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Larson's Strategies for Excess Returns

Jeremy Glaser
Paul A. Larson

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Almost as important as having a sound investment strategy is having the tactical tools to execute it well. I'm here with Paul Larson. He is Morningstar's chief equities strategist and also the editor of the Morningstar StockInvestor newsletter. We'll look at some of his top tips. Paul, thanks for joining me.

Paul Larson: Thanks for having me.

Glaser: Let's start off by looking at your big-picture strategy that you use in the StockInvestor portfolios. How do you try to generate those excess returns over time?

Larson: My strategy is a very basic two-step strategy.  And the first step is I focus on companies that have wide economic moats. These are the highest-quality businesses that are in the market, and these are companies that should compound in intrinsic value at above-average rates for long periods of time. So, these are simply high-quality businesses, and that's where I like to go fishing.

The second step of my strategy is to buy these companies only when their stocks trades at a margin of safety, and I define that as having the stock trade below its intrinsic value.

So, again there are two steps of the strategy: One, focus on the good businesses that are going to compound in intrinsic value; and two, buy opportunistically when they are trading on the cheap. And I really try and do both things.

Glaser: This is a pretty straightforward idea, but there are many things that can be a little bit more difficult to actually execute. What are some of the tactical tools that you use to really make the portfolio work? What are pitfalls to avoid?

Larson: One of the tactical strategies that I have is I avoid companies that are exposed to a lawless geographies, and this is something I learned the hard way personally a decade ago investing in a Russian company called Yukos that was basically bankrupted by the government.

But my pain in investing in Yukos I continually use today as a reminder that when you invest in lawless geographies the government is the one really holding the cards. So, no matter how great the company is positioning, how cheap the stock, or how fantastic the--if they're a mining company, if they have this fantastic mine--if they're in a lawless geography, I just try to avoid those situations.

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Glaser: How about the actual trading? A lot of investors like to put, let's say, a stop-loss order in case [the share price] just falls too much and they want to liquidate their position without necessarily having to intercede. Is that something you think is a good idea?

Larson: Stop-loss orders make absolutely no logical sense in the framework that I use to manage the [StockInvestor Tortoise and Hare] portfolios. All else equal, if the fair value estimate of a stock is the same and the stock drops at 10% or 20%, we should be more attracted to that stock, not less attracted to it and thinking about selling it.

You can think back to what happened in the "flash crash" [in 2010] and people who had those stop-loss orders. Then they may have sold out of Procter & Gamble at $15 or $20 below where it was trading the previous day even though the fair value estimate of Procter & Gamble in the flash crash was basically unchanged.

The flash crash is Exhibit A regarding why you should avoid stop-loss orders.

Glaser: You mentioned in your strategy that you are looking for stocks that are trading at a big discount to their intrinsic value, but often stocks are trading at a fairly large premium to what you might think they're worth. Does that mean that you see shorting as an important part of your strategy?

Larson: I actually don't short in the Tortoise and Hare portfolios in StockInvestor, but I do short stocks in my personal portfolio. Although when I say short stocks, I should note that I don't actually short the stocks, I actually go out and I buy put options. And the reason I do this is when you actually short stocks, your potential downside is unlimited because the potential upside to the stock price is also unlimited.

Meanwhile, your potential upside as an investor is only 100% because that's as far as the stock that could potentially fall so that that risk/reward payoff is really not all that great. The benefits to us as investors are quite minimal. That said, I still find shorting to be beneficial not only because it can provide a hedge to the market, but also when I'm looking at a stock it's nice to know that buying is not my only potential option. I can also potentially sell the stock, and that gives me a much more balanced view when I'm looking at the name. Getting something out of that sunk cost of actually researching the stock gives me a much more balanced view.

Glaser: It sounds like that you might buy some of those put options but that going long is still your primary focus?

Larson: Absolutely. Owning stocks over the long term is still primarily what I do. Owning those high-quality firms over long periods of time, I think, has been a winning strategy for us, and I think it's going to continue to generate excess returns in the future.

Glaser: Paul, thanks for your tips today.

Larson: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser.

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