How To Build A Net Net Stock Portfolio That Ed Thorp Would Love
This guest article on how to build a net net stock portfolio was written by Net Net Hunter member Xavier Hill and may or may not reflect the beliefs of anybody else at Net Net Hunter. Photo above by Justin Ladia.
Portfolio management convention requires you to have a “balanced” portfolio that reduces overall beta and maximizes alpha, but why follow convention?
What if we instead overweight our net net stock portfolio with a few great opportunities and ignore diversifying risk? What if after having done the research we determine that an opportunity is both too good and true?
For net net investors we are continually scouring the market for opportunities and while Net Net Hunter provides us with lots of opportunities, some are inevitably better than others. Therefore provided we have done the research, we need to be prepared to be far heavily weighted on the best stocks in order to generate the best returns.
I feel Warren Buffett’s ability to go overweight stocks he knows are trading well below intrinsic value is perhaps his most underrated skill. While Buffett is incredibly intelligent and has an unbelievable temperament, it is his ability to invest big time in a bargain stock that sets him apart from so many other investors. Buffett does not worry about a balanced portfolio, he understood from an early point in his career that great opportunities are rare, so when they come around you need to commit.
"Put all your eggs in the one basket, and watch the basket." - Andrew Carnegie
When you look at the world’s great fortunes they are nearly always made through someone taking a huge position in the one investment. From the Railway moguls like Carnegie, to Bill Gates and Mark Zuckerberg the reality is great opportunities are exceedingly rare so when you see them you really need to commit.
What makes Buffett special is that he did not build a company from one unique opportunity or unique insight, he made his fortune by buying publicly available stocks. Literally anyone could have largely invested in what Buffett has.
Buffett understood from the beginning of his professional investment career that you need to take oversized positions. This was the difference between Buffett and his famous mentor Benjamin Graham who advocated for a more diversified portfolio. Buffett would invest 35% or more of his fund’s entire portfolio into a single net net stock. You can read a terrific example of this when Buffett became an activist investor in the building plan maker and storage company Sanborn back in 1958. John Chew at CS Investing wrote a fantastic case study about this. The stock was an unbelievable net net and Buffett did not miss.
Buffett still takes oversized positions today. A review of his current portfolio shows 17% in Kraft Heinz, 16.1% Wells Fargo 11% Coca Cola 12% Apple and 8% in American Express. In fact you analyze Buffett’s portfolio at any point in his long history and you will see Buffett taking large oversized positions - Far bigger positions than nearly any other fund or investor would.
What You Need To Build A Solid Net Net Stock Portfolio
So, what allows Buffett to do this?
Simply put Buffett has the confidence in his ability to know when he is right and the market is wrong. From Buffett’s telling it was on his honeymoon where to true realization occurred:
On my honeymoon I traveled out west. When I visited the casino and saw all these smart well-dressed people participating in a game with the odds against them, it was then that I realized I won’t have a problem getting rich! - Warren Buffett
While Graham had already educated Buffett in the manic depressive that is Mr Market, on his honeymoon Buffett saw the human face of Mr Market and clearly he liked what he saw.
Buffett has often said:
"[To] Improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches — representing all the investments that you got to make in a lifetime."
Of course it is easy for Buffett to say. He has the experience, temperament and intelligence to see what the market cannot and take advantage of the mispricing. Add to that the fact that you cannot be 100% sure that any net net will work out - we’re always looking at probabilities of being correct - and taking a strong concentration becomes tricky. But, there are steps we can take to overweigh our best picks to build the best performing net net stock portfolio.
It is this ability to take oversized positions that is the next step in my value investor journey. I have seen opportunities in the past, ones that seemed too good to be true so I did not bet big on them, only to regret not doing so. I would see an opportunity and be convinced that there was something I was missing. I would say to myself “How could the market be so inefficient? This makes no sense so it must be too good to be true.” It wasn’t.
There is no point in beating myself up about it but I would see these stocks sometimes quintuple and while hard to watch, ultimately gave me more and more confidence in not just value investing but in my ability to find these gems. After one particular episode I vowed never to pass on loading up on a great opportunity again. Next time I see a great opportunity I will take full toll.
In November last year I convinced myself I had found another massive mispricing in the market in the German power tool manufacturer Einhell. Here was a company trading below net current asset value (NCAV), selling low priced power tools across the world. Revenues, profits and dividends were/are growing, which is rare for an NCAV stock.
