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United Health Group Competitive Advantages: Scale, Cost, Network – and Efficiency.

How does United Health Group (UHG) drive its competitive strength in the US healthcare market?

United Health Group comprises two distinct, complementary business platforms, United Healthcare and Optum. UnitedHealthcare offers health insurance benefits under 3 divisions. UnitedHealthcare Employer & Individual serves employers of every size and private or public sector. United Healthcare Medicare & Retirement serves Medicare beneficiaries, including Medicare Advantage, and retirees. United Healthcare Community & State manages benefits for state Medicaid and community programs.

Market Share drives scale and derivative network advantages. Through organic growth as well as serial acquisitions, United Healthcare has become the largest insurer in the US, by premiums written and number of lives covered. Of note, it has the greatest number of Medicare Advantage clients. Its market share in a number of local markets is large enough to drive competitive advantages of scale; with a majority local market share of customers insured, it can demand lower prices from medical providers. Accordingly, it can offer lower insurance premium prices to payer clients such as employers. The low prices resulting from scale advantages, support the competitive advantage of network effect. The employers attracted by low premium prices, attract providers who need access to the population of insured patents.

Business diversification confers economic resiliency

Optum contains 3 segments: Optum Health, Optum Rx, and Optum Insight. These are diverse businesses that reinforce the business agility and competitive strength of each other and the United Healthcare insurance platform.

Optum Rx is a Pharmacy Benefit Manager (PBM) which creates switching costs competitive advantage related to contracts with employers. PBM scale attracts drug makers and pharmacies who need access to the insured patient population. Low Cost competitive advantage results because the PBM can demand lower prices from these pharma companies and pharmacies. These lower prices attract employers, which attracts drug makers in a virtuous cycle. UNH actually ranks third in market share, among large US PBMs

Optum Health operates medical care providers; chiefly primary care, urgent care and outpatient surgeries, as well as a wide range of ancillary care services. Optum Health operational efficiency is guided by data, technology and analytics of Optum Insight, described below. These tools improve care practice and reduce cost. When patients covered by United Healthcare insurance use care from Optum Health, the relatively favorable value/cost ratio obviously reduces costs for the insurance group. But these attractive margins also attract business from other insurers.

The business diversification brought by Optum Health benefits UHG by increasing revenue when medical care utilization increases, such as during seasonal epidemics. This gives UHG an advantage which pure play insurers do not have because their medical loss ratio (MLR), the proportion of revenue paid in claims, must increase during such episodes.

Optum Health includes Optum Financial, including Optum Bank. With over 24 million consumer accounts, nearly $22 billion in assets under management, Optum Financial facilitates payment flows for consumers, via tools which include Health savings accounts, Flexible Spending Accounts, Health Reimbursement Arrangements and other financial benefits. Optum Financial charges fees and earns investment income on managed funds

Optum Insight is an analytics and consulting service business made possible by the digitalization and exploitation of data resulting from the considerable experience of UHG. It has likely the largest medical records data collection in the health insurance market, including over 285 million lives of clinical data and claims (URL 2023 10K) In this division, data is harnessed to various important applications for insurers, providers and patients. Meanwhile, the evolution and growth of the Optum Health care provider business gives United Health Group an experiential advantage that pure play insurers do not have. It serves as a living laboratory of the Optum Insight management intelligence.

In essence, the Optum Insight business consists in harnessing data to increase economic efficiency and consumer, payer and provider engagement in healthcare. Increasingly, this consists of the application of digital tools, with Artificial Intelligence (AI) in an important role. Software tools obtain a higher gross margin than the healthcare provider business they are deployed in. By reducing friction, improving the patient and provider experience and reducing costs of inefficiencies in the US healthcare system. Optum creates value which drives its competitive advantage.

For providers and insurers, Optum optimizes revenue cycle including coding, billing, utilization review. Medical records and claims data is exploited using AI, including novel natural language recognition software which it patented. It provides management consulting and clinical quality guidance resources to enable modernization of administration and improved business efficiency including value based care. Digital transformation reduces administrative costs and delays.

Optum thus provides diverse resources to enable client insurance or care provider businesses to improve their performance. Especially the smaller companies in these industries tend to have thin margins. A contract with a consulting client may include a financial or performance outcome which must be attained in order for Optum to be paid for practice changes or software tools it advised and managed. At times, the Optum Health segment acquires businesses that were not financially successful enough to remain independent, as in the recent case of the national physician practice network of Steward Health.

Optum Insight reinforces the competitive advantage of the United Healthcare Group by increasing efficiency and raising margins of all UHG business segments. And Optum’s management consulting services do not benefit UHG just by compensation for the services rendered. Contracts whereby Optum Insight is deeply involved in clients operations likely have advantages of switching costs. Moreover, a client such as a medical provider group which increases profitability because of Optum management consulting, can raise United Health insurance margins by tolerating lower insurance reimbursement, in order to serve the patient population of United Health insured consumers. This is where the larger amounts of revenue is created, as a result of the work Optum does to reduce business costs for the care provider entity, such as hospital or practice. The management consulting work of Optum reinforces the scale and low cost competitive advantages that enable UHG to attract employers and other payers of health insurance.

Of the 4 business segments of UHG, Optum Insights has the highest operating margin. However, because of recurrent acquisitions, Optum Rx and Optum Health segments have grown faster in size. Nevertheless, as I described, I feel the business activities housed in this smallest segment are key to sustaining the company’s competitive advantage.

Over 10 years from 2013 to 2022 (I read 10 years of annual reports for this), UHG Operating Earnings were contributed by the 4 business segments in proportions which changed as follows. In 2013: United Health: 74%, Optum Health: 9.85%, Optum Insight: 8.6%, Optum Rx: 7.4%. In 2022: United Health: 50%, Optum Health 21%, Optum Insight: 13%, Optum Rx 16%. Over the decade, the percentage of Operating Earnings provided by United Health insurance segment declined from 74% to 50% of the corporate total, with those of the other three segments increasing. Earnings of Optum Rx and Optum Health rose more than those of Optum Insight, because they included the earnings of newly acquired companies.

