CHAPTER 8
Passive Portfolios, Cash Level, and Performance

If you have made it to this point in the book, you probably realize that there is no secret to investing. Once in a while, I come across someone expressing the wish that Warren Buffett reveal his investing secrets to the public. Buffett has revealed all his investing secrets over and over throughout the last 60 years in his shareholder letters, interviews, speeches, and writing; they are there for everyone to grab—you just need to be willing to work hard and learn.

If, however, you are not interested in studying investing, or you don't have the time, you can still benefit from the growth of great businesses by simply investing in the S&P 500 index funds, a good mutual fund, or a basket of good companies. As I demonstrated in Chapter 3, S&P 500 companies do relatively better than all other U.S. businesses on average. A cautious and survival-bias-free study by Sungarden Investment Research found that over ten-year periods, the S&P 500 index beat 60 percent of actively managed mutual funds.¹ Even Buffett said that if he died, his wife would invest in an index fund. About index investing, in his 1993 shareholder letter, Buffett wrote: “When ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”² S&P 500 index funds generally have low fees and low portfolio turnover. Low fees is also one of the key reasons the index funds outperformed, and low portfolio turnover makes index-fund investing more tax-efficient.

To achieve the best long-term results, you should avoid trying to time the market and should instead buy the index funds continuously, regardless of how the stock market is doing. You also need to be constantly fully invested. If so, over the long term, you will do very well. You can do even better if you invest in a basket of good companies at reasonable prices and take advantage of the benefits of long-term higher business returns of these good companies.

A Basket of Good Companies

In Chapter 3, I highlighted that if we focus our investing on the good companies that are consistently profitable and have high investment returns, we can lower the chance of losing money and achieve above-average overall returns. If we buy them at reasonable valuations, the returns should be even better. Those who do not have the time or interest to study the details of each company can instead simply buy a basket of these good companies, which should do better than index investing over time.

GuruFocus began tracking a portfolio of these companies in 2009. The portfolio consists of 25 companies that were constantly profitable during the prior ten years and were undervalued as measured by the discounted cash flow model. Following are the performances of the portfolio from January 2009 to September 2016:

Year	S&P 500	25 Undervalued Predictable Companies
2009	23.45%	55.72%
2010	12.78%	20.17%
2011	0	–3.32%
2012	13.41%	5.29%
2013	29.6%	24.81%
2014	11.39%	11.38%
2015	–0.73%	–0.17%
2016	9.54%	21.08%
Cumulative Gain	148%	220%
Annualized	12.0%	15.7%

The portfolio is rebalanced annually on the first trading day of each year. The portfolio value is calculated daily. During the year, we do nothing to the portfolio. If any of the positions are acquired, they will be converted to cash or the shares of the acquiring company, depending on the structure of the acquisition deal. Since inception on January 2, 2009, the portfolio has achieved an annualized gain of 15.7 percent. During the same period, the S&P 500 gained 12 percent a year. Therefore, the portfolio of consistently profitable companies outperformed the market by 3.7 percent per year since 2009. All numbers do not include dividends.

In January 2010, we started two other portfolios of these consistently profitable companies that are sold at close to the ten-year-price/sales low and ten-year-price/book low ratios. The performances until September 2016 are reflected below:

Year	S&P 500	Top 25 Historical Low P/S Ratio Companies	Top 25 Historical Low P/B Ratio Companies
2010	12.78%	19.05%	16.39%
2011	0	–2.01%	–1.87%
2012	13.41%	17.79%	17.62%
2013	29.6%	29.60%	33.18%
2014	11.39%	15.09%	20.01%
2015	–0.73%	–3.75%	–4.63%
2016	9.54%	19.55%	16.6%
Cumulative Gain	101%	136%	139%
Annualized	10.5%	13.0%	13.2%

Since inception, these portfolios outperformed the market by about 2.5 percent a year.

