think you’ll get the gist of it:

Warren Buffett has built his fortune on buy-and-hold investing. His company, Berkshire Hathaway, is not only larger than every brokerage firm in the United States (many of which are much older than Berkshire Hathaway), but it is larger than Goldman Sachs, Morgan Stanley, State Street, Citigroup, Charles Schwab, and E*TRADE combined. (Based on market capitalization at the close of business on May 7, 2009.)

A Final Thought, On Volatility

It’s easy to look at our results and think that the ride was smooth. All you see in the above chart is three points in time, and a straight line joining each of them. The truth is that the results were volatile, and we suffered wide swings in the prices of each of our investments.

There is no way to control the daily swings of the markets or any individual position. Then again, there is no need to worry about it if:

1. You hold great investments at great prices, and
2. You have no intention of selling that day.

When the markets pounded Wells Fargo down to $7.80 per share, we were down 67% from our initial purchase at $23.41. We invested again at $16.63, but that only gave us an even larger loss on a dollar-basis, and we were still down 63% in a matter of days.

It’s easy to sweat over the market action if you need to sell, or if you don’t fully understand your reason for buying. Even my own brother, whom will remain nameless but trusts me implicitly (I have four, so don’t try to guess), commented on the unrealized loss and was tempted to swear off stocks completely until we had more clarity in the markets.

The truth is that stock prices, on a daily, monthly, and even quarterly basis, are quite silly. Buffett and Munger commented on this at the annual meeting, I discuss it in detail here on the site and in the book, but I’ll reiterate it: A major key to the success of one’s investment program is having the right emotional make-up to handle the market’s ridiculousness.

As I stated in this post, most people don’t have the emotional constitution for investing in stocks. With the markets down nearly 40% from their October 2007 highs, people that were plowing money into stocks two years ago are now sitting on cash and looking for bonds. It’s not just individual investors – many pensions, mutual funds, and other institutions operate with this backwards mentality that investing should be done when prices are high and may go higher, instead of when prices are low, even if they go lower.

Over the long-term, the markets work very well; but, your investment results will depend on how much time you can put into your investing and how well you suppress your emotions while focusing on making smart business decisions.

The results of the F Wall Street portfolio will not do as well as I’d like going forward (that is, very high, non-conventionalist returns) due to my lack of time for blogging; so, I’ll focus on trying to make smart business decisions when I can post here.

(Of course, we’ll keep on trucking at the firm!)

If, after reading this post, you think I’m fixating on the short-term, feel free to send me an e-mail to spark up a discussion.

On Selling Stocks To Raise Cash…

Let me pose somewhat of a rhetorical question, though you can answer it in the comments if you’d like: When buying a stock, what is the difference between taking the money out of cash, or selling a seemingly mediocre opportunity to raise the cash?

Why not invest your assets in the companies you really like? As Mae West said, “Too much of a good thing can be wonderful.”

Save Landry’s and AEO, I sold out of positions that I didn’t necessarily “really like.” I sold Adobe and Apple. Why? Let me bring up a quote from the August 9, 2008 Investment Performance post:

Adobe is fairly priced but I think it is a solid company. If I run out of cash and need to sell something, I’m happy to sell Adobe. If I don’t need cash, I think my money is better parked in Adobe at $34 and change than in a money market for a few years.

In this case, as the markets began to melt down, I felt that I’d have a chance to find companies I “really like” and wanted to have cash on hand to pull the trigger. What is the problem with dumping mediocre positions at mediocre prices? Why do I think they were mediocre opportunities? In my sphere of confidence and competence, if I had felt more strongly about these positions, I would have gladly invested 20% of the portfolio in them.

As an example: Though they are both down considerably from their highs, I never considered selling Johnson & Johnson or Wal-Mart, again keeping this quote from the same post in mind:

If you find four to six Johnson & Johnsons and Wal-Marts trading at discounts, you need not worry about owning anything else. You can put 20% or 25% of your portfolio into wonderful, rock solid businesses selling at discounts and walk away from your portfolio for years.

Selling Out of Landry’s

Landry’s was a workout that went bad. Plain and simple – no need to hang around.

Reassessing American Eagle Outfitters

While I don’t believe that valuations change rapidly based on price movements or that we should consider the current markets in investing, I do feel like I overpaid for American Eagle. Assuming I’m spot on with my valuation (which we never are, which is why we must demand a margin of safety), what could I expect from my American Eagle investment?