Einhell kept coming up in my screening process and I could not figure out why it was so unloved. Once I had read 5 years of annual reports I realized the market had punished Einhell for reducing Net Income from 6 Million Euros in 2012 to 1.6 Million Euros in 2014. Einhell was also punished for trading in Europe - even though it generates most of its revenues from exports to the USA and Asia. As I investigated, the story became more compelling as Einhell had turned the business around and, in 2015, had a Net Income of (Euro) 7.65 million. This is on a stock with a Market Cap of 60 Million Euros trading well below NCAV! The situation was ridiculous. The market was still in a haze thinking 2015 was an aberration and Einhell’s Revenues would soon collapse.
Having done the work I realized this was my chance and took a big position in November last year.
My faith has been rewarded.
But, this isn’t always the case. Overweighting positions to build a high performance net net stock portfolio without the required knowledge and experience can lead to really disappointing results. It’s easy for an inexperienced investor to overweigh the wrong stocks, stocks they assume will rise a lot but are really dogs… or even dangerous. For example, dividend paying net nets produce much lower returns.
Successfully overweighting a position takes a keen insight into business and investing, not to mention a solid understanding of the strategy that you’re using. This is why I find Net Net Hunter membership so valuable.
I now get what Buffett has always said about the structure of a portfolio, that in order to beat the market, you really need to beat the market. You need to beat the market in the size of the positions you take, the research you do and temperament you have. The sad reality is that the market largely consists of those same gamblers Buffett observed on his honeymoon and this is the opportunity for value investors.
Everyone reading this post is likely familiar with value investing and how to value a company but this still is not enough to achieve outsized returns. While a lot of advice is not relevant to the small investor, to really crush the market we need to select the relevant advice from Buffett and a host of other investing legends.
Overweighting outstanding buys is one of those ideas. Great opportunities are rare but they do happen, they happen because Mr Market is a manic depressive, they happen because so much of the market is made of gamblers, they happen for all number of reasons but what we need to understand is that they do happen.
When we do the work and when we understand right through to our subconscious that value investing works we generate the confidence to take oversized positions to build a great net net stock portfolio. Now get the required understanding, knowledge, and skill needed to pick the best net net stocks.
With net net stock investing, some principles are counter intuitive. Certain characteristics of a net net stock investment are associated with better or worse returns as a group. Faith in the wrong characteristic, such as dividend payments, and overweighting those companies can cost you a lot of money long term. On the other hand, overweight stocks with the most beneficial characteristics and your net net stock portfolio can really take off.
This is the path Net Net Hunter founder Evan Bleker is currently on. He’s started to leverage the thoughts of Edward Thorp and the Kelly Criterion and is earning great returns. Net net investing is all about leveraging probabilities rather than certainties, so it pays to overweigh net nets with the best probability of achieving the best returns.
To Build The Best Net Net Stock Portfolio, You Have To Overweigh The Best Net Nets
When Buffett reflects on his mistakes he says:
“The biggest mistakes have not been mistakes of commission, they’ve been mistakes of omission, they’re where we knew enough about the business to do something, and for one reason or another, we sat there sucking our thumbs, instead of doing something.”
We cannot afford to suck our thumbs as great net net stock opportunities are rare. If we are going to build a market crushing net net stock portfolio, we need to commit - it’s one of the keys to massive investment success.
Not Convinced About Overweighting To Put Together The Best Net Net Stock Portfolio?
What Buffett has discovered all the other great fund managers have discovered - even if they are not value investors. For example George Soros protege and investing legend Stan Druckenmiller says...
I’d say (the mistake) 98 per cent of money managers and individuals make is they feel like they have got to be playing with a bunch of of stuff. And if you really see it, put all your eggs in one basket and watch the basket very carefully.”
Druckenmiller is very frank on this topic he says investors need to be a total “pig” when they see a great opportunity.
When you look at the records of all the great money managers, From Icahn to Buffett to Druckenmiller to Soros or Lynch it is clear that to beat the market you need to take big positions.
Taking big positions is not easy and I am still learning but once you have confidence in value investing as a strategy, once you gain skill, insight, and confidence in how to value & identify the best net nets, you are ready to take the plunge. Sometimes a net net opportunity can be so good that you have to plow a lot of money into it. It is the path nearly all the legends have taken and will help you really crush the market year after year after year.
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