I should point out that none of these portfolios outperformed the market every year, but over time they outperformed the market average by decent margins. The performances listed above were achieved by initially investing 4 percent of the portfolio in each position. The portfolio was rebalanced once a year. At the time of rebalancing, we ran the screeners again. We do not make changes to the stocks that remain in the screen. We sell the stocks that are out of the screen and buy the new stocks in equal weight. The turnover of the portfolio was about 25 percent per year.

Compared with the Magic Formula invented by hedge fund manager Joel Greenblatt,³ the GuruFocus approach considers the long-term performance of the businesses instead of just the latest performance as with the Magic Formula. The quality of the companies in the GuruFocus approach is higher than the quality of the stocks that passed Greenblatt's Magic Formula screen. I expect the portfolio will also perform relatively better during down markets.

Nevertheless, these three portfolios have not been tested in down cycles. Among the model portfolios tracked on GuruFocus is the portfolio of Gurus' Broadest Owned Portfolio that did well in both up and down markets. This is a portfolio of the 25 most broadly owned stocks among a selected group of investors. The portfolio is also rebalanced once a year. You can view the latest portfolio and performance at this link: http://www.gurufocus.com/model_portfolio.php?mp=largecap. The annual performance of the portfolio is listed below. It outperformed the S&P 500 index by about 2.4 percent a year on average. Since inception in January 2006 to the end of 2016, the portfolio outperformed the S&P 500 index in 9 out of the 11 years.

Year	S&P 500	Most Broadly Held Guru Portfolio
2006	13.62%	15.18%
2007	3.53%	–5.47%
2008	–38.49%	–29.98%
2009	23.45%	30.70%
2010	12.78%	14.63%
2011	0	0.54%
2012	13.41%	16.99%
2013	29.6%	30.85%
2014	11.39%	12.30%
2015	–0.73%	6.07%
2016	9.54%	0.38%
Cumulative Gain	79%	129%
Annualized	5.5%	7.8%

We can see that over the past 11 years, the portfolio has outperformed the index by a cumulative 50 percent. This is significant for the investor who is trying to accumulate wealth over the long term.

The investing approach of a basket of high-quality companies is slightly more complex than investing in index funds. You need to hold 25 positions instead of just one, but it requires only one rebalance a year, and most times the rebalance simply involves about 7 stocks of the 25 in the portfolio. The 2 percent per year in outperformance makes it worthwhile.

Dividend-Income Investing

The high-quality passive-portfolio approach can also be applied to retirement investing. An investor can build a retirement portfolio of high-quality companies and live on the dividends paid by the companies in the portfolio, never having to touch the principals of the portfolio.

For a retirement portfolio, it is extremely important that the companies in the portfolios have durable financial strength and consistent profitability so that the companies can survive the bad times, as well as continue their dividend payments. Furthermore, the companies should be able to increase their dividend payment over time so that the investors' dividend income grows faster than inflation. The portfolio should be reasonably diversified across different industries to smooth out any industry downturn.

The requirements for dividend-income portfolios can be summarized as:

The company needs to have a strong balance sheet. A strong balance sheet is essential to the survival of the company and the safety of dividends. In GuruFocus's scale of financial strength ranking, from 1 to 10, the financial strength needs to be 6 or higher.
The company needs to be highly profitable. Only when it is profitable can it generate enough cash to pay out dividends and maintain solid financial strength. In GuruFocus's scale of profitability ranking, from 1 to 10, the profitability needs to be 7 or higher.
The company needs to demonstrate consistent past performance and profitability. This is guaranteed through GuruFocus Predictability Rank of 2.5-star or higher.
The company needs to have a reasonably high return on invested capital. GuruFocus requires a ten-year median return on invested capital of 10 percent or higher. This is the requirement for high-quality companies.
The company needs to be 100 percent profitable over the past ten years and have the ten-year median operating margin of 10 percent or higher.
The company needs to show reasonable growth capability. The growth rates of revenue and earnings should be 5 percent or higher.
The company needs to display a commitment to dividend increases for ten years or more.
The dividend payout ratio should be 0.7 or less. We hope that the dividend payout ratio is low so that it has more room for dividend increases.
The current dividend yield should be 2 percent or higher. This is a requirement that the dividend yield is higher than the market average.
The five-year dividend yield on cost should be 2.5 percent or higher. Dividend on cost is defined as the ratio of the dividend paid in five years on the cost today. This requirement makes sure that the company is increasing dividends fast enough so that within five years, the dividends on the current investments generate more income than they do currently.

