2015 a year of realization, refocus, and anti-diversification

Amateurinvestor beat the market soundly in 2015. The 1 year return was 23.7%; 3 year: 22.1%; 5 year: 21.6% and 10 year: 15.3%. The S&P 1 year return in 2015 was -0.73%. As of 1-5-2016, S&P 3 year return was 11.2%, 5 year return: 9.58%, 10 year return: 4.70%. Therefore I have approximately doubled the S&P returns for 3, 5 and 10 years.

The relative proportions of my holdings are as follows:

MSFT 48.75%
CNI 4.6%
SBUX 19.7%
V 24.7%
ADBE 1.4%

The portfolio is rather focused, in fact the number of stocks dropped from 8 at the beginning of the year to only 5 stocks today. I would like to share some thoughts regarding my sale of 2 companies this year, Cerner (CERN) and Intuit (INTU). I sold these because I realized their purchase was a mistake.

I bought Cerner in October 2013 at $57.75. Cerner is the largest dedicated digital medical records software provider, has an impressive gross margin and a business with a high proportion of recurring revenue and switching costs. I bought it because it has an impressive record of growth for over 35 years. It provides a software platform is a critical part of its client’s business operations. It has staying power and seemed to have a durable competitive advantage. At the time I bought it, I owned just 6 stocks, which seemed to me to be very few, even for a focused portfolio. It seemed wise to diversify into a new strong company I had found. I had a few small doubts at time of purchase. At the time CERN had risen because of recent success in agreements to sell its software and services to major medical centers, particularly Intermountain Healthcare in Utah. I knew it was richly valued. In addition, it regular buys shares to compensate for share based compensation, but still manages to continually increase its share count, which casts doubt on its dedication to shareholder value. Unfortunately, events have shown that because of its high valuation, any miss in analysts’ earnings/revenue estimates are met with a drop in the stock price. There has been some loss of important customers to competitors recently which casts a little doubt on the invincibility of its moat. I decided to sell on August 10. At this point I was uncertain how well it would recover from the market instability of that time. Moreover, I was provoked by a quarterly revenue miss. Overvalued stocks with evidence of weakness in their franchise do not do well in market downturns. I sold at $65.40, at a modest gain, so the damage was limited. On Jan 6, 2016, CERN was at $57.9.

My error in this case was a failure to understand the Cerner business well enough either to a. be convinced that its earnings would continue to grow safely in spite of current overvaluation and related vulnerability to temporary downturns, or b. realize that it’s competitive advantage and dedication to shareholders were lacking and therefore not good enough to earn a place in my portfolio.

Underlying this mistake is a more fundamental and common error, that of impatience. I could have simply taken the necessary time to analyze the company before buying. Had I done so, CERN would have been available at a little less than $50 several months later in May 2014. In any case, the allocation at the time of purchase was approximately 0.8% of the portfolio, so the damage was bound to be limited. I cautiously limited my allocation because of my trepidation regarding valuation and other factors mentioned above. In fact, one might ask what was even the point of investing such a small amount in this company. To this I can only reply that I acted from intuition instead of analysis. The advantage of this is that it certainly limited the damage caused, while adding experience. The avoidance of serious mistakes is an important part of investing success.

Upon reflection, I note that I cautiously limited the size of my allocation, and also that I feel a needed a deeper understanding of the company, and that I could have been more patient. We will revisit these points later.

Intuit is an apparently attractive business, with a dominant share in small business accounting software, and market leading shares in retail DIY tax software and professional accountant tax software. As are Cerner, Microsoft (one of my favorite investments) Intuit was a survivor of the early 1980s boom in computing. As with Cerner, it seemed to be a judicious addition of a long lasting company with clear competitive advantages to my portfolio of so called eternal companies. I bought it in February 2015 at $91.00. It seemed somewhat overvalued but I attributed this to the well-established strength of its franchise. It has introduced Quickbooks Online, a cloud based version of its dominant Quickbooks small business accounting software. Other than Turbo tax, the market leading consumer tax software, the other anchor of its competitive advantage is (was) Quicken, software for home finance management.

In August 2015, again at a time of market turmoil, Intuit management made some capital allocation decisions which shook my confidence in their competence, namely the decision to divest Demandforce and Quicken. Intuit had acquired Demnandforce, an email marketing company for small businesses, in 2012 for $423.5 million. Intuit thought to integrate it with Quickbooks. 3 Years later, CEO Smith explained the abrupt decision to divest this recent acquisition made for over 10% of its 2012 revenue at the related investor presentation. He matter of factly stated that Demandforce and QuickBase [another business divested at the same time) are great businesses, but they do not support the QuickBooks Online Ecosystem and both serve customers that are up-market from our core small business customers.” When asked by an analyst to address Intuit’s record of acquisitions, he stated “many of the larger ones have not gone well”. “…We have a mixed record in terms of bolt-on businesses, new businesses that may not plug-in directly with QuickBooks or tax businesses…” and promised that management had developed a “set of criteria that [future acquisitions] have to meet”. In other words, he was promising that 32 years after its founding in 1983, Intuit would begin to ensure acquisitions make sense for the company before purchase. Obviously these words are not those of a CEO of an eternal company. Quicken was one of its original businesses at the founding and was providing over 20% of revenue in FY 2014. I was surprised by the decision to divest this instead of adapting it and continuing growth.

