Disclaimer: All of the numbers and dollar figures provided below do not represent the actual amount invested in the market. The weight of each stock in the portfolio is what is important, not necessarily the presented dollar figure, however the dollar figures make it easier to think about. Therefore the weights are the same as the actual portfolio however the dollar figures have been altered to represent a $10,000 portfolio. Further I want to make it clear if you have not read the first article that this is not a how to invest in the stock market article. If you are looking for financial advice, please consult a professional with the necessary qualifications. This is strictly for the purpose of self-reflection, critique and learning from past mistakes and successes.

It is been quite awhile since the first chapter of this series and there are quite a few open ends that need to be tied up. Perhaps the most urgent is a further discussion of risk and how it relates to returns. I mentioned previously that my returns fell slightly short of what I could have returned with an investment in the S&P 500. But that is only the half the story as to generate those below average returns I took on additional risk. With an investment in only a few stocks, no one would consider this a diverse portfolio and there is certainly an element of unsystematic risk involved. The standard deviation of the returns in my portfolio were higher than that of the S&P 500. Put another way, the daily swings in the value of my portfolio were greater than that of the S&P 500. If we assume that a valid measurement of risk is how wildly the value of the portfolio varies on a day to day basis, than my portfolio was riskier than a collection of the 500 largest publicly traded companies. For that extra risk, I did not generate returns greater than the standard benchmark. In essence, what this means is that there was some portfolio or combination of stocks that would have yielded the same if not more returns at the same measure of risk. Or as stated in my previous article, I could have just put my money in the S&P 500 and I would have gotten better results with less day to day volatility.

Now I could write ad nauseum about the technical aspects of risk and returns, however there is an entire body of work on both of these subjects that could describe those concepts with more detail and accuracy than I think I would be able to manage and an audience would be able to stomach. I will issue a separate blog post specifically on those technicalities for that audience.

Moving on to an update of my portfolio’s performance, the table below shows the new stock prices and value of my portfolio verse the S&P 500. After a few more months, my portfolio is now beating the S&P 500 mainly due to a few reasons. Firstly, for the first three years of my portfolio, 21^st Century Fox did very little as far as generating returns. However, over the past few months, both Disney and Fox’s share price have increased significantly. Part of that is due to the potential merger between the two firms. There is a particularly interesting analysis to be done here as the news of the merger was announced at the end of 2017. However, the stock price had budged very little as of my last article in March of 2018. Common knowledge or a belief in the efficient market hypothesis, along with literature in regards to stock prices and acquisition announcements, would suggest that at the time of the announcement, there should have been some market correction. Generally speaking, acquiring companies have their stock price punished based on the knowledge that mergers often do not provide value to the acquiring company. Secondly the company to be acquired should see a rise in their share price up to the price of the offering, meaning that the price on the stock market should reflect the offer that the acquirer is providing. That correction is not expected to be immediate but as the acquisition goes through the regulatory process and gets closer to approval, one would expect the share price and the offer price to converge.

As far as my best guess to explain the phenomena of why both share prices have increased, one of them is simply the market rising, so part of Disney’s share price increase can be explained by the rise in the broader markets. For Fox, I think the increase in the stock price will be mostly attributed to the acquisition offer as that stock has been stagnant for many years. However the additional explanation is that the market sees the acquisition of 21^st Century Fox as value additive and that both corporations together should be valued more than what they are separately. This I think is also built upon the assumption that together these players can make a play into streaming which is part of Disney’s strategy going forward. I will like to comment in more detail on the strategic opportunity of that particular move, but the point is simply that there are many factors both within and outside of the acquisition that might explain this phenomenon.

Another recent winner was CSX train lines. When I was still in high school I had begun reading about Warren Buffet and some of his investment philosophy. While I generally ascribe to many of his teachings and thoughts on that subject, I cannot say I’m truly a practitioner of Mr. Buffet’s methods on value investing. For those not familiar with the term, the simple way of describing value investing is that you are trying to buy a dollar for some price less than a dollar. That would be the Ben Graham version of value investing if I had to describe it in one sentence. To maybe further clarify, price is what you pay. Value is what you get. The point of value investing when it comes to stocks is to identify companies whose value is greater than that of what I would have to pay to buy it on the market or the price.