The Operating Margins of the 4 segments have changed as follows: 2013: United Health insurance: 6.4%, Optum Health: 9.9%, Optum Insight: 19%, Optum Rx: 3.1%. 2022: United Health: 5.8%, Optum Health: 8.5%, Optum Insight: 24.6%, Optum Rx: 4.4%. Optum Insight is the most profitable as a business, although it produces the smallest proportion of operating profits.

Regarding current valuation of the stock, the price/earnings (PE) ratio is currently 21, approximately the same as the average of the last 10 years.

From 2014 to 2023, annual diluted EPS rose 4.186 times over, from 5.7 to 23.86 dollars per share. Meanwhile, ROIC, in mid-teens, and ROA, over 20%, have been quite consistent. Discovering United Health Group (UNH), a Novel Portfolio Holding. | amateurinvestor.net In recent quarterly earnings reports, the stock sells off somewhat when the medical loss ratio (MLR) is reported to exceed analyst expectations, regardless of the fact that UNH beats earnings expectations. It also declined when CMS raised Medicare reimbursement less than expected. Thus, the stock price is essentially unchanged for the year.

As we intimated previously, a preeminently successful health insurance company such as UHG has a history of continuing to raise revenue and profitability despite the apparently ever-present nemesis of medical costs, and ever reluctant (but inevitably materializing) payment for these costs. Having started a position in UNH about a year ago, ideally I would have waited until some of these transient misfortunes occurred, in order to obtain a lower price. Apparently, we do not live in an ideal world.

In Optum Insight, digital transformation, including AI, will continue to progress into the healthcare industry, liberating value, and no doubt United Healthcare Group will continue to lead here. Whereas AI is now a “hot topic” and expected to create vast stockholder wealth in a rush, healthcare insurance companies never seem to be popular. It seems UNH stock is held hostage to expectations regarding the MLR, regardless of its ability to consistently beat earnings expectations. The advantage of this is that it is less likely to rise euphorically, with subsequent dramatic drops in price. Instead, it must earn its way up in price through demonstrated, sustained earnings growth. As it has done, with an average annual return of 25.18% as of April 24, 2024, since March 1990. The total return calculator (including dividend reinvestment) only goes back to that date. But the stock had doubled between IPO on October 16, 1984, and April 1990.

Balanced fear and trust in portfolio construction

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1-10-2024 Humans have an emotional basis for thought, including their portfolio investment decisions. Therefore, practically speaking, a successful investment strategy must be able to operate while being associated with these emotions, functioning both in spite of, as well as because of them.

The market correction of 2022 was related to the Federal Reserve’s increase of interest rates, with consequent fears of prospective slowing of economy, and associated adjustments in analysts’ models and earnings estimates. Market downturns cause fear among holders of stocks. This is not totally avoidable, and it happened to me.

Why was I afraid? Unfortunately, I had committed a major error in my role as investor, an error which had become a pattern over several preceding years. New time constraints occurred, related to devotion family demands, passionate commitments to fulfilling personal pursuits, and duty to professional demands. Therefore, over a few years I had much reduced my formerly practically constant reading about my companies and investing in general.

Bearing in mind the nature of my investments, “eternal companies” with a durable competitive advantage that have the “culture” and capital, human and financial, to adapt to continue dominating their market. These companies can weather an economic downturn and rise with the recovery and continue on their march to growth. We know this because they have done so repeatedly over their history, and they continue to develop the qualities which drive this durability. And so these companies do not require constant monitoring to see if their earnings are finally coming into existence, or if paying customers are appearing, as is the case with some novel hot companies. Indeed, this is one specific advantage of the “eternal company” concept for the individual investor who has done the work to select investments, but does not want to spend an inordinate amount of time on an ongoing basis, worrying about his portfolio.

However, because I was no longer keeping close track of my investments, having reduced my immediate awareness of my portfolio companies’ current achievements and strengths, I was vulnerable to the fear which affects the ignorant in a market downturn. In the anxious and volatile market of Summer 2022, recession was widely predicted by economists for early 2023. I began to read again. I did not in panic sell my holdings at the low points. This was because I know they are sound investments and this attachment has an emotional tone. However, while I refreshed and reestablished my current knowledge of the repertoire of business strengths of my companies, I felt the need to do something to protect my portfolio from a time period of losses of unpredictable duration. I searched for a suitable candidate investment to which I might allocate part of my capital. One which did not correlate with my current holdings and might therefore better withstand a possible upcoming recession.

Thus, at approximately the end of January 2023 I shifted some funds from my current holdings, to a novel portfolio component: United Healthcare Group (UNH). I reallocated approximately 1/3 of funds from ADBE, 1/4 from MSFT, and less than 1/4 from V. I made these moved because of anxiety regarding recession, rising interest rates and the effects on tech and digital finance stocks. But I made only a partial reallocation, because I trusted my current companies would certainly eventually recover and in fact likely take market share during any recession.

As the broad market recovered in the second half of 2022, it became clear that I had traded a portion of funds out of my current holdings, just in time to miss the major recovery run ups of 12.3% for V, 49.3% for MSFT and 60.6% for ADBE. In contrast, UNH only appreciated approximately 8% between January30 and the end of 2023. My return on investment for 2002 would have been better had I remained fully invested in my original portfolio of eternal companies.

This episode yielded a couple of investor lessons. By regularly reading, keeping informed about your own investments, you are continually aware of the reason that they are sound investments. Had I done this, I might have held onto my ADBE, MSFT and V with more confidence, knowing that the companies would certainly survive and thrive. Even should a recession have occurred, as companies riding a wave of secular market expansion, they would play an early part in the rebound of market sentiment as the prospect of tangible economic growth reappeared ahead.

