Seeking Out Strange Stocks: How to Create a Value Investing Basket that MIGHT Get Decent Returns Even When the Market Falls

by Geoff Gannon


Someone emailed me this question:

“I know you are a stock only person.

But just for a minute I need your knowledge...I don’t look for 15% per year. I look for 6% a year for the next 5-7 years…on my money.

What would be the best/safest way to get it? Will a certain ETF, a dividend stock? SPY?  Japan ETF? India or Russia?”

I don't know of anything that can safely guarantee you anything like 6% a year. To give you some idea, even junk bonds now yield about 5.5%.

And I wouldn't call junk bonds safe. Their prices would fall as interest rates rose and the economy entered a recession. Both of these things will happen at some point. Will it be in the next 5-7 years? I don’t know. But, you can’t buy assets like that at today’s prices if you’re hoping to make 5-7% a year over the next 5-7 years even if the stock market does badly.

However, you can certainly find things that should return at least 5% to 7% a year over the next 5-7. It's just that:

 

1) Some of them will be specific stocks - not ETFs

2) Some of them may return a lot more than 5% to 7%

3) Some of them will lose money

4) It will take a lot of work on your part to find them

5) You will need to use a basket approach

6) Actually: I’m going to recommend a “basket of baskets” approach

 

I don't diversify widely. But, if you're looking to find something that will return 5% to 7% a year over the next 5-7 years, your best bet is to own a basket of very cheap (probably obscure) stocks. If these stocks are cheap, small, obscure, illiquid, etc. - it's less likely they will move with the overall market. Special situations (like spinoffs and other things mentioned in Joel Greenblatt's "You Can Be a Stock Market Genius") should also help get you closer to your goal of 5% to 7% annual returns over 5-7 years no matter what the market does.

The reason I’m starting off a discussion with “cheap, small, obscure, and illiquid stocks” is that I'm not at all confident I can find an entire stock market for you that will return 5% to 7% a year over 5-7 years given today's starting price. Although, in a moment we will discuss the possibility of putting 20% to 40% of your portfolio in things that are either directly or indirectly “funds” rather than specific stocks. More on that later.

But, first, let’s start with the specific stocks.

If you aren't doing a lot of intense stock picking that results in you only owning maybe 3-5 stocks at once (like me), you need a process for finding investments that is a more formulaic, “wide-net” approach.

A fund manager has to worry about putting large amounts of money to work. So, they lean in the direction of owning even more stocks than are really beneficial for "business risk" diversification purposes. You're an individual investor. So, you can just go with sort of the "optimal" amount of diversification in the sense of finding the point where adding additional stocks to your portfolio would have very little benefit in reducing volatility. That point is probably something like 20 to 30 stocks. The difference in volatility between a portfolio with 30 stocks and 100 stocks may be noticeable. The difference in volatility between a portfolio with 30 stocks and 50 stocks isn't.

So, no more than 30 positions for you.

And, we could do it with as few as 20.

For the sake of simplicity: I’m going to talk in terms of 5 baskets of 5 positions each. So, that’s a 25 stock portfolio.

I think your best bet would be to pursue a few sort of formulaic value strategies - "rule based" strategies - let's call them instead of using your judgment. So, what you'd do is go out and screen by hand to find the specific situations but those situations would each fit in one of maybe 5 strict bucket approaches.

So, I might suggest you set out to create a 25 stock portfolio with five buckets:

 

* 5 net-nets

* 5 spinoffs

* 5 closed-end funds/holding companies/etc. trading at a discount to NAV of their publicly traded holdings

* 5 stocks trading for less than the fair market value of their real estate (so stocks that own real estate but probably aren’t REITS)

* 5 cheapest ETFs/Country closed-end funds you can find in terms of Shiller P/E ratio

 

You mentioned yield.

Can you buy stocks where most of the returns come from dividends?

You could. So, you could have one bucket that is stocks with a dividend yield about the same as long-term corporate bonds but with a strong balance sheet, low volatility in the stock, etc.

Examples would be...

