Focused Compounding Capital Management 2Q19 LetterJacob Wolinsky
Focused Compounding Capital Management letter to investors for the second quarter ended June 30, 2019.
To Focused Compounding Capital Management Clients:
During the second quarter, the model portfolio returned 10.4% after fees. The portfolio is now up 25.9% year-to-date. The pace of this year’s increase in both the model portfolio and the S&P 500 can’t last. The U.S. stock market ended the quarter at a price-to-normalized-earnings ratio above where it has traded in all years except the late 1920s and the late 1990s. U.S. stocks generally are now overpriced. The stocks in your account are not. This quarter’s 10.4% gain in the model portfolio was caused by just 2 stocks.
NACCO Industries, Inc. (NYSE:NC) is the largest stock in the model portfolio. And it’s up nearly 60% in price this year. However, NACCO’s earnings per share are also up nearly 60% this year. So, despite the big increase in the “p” part of NACCO’s P/E ratio – the stock’s price-to-earnings ratio remains less than 9. A P/E of 9 is about half that of the overall market. NACCO remains a cheap stock. You can hear me talk about NACCO with Eric Schleien.
The other stock that contributed to the 10.4% quarterly gain in the model portfolio was Computer Services, Inc. (OTCMKTS:CSVI). This company – often just called “CSI” – split its stock during the quarter. In theory, a stock’s price should adjust perfectly in accordance with the split ratio on the day of the stock dividend. So, if CSVI stock was trading at $66 a share the day before its 2-for-1 stock split – it should have declined to a price of $33 a share immediately after the stock split. That’s not what happened with CSVI stock. Its split adjusted price rose on the day of the split. And it continued to rise after that. Academic research has shown that stocks that split their shares go on to outperform stocks that don’t split their shares. The theory is that executives like their shares to trade in a sweet spot. No one can agree on exactly what this sweet spot is – but, it’s definitely more than $10 a share but less than $100 a share. Therefore, the explanation offered by academics to explain the outperformance of stocks that split their shares is that it’s a signal of management’s confidence that the stock’s price will not drop out of this sweet spot during future trading. If management is comfortable splitting a $66 share into two $33 shares – that’s like management saying they can’t imagine their stock dropping 70% in the future (from $33 a share to $10 a share). Maybe that’s true. Maybe CSVI’s management did signal their confidence in the stock this quarter. But, I tend to think of the increase in CSVI’s share price during the quarter as being less rational than the increase in NC’s share price. Computer Services is the most expensive stock you own. I still like the business. And I won’t sell a business I like just to hold cash unless the price of that business has gotten absurd. CSVI’s stock price is not cheap. But it’s also not yet absurd.
You may have noticed I bought a foreign stock for the first time this quarter. I’ll continue looking for more of these. Specifically, I’ve been working on a process to turn up more Japanese stocks that fit our criteria. No promises though. Which reminds me, if you know of a stock that meets our 2 criteria – tell Andrew. He’ll pass the name on to me. Our 2 criteria remain:
1) An overlooked stock, that is ALSO
2) A good business