I like categorize stocks into three buckets.
The first bucket is compounders.
This bucket includes stocks like BRK, MKL, WFC etc. that have solid revenue growth (secular or structural advantages), high returns on capital (good business/industry), and plenty of reinvestment opportunities.
These are the best companies to own. Their intrinsic value rises steadily with time. If you stick with them long enough, your returns will mimic the return on equity (~low to mid teens). If you can add to your position when the price dips significantly below the prevailing intrinsic value, your returns will be juicer.
With compounders, you let time do all the work. These stocks let you sleep soundly at night, and require hardly any upkeep.
The relentless increase in intrinsic value is forgiving of valuation mistakes. The risk of overpaying can be mitigated by long holding periods.
So what’s the catch? Why can’t we just invest in compounders?
Turns out, you and I are not the only people in town who have this “deep insight”. Since everyone sees how desirable such companies are, the market rewards them with high valuations. Opportunities to buy these companies at substantial discounts to intrinsic value are rare.
From my experience, they encounter blips about once in year or two, when some short-term setback gets temporarily mispriced. Here I am talking about decent prices, not “back-up-the truck” type prices. Those, unfortunately, are really rare.
Our edge here patience, decisiveness, and a long horizon. There is no informational or analytical advantage.
If you are like me (someone who has fresh periodic infusions of cash to deploy), the waiting can be frustrating, if that’s your only trick. You may think that having a list of 5-10 compounders on a watchlist might help. It does. But only partially. Often when opportunities arise in such stocks, they arise all at once (like the 2008-2009 crash).
The second bucket is small caps and foreign stocks.
Examples of these in my current portfolio include stocks like MNDO, CODAF, and RSKIA, which are all sub $500m companies.
These are profitable companies with strong balance sheets and decent returns on equity. In the past, I have invested in companies with poor or negative earnings, so long as the company’s assets provided a sufficient margin of safety. I have now mostly abandoned this cigarbutt strategy. Time is the enemy in such asset-based investments, as intrinsic value gets eroded by mounting losses.
If you can psychologically handle such investments, then you should absolutely invest in such companies. For a small investor, the universe of such companies is far larger than the universe of small profitable companies with light debt burdens.
I have tried to fish in that pond. But I have realized that I don’t enjoy fishing there as much. Being around morbid companies makes me feel pessimistic.
So these days, I focus only on profitable small caps with decent balance sheets. Our edge here is the relative lack of competition, and tolerance for illiquidity.
Some of these stocks will go months without trading. This is both a pro and a con. The small size and illiquidity keeps the big fish and traders away. The downside is that building reasonable positions in some of these stocks takes patience.
Liquid Mid and Large Caps
Finally, the third bucket of stocks is liquid mid and large caps.
Stocks that I currently own that fall under this bucket include AAPL, LUK, IBM, and NOV. Even though they are followed and owned quite widely their stock prices can fluctuate over a large range.
Consider AAPL for instance, the largest company in the world. Over the last year and change, its stock price has fluctuated between ~$90 to ~$155. During the dip last summer, I bought my last slug of AAPL shares at $96. I sold out of most of my position between $125-$135. I hold my last 1/3 position, which I plan to dispose of shortly. AAPL may not be overvalued, but I am not as comfortable holding it at $150 as I was when it was sub-$100.
In any case, this volatility creates an opening for overlaying some options strategies. The options on these securities have a vibrant market, due to their size and liquidity. Strategies like cash-secured puts and covered calls can be used to enter and exit positions, or generate income on the side.
A current example is NOV. The stock has been trading between $30 and $40 for nearly a year. At $30, I think NOV is cheap. At $40, I think it is reasonably priced. So every time it drops to the low $30s, I begin selling puts methodically. Every time it springs back to $40, I begin ratcheting some covered calls.