Second, equally important: regularly search for novel portfolio candidate companies which are in a different business and sector than current holdings. Do this research in anticipation of a change in economic conditions which makes the novel companies a relatively better value. In this way, you can be ready to shift allocation into them at this relatively lower valuation compared to your current holdings. Moreover, preferential selection of companies in different sectors promotes construction of a portfolio whose future performance is less vulnerable to economic changes which harm a specific sector. Finally, keep informed of valuation conditions in the various market sectors so as to know when they are likely to present relatively better values and opportunities for purchase.

Because I did not maintain this regular, anticipatory research, I had yet to identify new portfolio candidates with relatively more attractive valuations, by the time MSFT, ADBE and V hit new highs in the second half of 2021. Instead, I delayed until they had already reached subsequent 52 week lows in Spring of 2022. I therefore lost the initial period of advantaged returns which could have resulted from diversification into non-correlating holdings.

Notwithstanding my apparently poorly timed UNH purchase, portfolio performance (IRR) for calendar year 2023 was quite good at 43.2% This was a product of both the durability of my long term holdings, and that of the new investment. I continued to trust in my long term holdings and therefore resisted selling them completely even in the face of significant price declines. This was balanced by anxiety regarding further losses related to a recession, prompting my search for a company meeting my investment criteria, with returns not likely to correlate with my current holdings.

I admit these emotionally related errors not just because I value transparency and truthfulness. It is important to know that an investing strategy can be reasonably successful in spite of your fears. A strategy which depends on perfect logic is pure fantasy.

Interestingly, the selection of UNH actually represents an evolution of my eternal company criteria. This innovation was stimulated by necessity, the mother of invention. I will describe my process for selecting UNH in a separate article.

The Personal Growth evolution of Consumer to Investor

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12-15-2023. From an only financial point of view, wealth might be defined as financial freedom which confers the liberty to choose how to allocate one’s time and resources, according to one’s personal values, and not from necessity. The path to this liberty is formed by many years of living in a way that builds that wealth. That is to say, time spent building assets. This is logical because wealth cannot be built by prioritizing expenses which result in transient pleasures (for example, expensive restaurant meals). Rather, wealth is built by accumulating assets which produce income greater than the value invested, that is, they have a good return on investment.

But there is a further underlying truth of a fundamental nature. Your personal values and habits determine whether you live as an investor, or as a consumer. Do you expect to spend on things which are satisfying but have minimal future value (return on investment)? Or do you conserve your financial resources, directing them in a focused manner towards projects which will give a good return on investment? The implication of this, is that if you are accustomed to living as a consumer, you are unlikely to reliably and successfully invest at isolated times, and thus make possible financial freedom.

Becoming someone who saves money to fund your investments, be they business, real estate or common stocks, requires a rearrangement of your spending priorities, from consumption to investment. And this changes your life in many ways, affecting your use of spare moments, choice of reading material, what you eat, choice of car, friends you choose, leisure time, clothes, etc.

Therefore, the path of learning to invest so as to gain financial freedom, is very much the path of Personal Growth, the path of investment in yourself. The hard thing about personal growth, is that it requires change. And the prospect of change brings fear, in that it implies abandoning the familiar emotional landscape.

I feel that this is at the root of the difficulty that Robert Kiyosabi describes in his seminal book “Rich Dad Poor Dad”. This book was probably the very first I read, in my personal transformation from consumer to investor. I believe in 2001. It sparked a life changing transformation over a number of years.

Kiyosaki initially paints a picture of the conventional Rat Race. According to conventions of socioeconomic status, a successful person lands a “good job” providing significant earned income. They spend this earned income to fund a desirable lifestyle, financing it with debt via in mortgages, credit cards. Frequently, both spouses in a marriage work. As careers prosper and incomes rise, so do taxes. Moreover, The couple must spend to enjoy themselves, on vacation, luxuries, the fruits which allow them to feel justified in spending their hours in labor. When children arrive, the dream house must be purchased. Home equity loans are obtained, meant to reduce high interest debt, which nevertheless seems to reproduce itself. As the children begin their education in the best school available, the spending increases dramatically. The conventionally successful citizens pursue the elusive goals of the ideal socioeconomically advantaged individuals. However, they never attain true financial freedom because of the poor margin of their income, primarily from labor earnings, over their expenses. They never built income earning assets. From a business point of view, the function of their Rat Race lifestyle run is to provide revenue for interest earning financial institutions which are financing their lifestyle.

In the Rat Race, all forces militate against the growth of assets, wealth and the attendant liberty. The alternative to the Rat Race, is to grow assets. The income these produce, with much less of your time commitment, will give you the liberty to choose how to spend your time, studying or working on something you value. You thus gain control over your life.

Anyone can achieve the prosperity conferred by owndership of assets, if they acquire financial education. That is, the understanding of assets and liabilities.

But what prevents individuals from embarking on their own personal growth of financial education? Emotions that are not fully recognized, such as fear and greed. Out of Fear it is that you take the suitable job which promises a solid pension, and not because you have a love and talent to fulfil your greatest potential as a bureaucrat. Out of fear you spend to impress your spouse or friends, or buy that house, which really means, acquiring the mortgage which ties you to that job, and address.

The path to personal growth might go something like this. First, recognize the emotion. Then, realize you do not need to act on it. Third, while you contemplate that emotion, see if you can understand what is actually, and with some reason, causing it. For example, fear of not having enough money in your old age. Fourth, think about a way that meets that reasonable need, more effectively. Regarding financial education, that would be, identifying an investment you could make that will provide a better return on investment. And this final step, is a long and fascinating adventure of education that will entail multiple episodes of uncertainty, but if you have the courage to continue the quest, will also entail times of euphoric discovery, followed by incredulity that few others have discovered these paths to wealth.