Requirements 1 through 6 exist to ensure that we buy only high-quality companies. Requirements 7 through 10 are used to guarantee that the companies meet the dividend requirements. I have created a screener based on these requirements with GuruFocus's All-In-One screener; you can find it by going to GuruFocus.com Menu → All-In-One Screener → Dividend Income Screener.

The number of companies that can pass this screener is heavily dependent on the market valuation. When the market valuation is high, the average dividend yield is low and fewer stocks can pass the screener. If I run the screener today—with the stock market within 3 percent of its all-time high after seven-and-a-half years of a bull market—only 16 stocks pass the screener and they have an average dividend yield of 2.4 percent, which is about 20 percent higher than the yield of the S&P 500 index. This same screener would have seen far more stocks passing a few years ago, when the market was lower.

At the dividend yield of 2.4 percent, an investment portfolio of $1 million generates $24,000 in annual dividend income. Nevertheless, the average five-year yield-on-cost of the 16 stocks is 5.44 percent. This means that if the companies grow dividends as quickly as they did in the past five years, investors will see their dividend income more than doubled in the next five years.

Holding Cash

In the dividend-investing portfolio, I set the minimum dividend yield as 2 percent. This is low relative to the historical level. The stock market is close to the all-time high and the dividend yield is at the all-time low. If one decides to require a higher dividend yield, there will not be a sufficiently diversified list of stocks to fill the dividend portfolio. Money has to be parked in cash to wait for better opportunities.

This is also the dilemma that valuation-sensitive investors currently face. After the market has run up, the valuation of most of the stocks is full. There are not enough stocks meeting the requirements of the margin of safety. Relaxing margin-of-safety requirements means a large downside risk. Again, money has to be parked in cash to wait for better opportunities.

Disciplined and experienced investors can choose to do so and may achieve better long-term results. But it is extremely hard to hold cash as the market continues to go up and up. Holding cash drags down the overall performance of the portfolio, especially at a time when cash is paying close to nothing and “cash is trash.” But when the market comes to downcycles, which it does once in a while and definitely will again in the future, holding cash protects your investments and allows you the opportunity to buy stocks at much lower prices. This is why the Yacktman Fund could outperform the S&P 500 by 11 percent in the down market of 2008 and by 33 percent in the market recovery of 2009. “Cash is king” during a down market.

When you hold cash, you still want to get some returns while maintaining the liquidity. You can buy short-term Treasury bills through TreasuryDirect or buy short-term Treasury ETFs such as iShares 1–3 Year Treasury Bond ETF SHY. The ETF, however, does come with some interest-rate risk.

You can sometimes get higher returns for the cash by engaging in merger arbitrage activities, which Buffett did frequently in his earlier years.⁴

Merger Arbitrage

When Buffett had more cash than investing ideas, he engaged in merger arbitrages to achieve higher returns than Treasury bills. This kept him from relaxing standards for long-term investments and “kept him out of bars,” in Charlie Munger's words. He continued to do this until at least the mid-1990s.⁵

With merger arbitrage, if Company A is acquiring Company B, investors short the stocks of Company A and simultaneously long the stocks of Company B in an equivalent number of shares. If the merger goes through, the shares will cancel each other and the investor pockets the price spread that existed at the time of the trades.

Sometimes mergers are cash deals. That is, Company B is acquired by Company A for cash. In this case, there is no need to short Company A stock. Investors just need to buy Company B stock at the discount from the announced deal price.

