This is the final article in a case study series related to our valuation of and investment in IBM. You can find the earlier articles in the series through these links: Intro, Options, Valuation, Scientific Investing. This article offers an overview of our framework for thinking about portfolio construction and offers a specific example regarding our position in IBM.

Before I dig into the specifics of the IBM position, I’d like to offer the framework I use to think about portfolio management. I have three main principles:

  1. Expose yourself to success
  2. Diversify cheaply
  3. Concentrate intelligently

The stock market allows savers to hitch a ride on the strength and resiliency of the global economy. An investment in the stock market is an investment in human progress, so unless you want to be sitting eating cans of pet food in a cave with Glenn Beck during your Golden Years, it’s better to stay invested.

Investing in a particular company (“concentrating”) can bring great rewards – think of Microsoft’s millionaire secretaries – but can also bring great risk – think Enron retirees in 2002. Exposing oneself to success in a diversified way means buying an index fund – the cheapest one you can find.

For those wishing to concentrate, one needs to understand how to be an intelligent owner. This means understanding how value is created and taking the time to understand the value of individual holdings. This topic is the subject of our third article in this series and the following video:

We split our portfolios into a few buckets:

  • Market Exposure
  • Concentrated Investments (4)
  • Bond Replacement (20)

The number following the last two categories are an indication of the number of individual stocks held in each. Human beings simply cannot keep a lot of information in their minds, so holding more than a handful of concentrated investments is folly, in my opinion.

“Bond replacement” investments mean investments like the one we have in IBM. These are covered call and short put investments, where the investor is doing essentially the same thing a bond holder does: accepting downside risk in return for receiving a fixed fee.

No one that I have ever met can keep the operating details of 20 companies in their heads (and yes, I have met on-screen pundits who claim to know everything…), so our strategy for selecting these securities is to tag along with smart people and to reduce risk through appropriate diversification. We follow a group of the best value investors, and make bond replacement investments in the companies in which the investors are making active purchase decisions.

As we mentioned in our Options Offer More Options article, the best strategy for selling options is to sell in “Travel Size” – short-tenor options, in other words. We also always sell At-the-Money for reasons mentioned in that article as well.

Since the end of 2017, the tendency for value investors to be selling rather than buying has been notable (though this has started to reverse itself recently), so we have been carrying more cash as positions remain unallocated.

Twenty names making up 20% of the portfolio implies an average position size of 1% per name. We try to create a bit of sector diversification here as well, so make a point not to tag along with investors in such a way to have an outsized concentration in any one sector or industry.

Some of the companies in this bucket are those that we know something about and of which we may have done a quick valuation. For those about which we have some passing familiarity we might double the portfolio weighting – setting aside 2% of our portfolio to collateralize a sold option position.

This is the situation we had with IBM for a year or so. I had done a moderately-detailed valuation of IBM as the Director of Research at YCharts, so did not feel uncomfortable with the increased position size.
Then, in the fall of 2015, just as the US market was starting to worry about the knock-on effects of a fall in Chinese stocks, our puts expired In-the-Money (meaning we had to take delivery of the shares), and IBM’s share price started falling further.

Figure 1.

During this time, I sharpened my pencil a bit and took a closer look at IBM’s valuation. Satisfied that IBM was worth more than it was trading, we more than doubled our position size again (to the 5% level) by buying the shares in the high-$120s per share range. At that point, IBM slipped into another bucket in the portfolio – the Concentrated Investment bucket.

As the price started to rise again, we enjoyed the capital gain from the improvement, and, when the shares started to climb into the $150 – $160 / share range, started once again to sell covered calls on the shares.

At present, IBM straddles the Concentrated Investment and Bond Replacement buckets. The Bond Replacement exposure allows us to continue to generate returns on the position even though the stock price has bounced in a range for a long time.

We believe that, within the next few quarters, results from IBM’s Strategic Imperatives’ growth will start to be more evident to the market at large. At this point, we will start shifting our stance from only accepting downside risk to one in which we are also gaining exposure to IBM’s upside potential.
We can effect this shift by covering less (or none) of our position with sold call options (i.e., not writing covered calls), by buying call options on the shares, by owning the shares outright, or – most likely – by a combination of all of these methods.

As time rolls on, we will post updates about this position, and about how changes in our allocation to IBM alters our allocation to other Concentrated Investments and to our broad market exposure.

We will be holding another Open Office Hour session tomorrow, Saturday, May 5, to discuss our valuation assumptions. Many seats are already spoken for, but we have a few spaces left. If you are interested in attending, please send me an email.