Truly, the personal growth of financial education is open to anyone. To begin, you need openness to the possibility of growth, and courage to leave your familiar fears. And both of those cost no money.

Snap Inc., Not an Investment.

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Snap Inc, “the camera company” IPO’d on March 2, 2017. Snapchat is popular and useful to those who use it. It is a prominent player in the currently expanding market in visual media on social media. Therefore, admirers of Snap products might be attracted to the Snap Inc IPO as an investment.

Does Snap meet criteria of an Amateur Investor investment? Let’s go through them. The first criterion of an Amateur Investor investment is the presence of a sustainable competitive advantage, such that the company sells a product that is indispensable to its users. It is virtually certain that in 10 years the company will still be dominant in the market for its product.

Will Snap be dominant in its market in 10 years? Let’s back up and ask a simpler question. Will Snap exist in 10 years? Hmm… Why not back up again and ask a different question. Did Snap exist 10 years ago? Of course, the answer is no. How could we get an idea as to whether similar companies had sustainable competitive advantages? Oops, I guess the word “had” kind of gives it away. As chronicled in this lovely Wall Street Journal article (I recommend subscribing to and reading the Wall Street Journal, especially Business section, because its articles are simply narratives based on facts, unlike articles in some other high profile newspapers (I won’t mention the New York Times)), a number of social media wonder stocks have climbed to the height of stardom and then fizzled when least expected, not necessarily even going out with a bang. For example, Twitter has over 319 million users, but its market value has fallen by more than half since its 2013 IPO. Friendster back in the first decade of the 2000s had 75 million users before fading. Other somewhat less successful social networks are mentioned in the article. There is evidence that Snap does not dominate its market and is not indispensable, in that Instagram’s launch of Stories, a feature similar to snapchat, resulted in a significant slowing of Snapchat’s growth.

The second criterion for an Amateur Investor investment is that the company adapts by evolving its competitive advantage into evolving new markets. Since Snap does not have a competitive advantage, it does not meet this criterion.

The third criterion addresses devotion to shareholders, for instance by making sure shareholders have voting power commensurate with their stock ownership, obtaining a good return on investment in acquisitions, avoiding stock dilution and so on. In fact, the shares floated in the IPO on March 2^nd do not have any voting power at all. They are Class A shares, with no voting power. After the IPO, close to 90% of the shareholder voting power is held by the two cofounders, Evan Spiegel and Robert Murphy. They hold all the Class C shares, which have 10 votes per share. I didn’t even bother to look up who owns the Class B shares, which have 1 vote per share. Because Amateur investors would not be able to get ahold of those anyway. Why does this matter? Say in a few years (or months?) Snap decides to acquire another asset, say another company. In order to raise the necessary cash, it floats a large amount of Class A shares (only about 25% of these were sold in the IPO), thereby diluting the shares in the market and causing the price to fall. Suppose many stock holders disagree with the wisdom of this acquisition. What can they do? Can they vote against it as in a normal company? No, there is nothing they can do. The founding company owners are already wealthy, they are not affected.

The fourth criterion for one of my investments is that the company must be at least 10 years old. The fifth, that the investment is worthwhile based on the company’s past achievements, not just its hoped for future attainments. The Sixth criterion addressed good return on investment, including low debt level, growing free cash flow, high gross margin, high ROI. Snap has no earnings, in fact its losses of over half a $ billion exceeded its revenue of about $400 million.

In a nutshell, it is not possible to be sure whether Snap will still be going strong in 10 years. It might, but then again, it might not. It has no earnings. Why take a chance speculating with your hard-earned money by buying this new company, when instead you could buy a company which you could be sure would grow and continue to be extremely strong and successful for the foreseeable future?

For inexperienced investors that feel they want to try buying something they like, I must agree that gaining some experience in the stock market, if it is with a very small amount of money that you can afford to lose, might be a way of stimulating and motivating the emotional learning process needed to learn about proper investing. There are people who say you should not invest at all except with money that you can afford to lose. But we Amateurs know that is nonsense. Investment, as Benjamin Graham stated, is a purchase that upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative. There are various approaches to investing that could satisfy this definition, depending chiefly on what you, the individual investor, judge to be an “adequate”, satisfactory return.

In the Amateur Investor approach to investing, you must simply learn several important realities about businesses, the most important having to do with competitive advantage, of a durable nature. You are looking for the company of which in 10 years it will be said “in 10 years this company will still be growing and dominating its market, and evolving and adapting to continue extending this dominance into the changing market.”

Portfolio Performance for 2016: underperformed, but businesses doing well

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Performance of my portfolio for 2016 was only 7.4%, underperforming S&P which made 9.54%.

On 12-31-16 the relative proportions of holdings were

MSFT 49.9%

V 22.7%

SBUX 15.2%

CNI 5.59%

ADBE 4.98%

Cash 1.43%

No stock trades were made this year.

Beginning with Q2 2016 dividends were credited to cash instead of reinvested, to build a reserve for future purchase of stocks when they should reach an attractive low price.

The performance of my stocks in the market was as follows:

MSFT +14.65%

V +1.36%

SBUX -6.1%

CNI +22.67%

ADBE +9.59%

Possible causes of the relatively low performance are as follows.

In the market volatility in September 2015 and January 2016, the S&P fell 10% from its peak of 2126 on July 17 2015 to 1921 on September 4, 2015, before climbing again to a peak of 2099 in November 6, then falling 12% to 1864 on February 12, 2016. Unfortunately, I had no cash ready to invest in order to take advantage of the attractive low prices which appeared during the dip. That is one reason that my performance was lower than it should be. To address this, as mentioned above I began setting aside dividends to build a cash balance to fund acquisitions at attractive prices, whenever these should appear.

