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How Downside Protection, Patience Pay Off

Jason Stipp

Jason Stipp: I am Jason Stipp for Morningstar. It's the 10-year anniversary of Morningstar StockInvestor newsletter's Tortoise and Hare portfolios.

Here with me to talk about the performance of those portfolios, what's behind it, and some of his favorite ideas today is Morningstar StockInvestor editor, Paul Larson.

Thanks for joining me, Paul.

Paul Larson: Thanks for having me.

Stipp: So 10 years, looking back, can you talk a little bit about what the performance has been and then we'll dig into the portfolio strategies?

Larson: Sure. We've been blessed with some good performance over the last 10 years. On a combined basis the Tortoise and the Hare have returned 92.5% on a cumulative basis, and then that's versus the S&P, which is up a little more than 26%. On annualized terms on a combined basis the Tortoise and Hare is up 6.7% versus 2.3% for the S&P.

Stipp: So definitely some great outperformance versus that broad market benchmark. We also look at your performance against mutual funds that invest in a similar style. How have you stacked up on that front?

Larson: Sure. Thankfully it's also been quite good. Versus the large-blend category the Tortoise portfolio has beaten 99% of those funds in terms of performance since inception and then the Hare is beating a little under 98% of the large-growth category, which is the best category that it stacks up against.

Stipp: So certainly stacking up pretty well.

Can you talk a little bit about your strategy and what you think were the primary factors behind that performance? What are you doing in the portfolio that's different than a lot of your rivals out there?

Larson: My strategy is pretty simple, frankly. The first thing I do is I focus on companies that have wide economic moats, and a little bit less than 10% of our coverage universe here at Morningstar actually attains that wide economic moat rating. So, right off the bat I am focusing on what I would call the top 10% of companies in terms of business quality.

Then the second stage of my strategy is I only buy with a margin of safety, or as I define it, I only buy when these stocks are trading at a fairly significant discount to our estimate of their intrinsic value or our fair value estimate.

Stipp: So you're looking at a relatively small universe of stocks; you're also being patient and waiting. So it doesn't sound like there's a lot of activity in the portfolios necessarily?

Larson: No and that's actually something I'm quite proud of is, I'm not racking up the commissions and the other trading costs of the bid-ask spread and taxes and such.

Average annual turnover is actually around 17% versus the average mutual fund, which is closer to a 100%. So, my implied average holding period is measured in years--a little bit over five years.

So I think that this is important because when I'm buying stocks, I like to have that long-term focus, and knowing that my intentions are to hold a stock for a number of years, I'm much more careful buying it, [whereas] if I had a shorter-term timeframe, I might be a little bit sloppier on the vetting process with the idea that maybe I can get out in three months if something doesn't work out.

Stipp: So, certainly an interesting counter to the notion that you've got to be in the market trading every day and taking advantages of these small windows of opportunity. Yan can actually take a much more patient approach and get much further.

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Larson: I would agree. I think the key here is to find those solid businesses and own them for a long period of time as they compound in value and also, again, to only buy them when they are priced appropriately to give you that margin of safety.

Stipp: So, Paul, the last 10 years is an interesting time period to look at because we've had good markets in part of that time, and we've had terrible markets, obviously, in part of that time as well. How would you say the portfolio performed in these different market areas and what can you draw from the performance from the up markets as well as the severe bear market?

Larson: Well, my expectations of holding the type of names that I do, the higher-quality names, is that when the market goes down, I expect these portfolios to outperform the market, to actually lose less, and then in bull markets, when the market goes up 20% or 30%, I actually expect them to mildly underperform. But when you combine the two together, you get outperformance and the reason is it's incredibly important to lose less during the bear markets because it's just simple math that if you go down 50% and you go back up 50%, you only have about 75% of your initial investment. When you go down 50%, you actually need to go up a 100% to gain all that back. So, it's incredibly important to protect that downside in the bear markets, and that's what the portfolios have done. Actually, our best years of outperformance have been 2002 when the combined portfolio outperformed the S&P by about 10 percentage points--down 12% versus 22% on the S&P, and then 2008, where the combined portfolios were down only 27% versus 37% for the S&P. And it's that outperformance in those bear markets that really propelled the overall performance.

Stipp: So, in absolute terms, nobody likes to lose money, but when you lose less, then you have a much smaller hole to dig out of during those up markets?

Larson: Yes. I think the old saying certainly applies that you make all your money in bear markets, you just don't know it at the time. And that is certainly applied here.

Stipp: Right. Paul I want to dig in a little bit and talk about some of the individual holdings, and I would like to get some of the bad news out of the way first.

What were some of the names that didn't work out for you and what have you drawn from some of those experiences?