The biggest risk with merger arbitrage is when the merger falls through. Usually, during mergers, Company A offers a large premium for the stocks of Company B. After the merger announcement, the price of Company B stocks immediately jumps and is now close to the offer price. If the merger falls through, Company B stock will fall right away to where it was or even lower. The investors who look for making perhaps just 2 percent on the price spread will see a loss of maybe 40 percent or higher. In this case, the investors have to sell the Company B shares at a deep loss to prevent a failed short-term investment from becoming a long-term burden. Therefore, if only one out of 20 merger arbitrages fails, the investor makes no money.

Sometimes there are also pleasant surprises. After the merger announcement, another company may also want to buy Company B. They will need to offer a higher price. This bidding war can lift the stock of Company B even more. So, instead of just getting 2 to 3 percent, you may get 20 percent or higher returns in a very short time. This is an “I am feeling lucky!” moment with merger arbitrage.

But there are far more broken deals than pleasant surprises. Because of the disparity of risk between gain and loss, the key to merger arbitrage is to avoid bad deals. Both Buffett and hedge fund manager John Paulson had great success with merger arbitrage.⁶ They both follow strict rules to avoid the deals that might go bad. These are some of the things to consider before getting into a position:

Is this from a large acquirer?
Does the acquirer have a good track record of closing deals?
Is the merger agreement definitive?
Is the deal subject to financing conditions?
Is the deal subject to due diligence?
Is the company being acquired by a solid performer?
How reasonable is the valuation?
What is the regulatory risk?
What is the tax consequence?
What is the chance of another bidder coming in to sweeten the deal?

Even with these considerations, many other things can happen to break a deal: market conditions, interest rates, politics, another bidder, and so forth. Investors need to diversify their activities across different industries.

Merger arbitrage is for sophisticated investors only. Interested investors can read Paulson's “The ‘Risk’ in Risk Arbitrage” in Managing Hedge Fund Risk, compiled by Virginia Reynolds Parker.⁷

How to Look at the Performances

Increasing the cash level in the portfolio when the valuation is high and reducing it when the valuation is low doesn't necessarily generate higher long-term returns because it is impossible to know how long an overvalued market can stay overvalued. You may get into cash too early during a bull market and miss gains, and you may reduce the cash level too late and again miss gains.

When it comes to looking at the performance of an investing strategy, the biggest mistake investors make is usually looking in the rearview mirror. They make their decisions based on the strategy's performance in the near past and tend to put their money into the investments that did well lately. This is also how most investors treat mutual funds and ETFs. At the end of the 1990s, many investors switched to the technology sector because the technology funds did far better in the preceding several years. The problem is that the technology sector outperformance lifted the valuation of the sector and positioned it for lower future returns. This is the case for all funds and strategies that concentrate their portfolios in certain sectors, regions, or asset classes.

Investors should look at a fund or a strategy's performances during at least one full market cycle to decide if it is working. This is true for sector funds and region funds. It is also true for funds or strategies that focus in any industry or asset class. If the market continues to go up, the funds which have chosen not to be fully invested all the time will underperform. But if the market goes down, these funds will outperform, as they may take advantage of the lower valuations during market corrections with the cash in hand. This is why the previously mentioned study by Sungarden Investment Research found that during the past two bull markets, the S&P 500 index outperformed 80 percent and 63 percent of its peers. However, during the down-market cycles, the index beat only 34 percent and 38 percent of its actively managed counterparts.

A full market cycle here means from peak to peak or trough to trough. The last two peak-to-peak full cycles are from the first quarter of 2000 to the third quarter of 2007, and until about now, the first quarter of 2017. The current bull market that started in March 2009 may still last, but it should currently be very close to its peak.

In summary, even if you are not interested or don't have the time to research companies, you can still benefit from the long-term prosperity of great businesses by investing in a basket of good companies. You do need to stick to a strategy and stay fully invested all the time and buy on a dollar-cost average basis. You will do considerably better over time with this strategy than with index funds.

For those who enjoy researching businesses and companies, you can do even better by concentrating your investments on a handful of good companies. There is no secret. Once you are in the framework of buying good companies at fair prices, the only things you need to do are learn about the business and work hard.