Another reason was that SBUX and VISA had suboptimal years in performance, although not as businesses. SBUX missed revenue expectations for the first threequarters of 2016, then beat in Q4. It beat earnings in Q1, met in-line in Q2 and 3, and barely beat in Q4. The stock price more of less followed these results.

During 2016 Starbucks began developing its strategy of “premiumization” of the Starbucks experience, with the Roastery flagships stores and the Reserve category of Starbucks stores. The various initiatives to expand the Channel Development segment continued. The Full year 2016 revenue rose 11% and non-GAAP EPS 17% yoy, so hardly a poor showing. The trailing PE is currently about 30, which is approximately average for recent 10 years. The continued evolution of SBUX to strengthen its competitive advantage and adapt to new markets is intact.

VISA acquired VISA Europe on June 21, 2016, for €12.2 billion ($13.9 billion) and €5.3 billion ($6.1 billion) in preferred stock, convertible to VISA Class A stock, with an additional €1.0 billion, plus 4% compound annual interest, to be paid on June 21, 2019. To pay for this, VISA in December 2015 issued $16 billion of senior notes with maturities ranging between two and 30 years. The acquisition was expected to be dilutive to earnings in 2016 in the low single digit range.

Stock dilution is being offset as the $16B debt issuance is being used partly to increase stock buy backs. The acquisition should be accretive in low single digits in 2017 excluding integration costs, and accretive in high single digit range by 2020. The increased earnings are partly from increased efficiency: increased scale, cost cutting efficiencies realized by integration of the businesses, and benefits related to Visa Europe’s transition from a member-owned association to a for-profit enterprise. VISA Inc. will be positioned to take on the estimated 37%, or USD $3.3 trillion, of personal cash and check spending in Europe. Europe has been an early adopter of mobile payments using NFC, expected to grow. Visa Inc. has aggressively launched new mobile payment partnerships, platforms and products that will enable faster growth and adoption of mobile payments in Europe. This includes new tokenization services, support for digital wallets and wearables, strategic investments in other enabling technologies, ecommerce (such as VISA Checkout) and P2P payment capabilities, as well as the opening of several global innovation centers.

VISA will be able to present a seamless experience and global capabilities to its European and international clients. Hence the evolution of VISA Inc. to strengthen its competitive advantage as digital payments global market leader, and adapt to serve evolving markets, is intact.

A sensible policy for cashing and saving dividends to invest in volatile high growth stocks at infrequently occurring low prices

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1/18/2017 16:56

In the market volatility in September 2015 and January 2016, the S&P fell 10% from its peak of 2126 on July 17 2015 to 1921 on September 4, 2015, before climbing again to a peak of 2099 in November 6, then falling 12% to 1864 on February 12, 2016. I did not have a source of cash with which to take advantage of some really attractive bottom prices in stocks, specifically ADBE. I resolved to find a way to take advantage of the low prices which appear in market dips, as purchases made in teeth of market terror are key to producing the most outstanding returns.

The purchase additional stocks for the portfolio must be funded either from the sale of current holdings or from cash kept for the purpose (I do not consider the use of debt to be a sound option).

There are various arguments against the sale of current holdings to simultaneously fund new purchases. The decision to buy is driven by the identification of a prospective purchase that is currently found at an attractive, low price, or where business prospects for the company appear to be more promising in the immediate future. Meanwhile, to optimize return, the company that is sold to fund the purchase would be judged to have less promising prospects and hence likely to fall in price, either because it is currently judged to be overvalued, or because business prospects appear uncertain in the near future. But there is no particular reason that the advent of an attractively low price in the target purchase would coincide in time with an attractively high selling price in another holding. Rather, one may be faced with the prospect of selling a stock at a merely reasonable price to enable the purchase of a stock which is found to be hopefully at a nadir. Unfortunately, the decision can potentially be wrong on both sides, that is, the price of the target purchase may subsequently fall even more, while the sold stock may subsequently continue to rise.

A variation of this strategy is to sell a stock that seems overvalued, or is expected to fall in stock price, in order to build up a cash reserve to fund purchases of a stock in the future, rather than simultaneously. The problem with this strategy is that it based as it is on prediction of the future, a sketchy enterprise at best.

Indeed, the problem with any approach based on predicting the future of stock prices is that stock prices do not necessarily reflect current business events in the company in question at all. They may rather reflect the market’s shifting reaction to those events, in turn driven by entirely distinct and distantly related social or economic forces. Because of this, a stock that seems overvalued, and thus a likely candidate for harvest, may continue to rise into regions of continued overvaluation if social or economic sentiment looks favorably upon it, against conventional rational business expectations. In this case, the sale price would be regretfully too low, too soon. Or in fact one may decide the stock should after all have been held for the long term. Conversely, the tide of market sentiment may tumble a stock even though the company is prosperous, producing regret that one did not harvest at the previous peak.

One characteristic of my investing approach is the attempt to recognize and understand the emotional currents underlying investing decisions. By doing so, one can steer a course that is free of emotional hazards to sound investing decisions. In the present case, awareness (perhaps not fully conscious) of the shakiness of one’s predictions about future prices is likely to cause anxiety which interferes with rational trading decisions.

One cannot change a future outcome that one does not control, either before it happens, or after it has happened. But since no one else can either, failure to do so does not impair one’s performance relative to other investors, that is, relative to the market. What one can do is first, avoid the chances of making an error, while maximizing the chances of better results, and second, minimize the emotional influences which interfere with sound investing decisions.

A different strategy is to build up cash reserves to fund stock purchase. In the absence of new cash, the only possible source of these is stock dividends credited to cash instead of reinvested. These have a few advantages as a source of cash. First, the cash is contributed regularly, at a range of different stock prices, so that no bet is made that a particular price would have been the optimal selling price. Thus, one avoids the chance of making a large error in choosing a sale price which may turn out later to have been the wrong one. no specific decision must be made to sell a treasured holding, with the accompanying distress. This will minimize the emotional turmoil which leads to hasty, ill thought out decisions.