Buying at $26 when the value is just $18 or so, the only thing I can hope for is that the value eventually creeps back above my price point, and that I eventually break even on my investment. But note the key word: Hope.

Optimism and pessimism have no place in investing. From a realist standpoint, I’m not willing to wait for American Eagle to grow to that $26 level, nor am I willing to hope that “some fool” is willing to pay $26 for an $18 business like I did.

Which is the better allocation of capital: Hope that time will correct your mistakes, or admit your mistakes and move on to better opportunities? Remember: You don’t have to make it back the way you lost it.

Perhaps there are other solutions that make more sense than mine; however, wishful thinking – and its usual companion, thumb sucking – is not among them.

I don’t know if Buffett was talking about admitting mistakes and taking losses in that quote, but it is quite appropriate when you overpay for a business and then rely on time and hope to correct your errors. I’m not willing to suck my thumb, hoping that I didn’t make a mistake when other opportunities are so clear.

Now, you can make the case that AEO was not a wonderful business, and I’d agree – that’s why I didn’t invest 20% in it. I still think it’s a good opportunity…but at the right price. $26 is not the right price, and if it falls to $7 or $9, I’d consider buying again. Still, at $7 or $9, I’d have to first ask if there are any companies I “really like” out there at attractive prices. If not, AEO is an option.

How The Economy Affects The Valuation

The economy affects the valuation to the extent that AEO’s cash flow will likely pull back to a lower level, which would then be the starting point for a new valuation. We can’t use last year’s cash flow as a starting point for projecting future cash flows because future cash flows will likely have a lower starting point when the dust settles.

Lower cash flow means lower valuations. In this case, we have a lower starting point than we projected, and future cash flows will all likely be lower than projected as the business recovers from taking a step back.

It’s paramount to remember that these things are actual businesses. The fact that AEO generated $x of cash flow last year doesn’t mean it will necessarily do so in the future. Management will have an uphill battle to get people in the stores spending money, and they won’t rush back to do so. This is business, no matter how rosy the spreadsheet says the past was…and business is tough.

Maybe I’m wrong again on AEO. Maybe it really is a $25 or $30 or $70 per share business. And maybe you can find confidence in buying it today at $11 or holding it from $26. That’s what makes investing so great – the fact that we all see value (or a lack of value) in different ways.

This is my thesis, and the reason that Joe Ponzio sold American Eagle Outfitters. If you personally see more value or disagree, load up the truck. Don’t let me sway you one way or the other…you’ll never sway me just the same ☺.

The F Wall Street Portfolio

Excluding LNY which was a workout that went bad, I sold $18,000 or so worth of stocks, and turned around to purchase $25,000 worth of two companies – $20,000 of MMM and $5,000 of NTRI.

It’s a tough market for all long-term investors; and, because we’re looking to beat the markets by five or ten points a year over the long-term, that means we hope to lose less when the markets are falling, make money when they are flat, and hope to keep up or out-perform when they are on the rise over the long-term.

Since June 25, 2007 – the day the site started – the F Wall Street portfolio is up 2.9% versus a 30.2% loss in the Dow and a 35.3% loss in the S&P 500. The relative out-performance is still quite stunning. (There’s something to this “buy good businesses at attractive prices” hullabaloo.) A $100,000 investment in F Wall Street’s portfolio would be worth $102,898 as of 10/31/2008, versus $69,840 in the Dow and $64,681 in the S&P 500. (I didn’t have time to run it against the DIA or VFINX like I did in this review.)

We’re still sitting on about 28% in cash, waiting for another fat pitch from the markets.

For you visual folks:

Of course, the portfolio has only been running for about 16 months – way too short a time to judge performance. Still, I’m quite pleased with the results.

Keeping the long-term in mind…no matter what happens in the markets, we’re not going to look at the performance again until June of 2009.

I hope that clarifies things and satisfies curiosities. Happy Halloween!

No matter how short or long, shallow or deep the recession turns out to be, you can usually bet on one thing: The stock markets tend to rise before the economy turns around. So, forget timing the markets. Instead, let’s look at timing your purchases.

The Backwards Mentality of Riding Waves

We all know Buffett’s saying: Be fearful when others are greedy; be greedy only when others are fearful. We also know that this likely means that now is the time to get greedy, and that any continued decline means that we should all “get greedier.”