The poorly planned capital allocation into Demandforce and the abrupt divestiture of Quicken gave me the impression that Intuit management may not be able to adapt successfully to future markets. I had bought in February 2015 at $91.02 and sold in September at 89.26. I found it difficult to pinpoint where I went wrong here. Intuit seemed to be a sound and strong business, providing necessary products which had market leading shares. Perhaps if I had read more of the past financial reports, I would have discovered other episodes of poor acquisitions. Perhaps I should have simply observed its progress over enough time to get a more detailed impression of how it functions. Prior to its purchase, I had considered Intuit to be a strong business with an economic moat which was akin to those I owned. I actually sold shares in Visa and Starbucks, both of which were highly valued by conventional measures such as cash return, to buy Intuit. As happened with Cerner, I felt I lacked deep enough understanding of the company and its management, without which I was vulnerable to nasty surprises.

In the case of both Cerner and Intuit, I felt surprised by adverse company events, and retrenched back to my long term holdings. Therefore, 2015 was a year of realization, that buying companies which seem to be good businesses, and even to have a durable competitive advantage, is not enough. they must be observed to dominate their markets for the foreseeable future, and be observed to demonstrate management competence and respect for shareholders over some time, until one is convinced.

But how is one to judge when the evidence is enough to justify buying and holding forever? Sometimes the clue to a solution to a life problem can be found in a careful reflection upon the experience, and asking the question, “how did it make you feel”. This is because the correction solution is only correct if it is the right one for yourself. In the case of investing, as Benjamin Graham stated, “the investor’s chief problem, and even his worst enemy, is likely to be himself” (Intelligent Investor). The investor will need to be comfortable holding his security in the face of inevitable market fluctuations. In this case, as previously noted, I reflected that I did not feel I had a profound enough understanding of the company to feel comfortable holding in the face of a market downturn. The solution then is to wait and continue to analyze the company until I feel I know it well enough to be able to commit, or not. There are also cases of companies which are actually worthy, but seem overpriced, in which case one would wait for a market downturn even after having come to understand the company sufficiently.

This process of coming to understand the company is not purely intellectual. For example, I doubt a simple analysis of financial statements prepare one for Intuit CEO Smith’s rather absurd explanation of his failed acquisition of Demandforce. I believe rather than one must experience the company as much as is possible via its communications, perhaps its products, and by communicating when possible with clients, customers, employees. One must build a relationship with the company, until one feels one can trust it. This is actually what the legendary investor Philip Fisher (author of the book Common Stocks and Uncommon Profits) termed “scuttlebutt”, the flow of information he held indispensable for analyzing a growth stock.

Exploring a company which seems promising, and might rise in value, while waiting to feel fully comfortable enough to commit before buying, is difficult for two reasons. First, it requires patience. Inevitable, one is afraid of missing a low price. Second, it is surprisingly difficult to be motivated to really experience a company, to form a relationship with it, unless you have an interest in it. This may lie behind the investing approach of the excellent hedge fund ValueAct Capital. The investment staff study a company until it seems to be a good bet, then buy a small share and continue to follow it until they know it well enough to feel they know how it makes money, and what to expect from it. They then deepen the relationship by buying a stake large enough to command a board seat, and continue becoming part of it. Perhaps by buying a small stake in a company, I can be motivated to follow it closely enough to understand it better. Seen in the light of these thoughts, perhaps my cautious forays into new additions to my portfolio may not be faulted too much, but in fact be considered a necessary step to taking the time to come to know a company. And by limiting the size of initial investment, I limited the damage caused by errors. But the benefit is that this might be a way to actually discover new gems. Such was indeed the case with Adobe, a small investment I made which was turned out to be a wonderful investment.

Finally, 2015 was a year of anti-diversification, the acceptance that there are truly few companies which have exhibited the qualities of an eternal company in a lasting way, and acceptance that there is no need to diversity just for its own sake. In 2015 I sold Visa and Starbucks, which I had owned for years, and which I knew where companies with very strong franchises, to buy a new company, INTU, which I was less familiar with. Having corrected this error, my portfolio was whittled down to 5 companies. This time, I feel happy with the small number.

But again, reflecting upon this retrenchment back into my small collection of investment gems, I find that the high degree of comfort I have with my existing portfolio, continually reinforces the reluctance to invest in new companies. As my understanding of and satisfaction with my exclusive set of existing investments grows, this sets a higher bar for new companies to meet. And this may actually be an anti-diversification mechanism by which focus investing reinforces its own success.


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