There are thoughts pro and con this strategy. Crediting dividends to cash means they will not participate in the hopefully continued rise in the stocks they were contributed from. In order to make this strategy worthwhile, one needs to buy new investments at a low enough price, or to achieve a high enough return on investment, so that this will compensate for the time of missed returns before the cash was invested.

Purchasing at a discount from the long term stock growth rate is crucial to maximize the chance of a good outcome. If the stock fits criteria for the portfolio, none of which depend on short term market action, then its long term growth rate should approximate that of the portfolio. The cash that is held pending the new stock purchase has a return of 0%. Let us assume that the stock to be purchased would have a certain price at the time of purchase, if the stock was adhering continually to the long term portfolio growth rate ( R ), and call this P (r). Let us assume that at the time of purchase, the stock has fallen so that it is discounted in price P (r). In order for the cash invested in the new purchase to attain the portfolio ( R ), then the discount from P (r) at which the new stock must be purchased must equal the time the cash was held, in years, t (cash), multiplied by ( R ). The illustration below shows this for a stock bought with cash that has been held for one year.

For cash held for less than a year, then the discount from P (r) would need to be relatively less, while still enabling the stock to attain the same portfolio ( R ). One source of error in purchasing stocks, especially volatile high growth stocks, is failing to patiently wait for an adequately low price. In my proposed strategy of using accumulating cashed dividends to fund new stock purchases, the fact that the cash balance builds up slowly as dividends are contributed, is an incentive to wait for an adequately low price so as to generate returns at least equal to ( R ). This is because frequently making small investments which use up the accumulating cash, if made at a discount to P (r) which is less than t (cash) times ( R ), will result in subpar long term returns.

There remains one question: if the stated goal of a rational policy of accumulating cashed dividends and reinvesting them, is to merely match the long term growth rate of the portfolio that would be attained if the dividends had been automatically reinvested in their respective stocks in the first place, then what is the point of hoarding the dividend cash in the first place?

The reason is as follows: some stocks seem to have a higher expected growth rate because of the strength of their business and market expansion. However once this is well recognized by the market, the stock in question becomes chronically highly priced, and is rarely available at an attractive price. However, these stocks can yield great returns if they can indeed be found cheaply. And, inevitably they sooner or later do fall in price. In fact, when a company from which the market has high expectations (ADBE), meets a setback, it is generally swiftly punished and its stock falls more than would be the case for a company with a solid business but from whom the market has more conventional expectations (Philip Morris International). This type of company might be termed a Volatile High Growth Stock. The above strategy of accumulating cashed dividends to take advantage of these infrequent opportunities can then in fact lead to overall increased returns.

Again the promise of higher returns by a high growth stock is only likely to be fulfilled if the purchase price is low enough. On this inarguable basis, a sound strategy might be to buy the target stock with half of the available cash when it reaches a % discount from the previous 52 week peak, that is equal to the 10 year growth rate for the portfolio ( R ). Should the target stock fall to 2 x ( R ) from the same previous peak price, then the remainder of available cash will be invested in it.

This strategy may not be perfect, for example it may result in only half of the available cash being invested in the target stock at an attractive price. On the other hand, it preserves the chance for purchase of at least some of the target stock at the truly great price of a 30% discount to previous peak. This approach should at least preserve the average portfolio growth rate from damage caused by ill-advised purchases. Meanwhile, If the target stock is one with growth rate relatively higher than the average for the portfolio, this should raise the portfolio performance.

Bought more ADBE in 2016; reflection upon the emotional aspect of the trade

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On January 11, 2016 I sold 6.5% of my MSFT stake to buy ADBE. I thus somewhat more than tripled my stake in ADBE, which nevertheless made up only 5% of my portfolio as of 12-31-2016.

The timing and pricing of this trade was as follows. In August-September 2015 the market sold off by 10%, then recovered, only to sell of by approximately 12% in January 2016. ADBE had bottomed on 8-24-2015 at 75, down 13% from its previous peak at 86 on 8-17-2015. It then rose again to peak at 95 on 12-29-2015 before falling 22% to nadir at 74 on 2-9-2016.

I bought ADBE at 88 on 1-11-2016, down less than 8% from the 12-29-2015 peak of 95.

In fact, since 1-11-2016 MSFT is up 20-83%, ADBE up 19.56% as of 1-18-2017.

But MSFT pays a dividend of 2.35% currently, That trade isn’t looking too impressive. Bear in mind of course that the prices of both fluctuate, so on a different date, the assessment would be different.

Had I bought at the nadir of both stocks with MSFT at 75 and ADBE at 74 on 2-9-2016, since than ADBE up 46.24, MSFT up 26.89 not counting dividend, as of 1-18-2017.

The rationale for the trade was that ADBE is a high PE stock with expectations of high future growth which have become well recognized by the market. This type of stock rarely trades at an attractive, relatively lower purchase price. I wanted to increase my holding of ADBE and wanted to take advantage of a lower price. I still agree with the decision to increase my holding of ADBE, but obviously I totally missed the true opportunity for a better price.

This episodes proves again two timeless investing truths. First, it is true that valuable and expensive stocks will be available at a better price, if you can only be patient. Second, if you feel impelled to do something less you run out of time, just again, be patient. In fact using more time to decide will result in a better outcome. This is not the only time that it would have been more profitable for me to wait for a better price. In fact it is a recurring theme.

But upon reflection, I find that this conventional lesson only probes one layer of this experience. A distinct lesson is provided by considering the emotional aspects of the trade.