Investors, however, tend to have a natural tendency to want to ride waves. As the markets are falling, we tend to hold off on purchases, hoping to squeeze the last nickel out of our buys. When they rise, we find some satisfaction in watching our positions grow 1% or 3% in a single day.

Considering all we know about Buffett…how backwards is that? (And don’t tell me you don’t experience those feelings at least a little. Unless you have 50+ years experience and $60 billion, you know exactly what I’m talking about.)

Timing Your Purchases

When is a good time to buy stocks? All the time…so long as the price is right. But, here’s a little tip to help shake the market fears out of you: Only buy stocks when the markets are falling.

I’m not talking about buying in a “down” market like we’ve been experiencing over the past year. I’m talking about buying stocks on days like yesterday – a day when the Dow opened at 9,027.84 and never saw that level again, falling more than 700 points (7.8%) before ending the day down “just” 5.6%.

I’ve said it before and I’ll say it again – most people should not be entirely “in the markets” in general, and should opt for an intelligent strategy of bonds, or bonds and a few gigantic, “safe” companies.

Not sure if that’s you? Make it a point to pull the trigger only when the markets are falling. Then…make it a point to close your browser and walk away for three full market days. If that’s too much to handle, consider changing your strategy.

Believe me – when you can make purchases knowing that the markets are falling and that you’ll likely lose money for the day, investing will “make sense” just a little bit more.

Changes To The F Wall Street Portfolio

I mentioned that there have been changes made to the F Wall Street portfolio. As I’m at home, I can’t tell you the exact prices right now (I have them at my office); but, I can tell you that we:

• Dumped Apple in the low-$100s.
• Dumped half of Nutrisystem in the $19s, and the other half in the $16s.
• Nutrisystem keeps pulling me in – I bought some back today (when the markets were down) at $10 and change.
• Took a beating on the Landry’s workout, and sold out of the position in the low $13s earlier this month.
• Sold out of Adobe at near break-even prices.
• Sold out of American Eagle Outfitters in the $14s.

It seems like an awful lot of activity; but, Landry’s aside, it was all for one simple reason: As the markets began to melt down, I made a bet that some potentially “permanent” holdings would become available at very attractive, perhaps-never-again-seen prices. For that, I wanted to have cash on hand, as a Coca-Cola with a moderate margin of safety is a lot more attractive than an American Eagle with a moderate margin of safety (if it still had/has one).

(The reason for that discrepancy is predictability. You know Coca-Cola will be around, and most likely bigger, ten years from now. AEO? Though I don’t think it’s going out of business, I think we can all agree that it doesn’t offer the clarity of a Coca-Cola. The jump from “discount” to “fair value” would provide substantially the same returns; so, it’s better to opt for the easier, more predictable opportunity.)

Adding 3M to the Portfolio

So, I pulled the trigger on a new, perhaps permanent company – 3M (MMM). I won’t make the “permanent or not” decision on 3M if and until it approaches intrinsic value. Still, F Wall Street invested as though it is a permanent holding (20% of the portfolio) because it seems to offer the clarity and predictability I like in permanent holdings.

3M was added yesterday at $58.86 per share – the average of the high, low, open, and close for the day because I never discussed a price target for it before. Here’s the chart of intrinsic value versus market capitalization:

As you can see, the net price change in MMM over the last eleven years has been abysmal (even including dividends). I don’t attribute that to a bad business; I think it’s because 3M got overpriced a long time ago, and the markets had to wait for the business’ value to catch up.

So, the F Wall Street portfolio is now more invested than not, and has four positions, three of which make up the lion’s share of the value. For all intents and purposes, it is highly concentrated; but, I think our risk is a lot lower than the risks that many of these mutual fund managers are taking on General Motors and Amylin.

Portfolio performance? We’ll look at it again in June – the site’s second anniversary. Until then, we’ll focus on making intelligent decisions, regardless of the short-term price outcome.

In this “rough and turbulent” market, let’s take a look at the first year’s success and overall performance.

How Mr. Market Has Fared

I find it somewhat silly to compare performance to the indices for one simple reason – it is impossible for most investors to hold a portfolio equal to the indices. So, we’ll compare our performance to the Diamond Trust Series (DIA) – an exchange traded fund that closely tracks the Dow Jones Industrial Average – and the Vanguard 500 Index Fund (VFINX) – a mutual fund built to track the S&P 500. The Diamond carries fees of roughly 0.18%; VFINX has an expense ratio of roughly 0.15%.