Village Supermarket (VLGEA): 4.1% 

George Risk (RSKIA): 4.4%

I don't think there's anything particularly wrong with buying stocks like that if you're looking for 5% to 7% returns over 5-7 years. Those stocks have somewhat higher dividend yields than big cap stocks that pay dividends and yet their balance sheets show they are more overcapitalized and their stock trading histories show they are less volatile than big cap dividend payers like: Kimberly-Clark (KMB) with a 3.5% yield. Their business is not as diversified or predictable as Kimberly-Clark though. We could compare them to utilities. Those two stocks pay dividend a little bit higher than utilities. And utilities have a lot of net debt and no cash. These companies have low debt and high cash for the industries they are in.

So, would I include a dividend yield bucket?

Only if you found enough situations like the two I listed above. And I think asking you to assess individual dividend payers among more obscure stocks would be giving you a demanding task. It’s harder to apply a formulaic approach here. You need to understand the underlying businesses. So, I think it might be more trouble than it's worth to look for dividend payers.

What about the other buckets?

 

Spin-offs

There were several spin-offs this year including Hamilton Beach (HBB) from NACCO (NC) at the start of this month, Cars.com (CARS) from TEGNA (the TV side of the old Gannett). I own BWX Technologies (BWXT), because I bought into Babcock & Wilcox pre-spinoff and then I kept the BWXT shares and sold the BW shares. 

You can see a list of upcoming spinoffs here.

If you are going with 5 buckets that each have 5 stocks in them, I'd suggest making one of those buckets a spin-off bucket and keeping 5 spun-off stocks in there at all times.

Read and re-read Joel Greenblatt's "You Can Be a Stock Market Genius". The case studies from that book are all you need to know about how to invest in spin offs.

 

Holding Companies Trading at a Discount to NAV

The obvious example here is Pargesa. You can find a detailed description of the company’s net asset value here.

And you can find the stock's price and net asset value updated here.

Pargesa shares currently trade at about 65% of their net asset value. That kind of discount - 35% - isn't unusual compared to the trading history of the stock versus its NAV over the last 20 years.

The discount isn't necessarily fully justified though. Pargesa's NAV has underperformed its benchmark over the last 2-10 years. But, it's outperformed over the last 20 years and is beating it this past year too. The stock also pays a dividend.

I wouldn't put my own money into Pargesa at a discount of 35% to its net asset value. But, I would recommend it as part of a bucket where you have 5 closed end funds / holding companies / etc. trading at discounts to their net asset values. That's only if you're also using other, different buckets like spin offs.

Other publicly traded companies that trade sometimes at a discount to the shares they own include Urbana (in Canada), and now Altaba (AABA). Each situation is different. Urbana is partially publicly traded stocks like Pargesa but partially not. And Altaba is non-diversified in the extreme (it’s mostly Alibaba and somewhat Yahoo Japan). Management there has stronger incentives to close the gap between share price and NAV though.

There are tons of closed end funds out there. Many may deserve to trade at a large discount to NAV. I’d consider closed-end country funds more in another basket I’m going to talk about later. If you can find a country with a beat down stock market that has a low Shiller P/E and there’s a closed-end fund there that’s trading at an especially big discount to NAV because the country is so unpopular – that’s just a plus. So, I’d think more of holding companies trading at a discount to NAV for this bucket and then look for closed-end funds more in the low Shiller P/E country bucket I’ll discuss later. But, sometimes there are closed-end funds with discounts that seem large given what they own. You could put one of those in this bucket.

I used the example of Pargesa, because it has a diversified enough portfolio (20% type position sizes) in big, public European companies and it publishes very clear information on what it now owns, where the stock trades, etc. So, it’s the “cleanest” holding company I could come up with as an example.

 

Trading for Less than the Fair Market Value of their Real Estate

Warren Buffett owns shares of Seritage (SRG) in his personal portfolio. This is the company spun-off from Sears (SHLD) that still has Sears as a tenant (often paying below market rents). If and when Sears enters bankruptcy, there's concern Seritage will be insolvent (I imagine it will also get sued by Sears's creditors at that point). Will someone step in offering to recapitalize it and take control? Will someone want to acquire the whole thing? I don't know. I wouldn't put my own money in Seritage. But, as part of a bucket of 5 stocks that appear to be trading for less than the property they own/control (have long-term leases on). I think this makes sense.