Larson: Sure. Well, perhaps my biggest single mistake was I actually owned Washington Mutual for a number of years and continued to hold it when it went through the bankruptcy. That was obviously a huge, huge mistake. I was bearish on housing well before the crash, but I was not prepared for the magnitude of the problems that we experienced going into the Great Recession. So, that was probably my single biggest mistake.

I also bought in late 2006 and 2007 a couple of relatively levered companies, Cemex and also Vulcan Materials. These are companies that were using debt to go out and buy other companies, and it seemed like not a bad idea in 2007. You can acquire the company, take on debt, pay down the debt with the cash flow that you would acquire, but doing that in 2007, that was obviously not good timing, and it was very easy to look like a goat with just about anything that you would buy in 2007.

Stipp: So, I know that you had some very good company on that WaMu call, a lot of other very smart investors were caught holding that one during the downturn.

So, just a follow-on question to that: When you're thinking about position size, you said not losing money is a very important thing. Obviously these bad calls didn't sink your portfolio. Your portfolio was still able to outperform. So how do you think about that?

Larson: Well, I am a believer in the Kelly criterion, more in spirit than in actual quantitative manner. And what this is, is I have relatively high-confidence positions in the portfolio take a larger weight in the portfolio than those positions that I am a little bit less confident in.

I do run a relatively diversified portfolio, as you mention. I do have some large weights in the portfolio, 10% or greater weights, but these are companies that are generally not levered. If there is one common denominator in my mistakes, it was companies that had bad balance sheets, that had levered balance sheets, so when something bad happened, it really magnified the problem.

So, I'd say, staying away from companies that have relatively large amounts of debt, and also keeping those relatively large position sizes in the wide-moat firms that have the good balance sheets--I think the combination is important.

Stipp: OK. So, Paul, I want to turn a little bit now and talk about some of your good ideas today, where you're finding opportunity. Market overall has been pretty fairly valued recently, but you're finding some pockets value here and there?

Larson: Well, with the recent sell-off, we're starting to see more pockets of opportunity, but the stocks I like the best today are actually the ones I've liked for a while.

One is Lowe's. This is a company that has been hurt by the downturn in the housing market, and the stock has certainly reflected that, but the market is not giving the company any benefit for an expected upturn in housing when we get to more normalized positions once all this excess inventory is actually burned off.

We think that there's pretty significant upside potential for profit margins here. We think the stock is worth $36 versus a price that's in the low $20s.

Another favorite of mine right now, another real estate play so to speak, St. Joe Company. This is a company that does not have any net debt on the balance sheet. It actually has over a $100 million in net cash sitting in the balance sheet. It's basically a giant land holding company. So they've gotten the cash-burn rate down very low. Meanwhile the implied valuation on the stock is incredibly cheap: less than $3,000 an acre at the current price. And we think that the stock is worth roughly $34 versus a current price near $19.

Stipp: So with St. Joe, what is all the pessimism around it? Because this is a controversial name; it's in the news a lot. A couple of smart investors are on the bear and the bull side on this stock. What do you think is behind that great pessimism?

Larson: Well, I think it's just Florida real estate, and you look at the last couple of years in Florida real estate, it has been an unmitigated disaster, but just because it's been a disaster doesn't mean it is going to be a disaster from this point forward, especially given the current implied valuations.

People are still going to move to Florida; the beaches are still attractive. The sun still shines in Florida. These are things where I think the secular move from the Northern states to the Southern states is going to continue. And ... they just opened a new airport about a year ago in the area; [St. Joe's] land actually surrounds the airport, and I think the new airport is certainly going to catalyze development in the Panama city area.

Stipp: The last name you have for us, Paul, is one also that I know Josh Peters, who is the editor of Morningstar DividendInvestor talks about some. What is that name that's in the pharma industry?

Larson: Abbott Labs, a local company here in Chicago. I'd say this is probably my favorite health-care name at this point in time, and we think it's worth $68 versus a current price near $51, and the current market price is right around a 10 times forward earnings rate, and this is for a company that is a wide-moat name--a relatively high-quality, diversified name--that should grow its top-line revenue over the next couple of years at a 7% to 8% rate. And yet here we have a stock that's again trading at about 10 times earrings. It just seems like a good bargain. And you mentioned the dividend; you are getting paid over a 3% yield today while you are waiting for this growth to be reflected in the stock price.

Stipp: And in today's environment, 3% is nothing to shake a stick at.

Larson: Nope.

Stipp: All right, Paul, congratulations on the last 10 years and best wishes for the next 10 in the StockInvestor portfolios.

Larson: Thank you.

Stipp: For Morningstar I'm Jason Stipp. Thanks for watching.