Style Matters

We all know that investment style is important. Typically we think of style as the trade-off between growth and value. The real answer is a bit more nuanced. In my personal investing, I have segregated brokerage accounts for different styles, and I have been managing money this way for a long time.

Style1: Dividend Growers: great franchises, dividend increases every year, good balance sheets, less disruptable products. Examples: Coke, Pepsi, Lockheed Martin, Hersheys, Kimberly Clark, etc. This account has a stated return goal of 7% or more. Right now, these stocks are doing very very well. In fact, this strategy has been up nicely every year, including great performance in 2022, but it is never up huge in any year.

Style2: Quality GARP stocks: great franchises, quality at a reasonable price, market leaders for their products, good balance sheets. Examples: Amazon, Google, Micron, Mastercard, Visa, Booking.com. This portfolio is where I put my less mature growth franchises. Coke has been a good grower for 100 years, but its a lot more mature than Google or Micron. This portfolio has done extremely well, but has drawn down almost 20% in the recent mini-bear, giving back all those great gains in 2021.

Style3: High Yield Plays: lower quality franchises, lower quality balance sheets, distributing high amounts of cash to shareholders typically through dividends. Examples: Exxon & other oil stocks, a few BDC stocks yielding 8% and over, some REITs and second tier hotel stocks. The high energy and materials weighting in this portfolio, combined with the income securities has been a winner in 2022. This portfolio is up slightly year-to-date.

Style4: Speculative Small Cap: pre-revenue biotech, med-tech, other negative cash flow concepts. This portfolio has been slaughtered, even with large holdings of cash. In fact, I was able to see risk, but I kept open a few positions I liked - this was a mistake. Cash was over 50% of the portfolio, and the strategy still lost 30%. Wow. These small-caps are down 70% to 80% on average.

Ampio Pharmaceuticals (AMPE) is an example of one of these disasters:

Sure, I did buy some 2 years ago around $0.40, rode that up and sold calls against it a few times. But this is the type of stock that you can justify a 1% position but not a 5% weighting. If you were like me and had 5% of your strategy invested in this, then you lost everything on a mark-to-market basis. I actually added some shares at $1.60 - these should have been sold immediately when the stock dropped 10% from cost. This would have prevented massive destruction of capital. For those of you looking for a stupid stock with massive upside potential, AMPE could be your name as you can buy at $0.25 and dream of a $2.00 or $4.00 outcome. In fact, it appears that its product may actually work, but it has had a difficult time convincing the FDA. There are so many stocks like AMPE: the story remains the same year after year as they issue more and more shares to fund the extension of the story.

The performance of Stye4 has made me realize that the next time I buy a small or micro-cap stock, I need to have a non-negotiable 10% stop-loss. If the stock is down 10% from the entry cost, I need to sell, no exceptions. You can hold Coke or Google through their 20% or even 40% selloff - these companies will rebound and sometimes even thrive if you hold on. Your small cap company that loses money has a very high probability that once the stock breaks, that the stock just goes down and down, year after year, every year. Every 18 months they will do another financing, further adding to the share count and further capping potential upside.

We all knew that styles matter, but this example of 4 different styles, some up, some down huge, shows that it really pays to be diligent in controlling style risk. Personally, I like to ask myself "will this company still be dominant in 20 or 30 years?" That line of thinking is comforting going into an earnings release - I am quite confident that McDonalds, Google, Coke, and Pepsi are going to be high-quality companies a few decades from now. Another way of thinking about it is whether your stock serves luxury, the middle or the low-end. I prefer companies that serve either the low end or luxury. The middle-class has been squeezed for years and that trend should continue. McDonalds should thrive over the next few decades and I am happy holding LVMH too, as the number of global millionaires will keep rising.

Prices have adjusted downward this year, but its still not time to get aggressive. The catalyst to get aggressive will be some type of large stimulus from either the Fed, the government, or a big stimulative drop in energy prices back down to $65.

Thanks for reading the Finance Professor.