In the past, I've mentioned a couple other companies that will - at certain prices - come close to qualifying for this group. You should watch them. They are: J.W. Mays (MAYS), Ingles Markets (IMKTA), and Green Brick Partners (GRBK). These aren't my top suggestions for this bucket (though J.W. Mays is something to look at very hard). They're just examples of stocks I've mentioned at some point on the blog that have a substantial amount of real estate relative to the market cap the companies sometimes trade at.

Again, I wouldn't spend a lot of time speculating about the future of these companies like you would if you were making individual stock picks for an overall portfolio. Instead, I'd look at something like J.W. Mays which is illiquid, has no correlation to the overall market, etc. and just try to figure out if the properties it owns/controls are worth more than the market cap. If they are, add it to your "stocks trading for less than the fair market value of their real estate" bucket. And then try to keep 5 stocks in that bucket at all times. Don't sell one till you have something new to take its place in the bucket. That’s true for all these buckets. Hold each position till you can find a “sixth” position that could replace it. Only then sell out of anything in the bucket.

 

Net-Nets

These are incredibly hard to find in the U.S. They are often so illiquid even individual investors may have trouble getting enough shares. Around the world, like in Japan, it can be easier to find net-nets. Don't buy into frauds or companies clearly on the brink of insolvency. Don't buy into any company that is actually Chinese but lists in the U.S.

Honestly, I’d suggest just finding 5 Japanese net-nets right now, because that will be easiest. This would, however, put your portfolio 20% in Japan. You might not want to do this. Though, I actually think it’s fine. As long as you are creating the kind of value buckets I’m talking about here, I think you can put 20% in one country and not hedge the currency. I’m going to talk about 5 countries to invest in later and I’m not going to mention hedging the currency there either.

But, what if you really wanted to hold U.S. net-nets instead.

What are some current examples of the kind of stocks you can put in your net-net "bucket"?

- Paradise (PARF)

- Richardson Electronics (RELL)

There are others out there. The traditional - Ben Graham - rule is to buy these stocks at two-thirds of NCAV and then sell them when they reach NCAV (for a 50% gain). Ignore this. Any stock trading near NCAV is incredibly cheap, has to be unloved, obscure, etc. Once a stock gets down to the price level of being a net-net just focus on whether it's a fraud, whether the financial strength (F-Score and Z-Score) is adequate, and whether the company has been around a long time and made money in the past.

Just keep this bucket - like your other buckets - full of 5 stocks at all time. So, when you identify other net-nets that can take the place of the existing ones, you're allowed to sell the old ones. But, don't leave an empty slot in this bucket.

Once you buy any position – in any of these buckets – I’d also encourage you to make that position “off-limits” as a sell for a full year. So, just review old positions to be replaced with new positons once a year. People spend too much time deciding how quickly to sell their spin-offs, net-nets, etc. when they start moving. Let them run a year. Then decide.

 

Cheapest Countries Bucket

You can find mentions of the Shiller P/E ("CAPE") for various countries on some websites and in some articles. Here are two examples:

GuruFocus

Article in The Telegraph

Right now, these kinds of articles / sites are going to suggest you buy ETFs/closed end funds in markets like:

*Russia

*Brazil

*Turkey

*South Korea

*Spain

Etc.

I wouldn't put my own money in any country funds. But, if you are only allocating 20% of your portfolio into country funds in total and you always keep 5 countries in this bucket, you'll be putting 4% into each country. That's an acceptable risk. Don’t bother hedging anything.

So, if you want to try to find an approach that is more likely to get you 5% to 7% returns over the next 5-7 years regardless of what the market does, I'd suggest using 5 buckets with 5 stocks in each of them.

So that’s: 5 low Shiller P/E country funds, 5 holding companies trading at a discount to NAV, 5 stocks trading at less than the fair market value of their real estate, 5 net-nets, and 5 spinoffs. That will give you 25 stocks that should have a chance of returning 5% to 7% a year over the next 5-7 years even if the market doesn't.

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