First, I felt I was missing out by not owning more of ADBE, a wonderful company with an insurmountable competitive advantage in its business (digital media) which it is strengthening, while building a second business (digital marketing) which looks likely also to have a sustainable competitive advantage. This created a sense of urgency to trade.

Second, since I held no cash, I needed to sell another holding to buy more ADBE. All of my 5 stocks are treasured holdings. Part of holding such a concentrated portfolio is the nagging thought that perhaps I should be more diversified, at least within my 5 holdings. This added to the anxiety surrounding the trade; on one hand, I should trade into ADBE, on the other hand, I was reluctant to sell my other holding.

the emotional aspects of investing must be explicitly embraced and addressed, rather than just suppressed. Same as in the rest of life. Remembering that good investing is a model for a fruitful life, lived to its fullest potential.

In perspective, the sum of money used for this trade was a very small proportion of my portfolio , less than 3%, as to make only a small difference at best. This suggests that instinctive fear led me to avoid putting a healthy proportion of my portfolio on an investment.

Regarding strategies to reduce the roil of emotions interfering with sound trading next time. One suggestion is to create a relatively fixed, preplanned trading strategy.

For instance, wait until it is reduced 10% from the peak and use half of the money available for the sale. Then use the rest when or if the 20% discount is reached.

This assumes that you really want to own the company. If it is a new investment that may not have the same conviction as a better understood, long term holding, then waiting for the full 20% discount is probably best.

Second, in order to isolate the decision to purchase from the reluctance to sell a current holding, it would be helpful to have a source of cash for new purchases. This is the topic of a subsequent post.

The lesson to be learned from this episode is not just that patience is a virtue in investing. For the barrier to patience is often posed by the emotions impelling a trade. One cannot simply make one’s emotions disappear. I for one, have been successful in making them disappear so far, and I am surely not alone.

A better approach may be to 1. analyze the source of the emotions. In my case, my rush to trade and poor decision making was not simply from a greedy rush to chase a hot stock. By understanding the source of the feelings, you can know how to neutralize them. 2. have a strategy to avoid a repetition. For example, I will trade at specific target reductions in price, and not worry about trading until then, merely watching the market prices regularly. I know my portfolio is sound as is, there is no urgency to trade unless it is actually at an attractive price. 3. have a source of cash for purchases. Again, this point will be the subject of a different post.

In sum, the emotional aspects of investing must be explicitly embraced and addressed, rather than just suppressed. Same as in the rest of life. Remembering that good investing is a model for a fruitful life, lived to its fullest potential.

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Essential Criteria of an Amateur Investor investment.

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edited 4-4-2016
1. Sustainable Competitive advantage defending or growing market share in its specific market. This is the sine qua non of our investment choices and the foundation of our approach to investment. The company with a competitive advantage is rare. It is marked by the ability to increasingly attain returns on investment above its cost of capital, and above those of its competitors. A competitive advantage might be made durable by low cost/high volume leadership among competitors; barrier to market entry of competitors; product differentiation/switching costs to customers. The company with a sustainable competitive advantage sells an indispensable product.

2. No competitive advantage truly lasts for ever. Hence, a related critical facet of the competitive advantage feature is that management consistently anticipates or reacts to changes in the market or competitive landscape by finding profitable ways of extending the company’s competitive advantage into new markets that are tangibly related to its current markets. That is, the company adapts and evolves to perpetuate its competitive advantage by extending it into the evolving new markets.

3. Evidence of devotion to shareholders by its capital allocation, manifested in the following ways
stock buybacks to reduce share count
avoiding excessive dilutive stock compensation
obtaining good returns on investments in acquisitions
aligning reward and performance of management and employees to reward shareholders and long term company performance
allowing shareholders to have voting power commensurate with their stock ownership.

4 Common stock of publically traded company based in U.S. or other relatively transparent legal environment with respect for property rights, at least 10 years old.

5. The investment worthy activities of the business are demonstrated in the record of its past and present achievements, not in the hoped for future.

6. quantitative evidence of ability to obtain returns on investment above cost of capital, such as low debt level, growing free cash flow, high free cash/revenue, high gross margin, high ROE and ROI.

Management must defend and extend competitive advantage

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The first criterion for an eternal investment is the presence of a durable competitive advantage. This means other companies are not able to compete with the company in its markets. But there a critical second two aspect of this feature. An impregnable competitive advantage by itself is not enough to confer everlasting earnings growth. A second critical facet of this feature is that management consistently anticipates or reacts to changes in the market or competitive landscape by finding profitable ways of extending the company’s competitive advantage into new markets that are tangibly related to its current markets. As technology evolves to change markets and create new markets, the company adapts to meet new demands. Otherwise, other so called “disruptive” companies will meet the demands of those new markets. in some cases, new technology can abruptly threaten a company’s product with obsolescence. Then, the company must either change its business to adapt to the new market, change to serving a market related to its original product, or fold. The cash built up through its current strong franchise, and expertise in serving the current market, should give the company a head start in adapting to change. But in order to execute this, management must maintain a culture which detects looming changes, proactively develops new initiatives and enforces profitability. Indeed, it is management culture that establishes dominance in different, evolving markets over the history of a long lived, “eternal company”. The continuation of a company’s competitive advantage into the future is not guaranteed, but shaped by management culture.