From June 25, 2007 through August 8, 2007, DIA fell roughly 10.3% when factoring in the effect of reinvested dividends. Because we are looking at a period of just over 13 months, let’s convert to an average annual return – the average annual return for the DIA was (9.2%). A VFINX investor fared a bit worse – down 11.6% over the thirteen months, or (10.4%) on an average annual basis.

The F Wall Street Outperformance

Just following the blog closely, the F Wall Street non-conventional investor did much better. The total return for the thirteen months was 14.6%, with an average annual return of 12.9%. The relative outperformance was stunning. The DIA was the better of the two passive index investments, and F Wall Street outperformed it by 24.9% on a cumulative basis, and 22.1% on an annualized basis.

A $100,000 investment in the Diamond on June 25, 2007 was worth $87,765.63 on August 8, 2008. Throwing $100,000 into a brokerage account on June 25, 2007, patiently practicing your assiduity, and buying the no-brainers discussed on F Wall Street would leave you pleasantly surprised to find $114,629.08 in your account on August 8, 2008.

Admittedly, judging performance based on thirteen months is silly. You can’t look at ten years of business history, project the future of the company for twenty years, and then focus on daily or annual performance. Still, if visitors are on the fence about practicing assiduity, waiting for a fat pitch, and ignoring the markets, this first year might help push you off the fence and into the annual reports.

The Chart of Performance

For you visual folks out there:

F Wall Street Stock Holdings

The F Wall Street portfolio would currently contain just five investments:

• Johnson & Johnson (JNJ) purchased at $62.33 on June 27, 2007;
• American Eagle Outfitters (AEO) discussed on July 12, 2007, but purchased on July 25, 2007 when the price fell back to the $26.31 target;
• Wal-Mart (WMT) purchased at $43.43 on August 16, 2007;
• Adobe Systems (ADBE) purchased at $34.93* on February 1, 2008;
• Nutrisystem (NTRI) discussed a number of times, but ultimately purchased on July 9, 2008 at 13.79*.

* Because no price target was discussed, I used the average of the open, high, low, and close for the day.

You’ll note that I did not include any other positions discussed (eg. Graham Corporation (GHM), Pfizer (PFE)) because I never really analyzed them thoroughly on the blog or talked about them after the fact.

F Wall Street Workouts

In addition to the five long-term purchases, we engaged in two workouts – both of which were highly successful:

• Tribune Company, purchased on December 4, 2007 and sold on December 20, 2007;
• Radiation Therapy Services purchased on January 21, 2008 and sold on February 11, 2008.

I did not include the Clear Channel Communication workout that I bought and sold the week of March 25, 2008 because I never really discussed it here, I didn’t assume a double-dip on Tribune when the price tanked for a brief hour the day of the deal for no reason (but I think I mentioned it somewhere on here after the fact), and I didn’t assume an “average down” in RTSX – purchasing more when the price kept tanking to the mid-$20s prior to the deal’s close.

In short – I didn’t pretend that every transaction was perfect and at the perfect price. Instead, I tried to use plain vanilla purchases and sales based on the dates I discussed them (or the day following the evening I discussed them) and I assumed $9.99 trades on the stock purchases and sales. I assumed we purchased every stock that was attractive, cheap, and timely. For example, I didn’t assume a late March purchase of Nutrisystem because I talked about it later. I did assume we bought it that day after I posted this comment one evening.

Sitting on Cash

As of August 8, 2008, the portfolio would have about 40.2% in cash.

Portfolio Construction

Building a portfolio is all about confidence and risk. If you find four to six Johnson & Johnsons and Wal-Marts trading at discounts, you need not worry about owning anything else. You can put 20% or 25% of your portfolio into wonderful, rock solid businesses selling at discounts and walk away from your portfolio for years.

In the F Wall Street portfolio, I put 20% into Wal-Mart and 20% into Johnson & Johnson.

The mid-caps and the “it’s a cheap mid-cap but I wouldn’t hold it forever” stocks may have a place in your portfolio, but each position shouldn’t be more than 5% to 15% of the overall portfolio. Adobe and American Eagle Outfitters both fell into that range; so, I put 10% of the portfolio into each.

The small-caps and the “it’s a cheap small-cap but I wouldn’t hold it forever” businesses are riskier in that a large competitor can crush them; so, each one should be less than 8% to 10% of your portfolio. Nutrisystem falls into that category and I assumed an investment of 5% into the company.

