The math of returns

I just released the fourth issue of the Oddball Stocks Newsletter and wanted to share a short excerpt from the introduction letter.

The topic is the timing and security selection criteria necessary to achieve market beating returns:

"To demonstrate my thinking here is a simple example.  Let’s consider a hypothetical $1,000,000 portfolio comprised of 10 equal weighted undervalued stocks.  In our portfolio we’ll assume that each stock is trading for 66 2/3% of book value and is worth 100% of book value for a potential 50% return.  Let’s imagine that three positions ($300,000) appreciate 50% to fair value each year, which would be $450,000.  If the rest of the portfolio remained flat for the year the investor’s return would be a quite satisfactory 15%.  Now at this point in time it isn’t as if we’ve lost hope in the other seven names, but they haven’t done much yet.  If an investor sells the appreciated securities and reinvests them in securities selling for 2/3 of BV and repeats this process year after year the portfolio will continue to earn above-market satisfactory returns.

For one to achieve market beating returns only 1/3 of the portfolio needs to appreciate at least 50% a year.  The rest of the portfolio can stagnate or even fall slightly.  The key to this is accepting that different portions of a portfolio are in different stages of value realization. One needs the patience to see ideas through, and the wisdom to minimize losses.  In this imaginary portfolio positions are held for a maximum of three years, if at that point they haven’t appreciated it’s time to sell and find a replacement.  Or if a position appreciated before the three year holding period was realized the position was sold and replaced by a new lower valued position."

When reading investment blogs or message boards I'm struck by how many people are looking for home run investments.  Rather finding investments with at least 50% appreciation potential and not losing money can generate market beating returns.  It's much harder to find stocks that will reliably double, triple, quadruple or more in a few years.

The above example should be a great gut check for what's in your portfolio.  A single loss or two requires gains from the rest of the holdings to be higher.  It's easier to avoid losses rather than finding home run stocks.  A portfolio with market generating returns doesn't need to be comprised of multi-bagger stocks, it needs to be one that avoids losses.

When a portfolio continues to hold losing positions, or invest in positions that consistently drop it's like a paddler trying to navigate a boat against the current.  It's possible to paddle upstream but it's a lot of work.  Avoiding losses is like paddling with the current, a bit of effort combined with the current results in a quick journey.

If you're interested in reading the rest of my thoughts on the subject, or reading about a number of very attractive companies profiled in this issue consider subscribing to the Oddball Stocks Newsletter.

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