One might say that no competitive advantage is truly eternal. The foreseeable future inevitably gives way unforeseen innovations. Competing companies use these to erode the formerly dominant company’s market share. Undoubtedly this does occur, and recently there is much talk of “disruptive innovation”. In many cases the problem may be more that management of company A does not efficiently enable utilization of novel tools to maintain its domination. Or, does not imaginatively envision how the new tools can be used to extend its markets. This might apply to Microsoft in the years between 2000 and 2014, when it seemed to focus more on maximizing profit from the windows, office, server franchise, rather than expanding into new markets for its software afforded by digital readers and mobile phones. In fact, arguably Microsoft’s own management which impaired its revenue growth, as much as the strength of Apple or Google. In other words, it is not that android or iOS phones have destroyed the market for Microsoft Office products, far from it. Rather, they have created a large new market for mobile computing, a market related to Microsoft’s market for its productivity software. And Microsoft has failed to extend its dominance into this new, related market. In 2014, in a vigorous departure by new CEO Nadella, Microsoft began making a concerted attempt to forge into the market for mobile productivity software, for example by releasing Office for iOS and Android. More interestingly, work on this software had begun under the previous CEO Balmer. But more interestingly still, the strategy of creating Microsoft applications for other companies’ platforms had been heavily utilized in earlier Microsoft history, so it was actually part of the engineering and management culture.

AmateurInvestor 15.4% 10 yr return beats S&P (5.2%), Berkshire Hathaway (8.69%) for Oct 2015.

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My portfolio beat the market this year as well as for the past 10 years. I also beat the 10 (8.69%), 5(10.92%), 1(-8.77%) and YTD (-10.49%) returns of Berkshire Hathaway (Brk.a). Just saying.

This year’s outperformance is partly due to a realization that the focused portfolio is focused for a reason. In late 2013 and early 2014 I added some stocks which seemed to fit the criteria to be an Eternal Company, but I could not explain fully why they did. I did this because owning no more than 4 stocks (V, SBUX, MSFT, PM) felt a little unsettling. I felt that stringently requiring that they manifestly exhibit the required criteria seemed unrealistic, given that so few companies with these qualities exist. And so I acquired some more companies, described below, and later sold them. Performance will have been improved by pruning these companies.

The good results were also related to investments in new additions to the portfolio which have become permanent investments and have contributed to growth.

In 2015 my portfolio ended with 5 stocks, V, SBUX, MSFT, ADBE, CNI.

This chapter resulted in a few lessons learned. In the search for Eternal Companies, possibly it is difficult to be adequately motivated to research the company unless you have an ownership stake. I am reminded that the ValueAct Capital hedge fund acquires a small stake in prospective investments after having done preliminary research, and then continues to perform intensive investigation sufficient to enable a profound understand of how the company makes money and the issues facing growth, before making a definitive investment. ValueAct is a focused fund. I suppose I will need to find a way to be more conscientious about researching new opportunities.

The reality that there are very few qualified Eternal Companies does not mean that investments made in companies that fail to qualify as such will still be as good. Rather, the dearth of Eternal Companies means an investment strategy focused on these will indeed result in a relatively focused fund. There is no way around this. Having proved this more fully to myself, I now feel more content remaining with my exclusive selection of companies.

Another lesson is that I am still capable of making errors. Fortunately, I am scrutinizing my own execution fully enough to correct errors before they cause serious damage. Conversely, I am still capable of learning.

Here may lie the most important lesson. Namely, that I can improve the way I invest. What tools might be best to address the issue at hand, that of picking a company which does not demonstrably meet the required criteria? One tool might be to write out the reasons justifying investment, as well as any weaknesses with the company, prior to buying. The narrative would cover a checklist of criteria critical for a good investment. Judgement regarding the criteria is gained by reading, as well as experience. The final analysis should be subject to a critical reading, in which the key assessment can be characterized as asking the question, “does this investment jump out at me as an obvious great investment?” There should be no doubt.

What are the most important qualities of an Eternal Company? First, the existence of a durable competitive advantage. This means other companies are not able to compete with the company in its markets. Second, management consistently anticipates or reacts to changes in the market or competitive landscape by finding ways of extending the company’s competitive advantage into new markets in a profitable way.

Note that this is entirely different from simply using its financial strength in a attempt to establish a foothold in markets which are entirely new to the company.

Below is a comparison of my returns with those of some renowned value investing mutual funds.

Fund/index	Expense ratio (%)	10y (%)	5y (%)	1y (%)	Ytd (%)
S&P 500		5.12	11.75	1.06	1.46
Amateur Investor		15.4	22.4	22.0	21.14(as of 11-25-15, est.)
Oakmark Select Fund (OAKLX)	0.95	7.68	14.67	-2.08	-1.08
Sequoia Fund (SEQUX)	1.0	7.28	12.14	-7.71	-8.68

Data is taken from Morningstar.

Following is a brief outline of the qualitative changes to the portfolio in the last couple of years. The companies I bought and subsequently sold at minimal loss – to – modest profit were as follows: Fomento Economico Mexicano (FMX, the Mexican Coca Cola bottler and owner of the Mexican convenience store chain Oxxo); Ebay (EBAY, operator of the online auction platform, online conventional merchant marketplace and PayPal, the latter subsequently spun off); Cerner (CERN, the largest dedicated electronic medical records provider); Intuit (INTU, with a dominant market share in desktop personal finance software with Quicken, small business accounting software Quickbooks, as well as growing businesses in consumer electronic tax returns with TurboTax.

I discovered two companies which have become permanent investments. One is a true Eternal Company, Canadian National Railroad (CNI, one of the seven remaining class I railroads in North America, has the lowest operating ratio of any rail on this planet, and other features that enable it to grow by focusing on growing their customer’s and their own business as opposed to competing on price).

The second addition to my portfolio is Adobe (ADBE software dominates the market for creative professionals, Adobe is now increasing profitability as well as market by shifting from permanent to subscription licensing in the cloud, and in a related market has created software to manage digital media campaigns which is growing in dominance.

Finally, I sold, with some sadness, an Eternal Company for which growth in earnings has recently become stunted partly by a slowing of its market growth, and in addition by the effect of the strong dollar, since its earnings are all outside the US: Philip Morris International (PM, which has the strongest portfolio of cigarette brands outside the US and is innovating in reduced risk cigarettes). It cannot match the growth of my other stocks.