As many of you know, I don’t mind using leverage on workouts if I’m fully invested. In the case of the F Wall Street portfolio, there was a ton of cash; so, no leverage was needed. Each workout was 20% of the total portfolio, even though I’ve talked about using as much as 30% as well as leverage.

Investment Performance vs. Portfolio Performance

Throughout the year, the portfolio sat (and continues to sit) on a considerable amount of cash as we look for new ideas. That cash is a drag on performance. Though the portfolio grew 14.6%, that return includes the effect of cash. The investments, excluding the effect of cash, grew 24.4 % – an average annual return of 23.5% – which includes some stellar performance, some mediocre performance, and American Eagle’s 50% haircut.

The investments on F Wall Street outperformed an investment in the Diamond Trust Series by 34.7% over thirteen months.

The Portfolio Plan

The logical question is: Now what? What is plan for these holdings? Should we take our profits and/or beatings and run? The market may get worse. Should we cash out and wait to rebuy on the dips?

I look over the portfolio and I don’t see anything worth selling yet. American Eagle Outfitters has seen its business take a turn for the worse; so, I’d institute Phil Fisher’s three year rule. Management has two and a half years left to get the business growing again or I’m gone.

Nutrisystem was grossly overpriced last year at $70 and change. When it hit $13 and change, I felt like the slowed growth (and some shrinkage) was factored in and it was still cheap. Assuming things play out as I expect, I see no reason to sell considering my ultra-cheap buy price. Of course, I’ll monitor the business going forward, but not daily.

Adobe is fairly priced but I think it is a solid company. If I run out of cash and need to sell something, I’m happy to sell Adobe. If I don’t need cash, I think my money is better parked in Adobe at $34 and change than in a money market for a few years.

Johnson & Johnson and Wal-Mart are permanent holdings so long as their businesses remain solid.

I don’t have to make any real decisions today. Sitting 40% in cash, I have to look for new opportunities – not fret over taking profits or losses on long-term businesses I just purchased in the past thirteen months.

The Portfolio’s Expenses and Risk Measures

To date, we’ve effected nine transactions – five long-term purchases and two workouts (for two transactions each). The total paid in commissions was $89.91, assuming $9.99 trades. Thus, the total expense ratio of the F Wall Street portfolio was 0.08% – half that of the funds mentioned earlier, two of the lowest cost funds in the universe.

How “risky” was the F Wall Street portfolio? Let’s think of it this way – the two funds had to be fully invested the entire time, and they had to hold stock in all of the companies of the DJIA or S&P 500 respectively, regardless of how great, mediocre, or bad those companies (i) were or (ii) were expected to become. The F Wall Street portfolio was 81% invested at its highest, but largely held and holds a ton of cash as we looked around for great opportunities.

The two pillars of the portfolio – JNJ and WMT – are massive, international companies with little business risk. Though many will argue that having 20% of a portfolio in a single company is crazy, those same people would love to own JNJ or WMT outright, even if it was their only investment. Add to that the fact that these businesses were purchased when they were on sale based on our estimations of intrinsic value and our risk plummets well below that of other investors (speculators) that blindly invest 20% of their portfolio into a single company with absolute disregard to value or fundamentals.

I’ve said it before – beta measures are nonsense and I don’t even look at or consider them. Still, for you numbers-oriented investors out there: The beta of the F Wall Street portfolio was 1.3 and the R-squared was 0.57 (or 57, depending on how you like your numbers). So, the portfolio moves faster than the market – a good thing. And, it moves largely independent of the market – another good thing.

Putting It All Together

One year performance means nothing. To date, however, F Wall Street has largely been a series of posts with no coherent portfolio to track. Even I was getting confused as to what we’ve discussed. In the past thirteen months, we’ve had a lot of successes, we’ve taken a short-term beating (AEO), we’ve engaged in some successful workouts, we’ve missed some short-term beatings (BX, ALU, AMLN, to name a few), and we’ve missed some high fliers (RIMM). And we’ve done it all without any regrets – comfortably, confidently, and at high rates of return.

All in all, I think we’ve had some very intelligent discussions and I think our performance, albeit short-term, is quite satisfactory, particularly in relation to the overall markets.

Happy belated birthday F Wall Street. Thank you to the more than three million visitors around the world that make this website enjoyable and educational. Let’s have many more years just like the past one.