Let’s take an overly simplified example of say, a steel company. Steel companies are very asset intensive, meaning that much of the company’s value is tied up in the stuff it owns. It invests heavily in plants to make steel. If those plants were built for a cost of say $200 million, we would say that the company is at least worth that much because theoretically I could take those different steel plants and sell them to someone else for what I built them for (perhaps a dubious assumption but let’s accept it for the sake of simplicity in this example). If there are 100 million shares on the market each selling at $1.90, than that would make the total value of the company on the open market $190 million which is less than the value of the company’s $200 million in assets. So in this case I could theoretically buy a slice of the company that should be worth 2 dollars at a discount of 10 cents. Now let me be clear in that generally you shouldn’t value companies on what they own, but instead on what cash they can generate with what they own. Assets are also not a popular valuation metric anymore as many companies are no longer asset intensive, but instead generate earnings from intellectual property or some nonphysical asset. But in returning to investment philosophy as valuation is a tricky subject in and of itself, I certainly care about price and value and the relation between those two things. However, I doubt my own ability to reliably determine a company’s value within a reasonable margin of error. Therefore I’ve learned to look for qualities in a company that I find attractive and then to look at the price of the stock compared to what I think it should be worth.

While learning about this investment methodology, I read about Warren Buffet’s acquisition of train line BNSF. At the time, I didn’t understand much about valuation, but I did understand the thought process behind why Buffet liked the business. The reality is that people aren’t really starting new train companies or building new train lines. There is relatively little competition in between train operators as they operate most of the time in a specific region where they are dominant. Lastly, through some rather odd developments, the train industry has a regulatory arm of the government that has helped protect them from competition from the primary threat which is long haul truck transportation. What this means is that the train industry is relatively predictable and free of heavy competition which is generally a good recipe for profits. At the time I was thinking of investing in train lines, most stocks in this industry were depressed based on fears of declining coal demand and production. Coal is often shipped by train and coal is especially important in parts of the country where CSX operates. However, CSX along with many train lines are extremely diversified in the industries they have exposure to. My assumption is that those fears were not entirely realistic as I was confident CSX would be able to fill that capacity that would have been taken by coal with some other product for shipping. I couldn’t be sure of what that product would be nor that the margins would be the same as coal shipping, but that the market was perhaps too bearish on the impact of coal on CSX’s business. Looking now at the stock, part of my assumptions were correct. But more importantly the stock has performed well because of those fundamentals which I had mentioned previously coupled with an improvement in the US economy. If the economy grows than more goods need to be shipped. That’s a pretty simple but reliable formula for the train industry.

Now one question that has come to my mind is at what point do you start to consider selling your winners and locking in those returns. That is dependent on so many factors, particularly the notion that as an investor you have an alternative way of employing that money in some other investment. The answer is not to think of stocks that have gained value as winners and stocks that have faltered as losers. The answer is to think about why you bought the company in the first place, and then analyze the company to answer the question if those fundamentals still remain true. One thing that I cannot reliably do with the resources at my disposal is predict when the market will turn or if the market will decide a stock is suddenly overvalued or undervalued. My strategy is to first find companies that have some sort of quality that makes that company attractive. It could be the industry, it could be a particular competitive advantage or technology. It could be just about anything. After that I will go to the valuation and try to decide if the stock is at the price that seems reasonable or cheap. But on the sell decision, I do not look at the stock price verse the valuation price, simply because valuation is incredibly difficult to do and never perfectly accurate. The valuation also does not tell you what the market thinks about a certain stock which is ultimately what determines the price. So the decision is instead dependent on whether the company’s fundamentals are still in-tact. If there is a shift in the industry that does not bode well for the company’s long-term success or if internally the company shifts strategy or is unable to maintain whatever competitive advantage I think it had, then that is when the sell decision should be made. There is of course the possibility that my analysis was wrong, that the qualities I saw in the company were not in fact true. That is also the point at which I would consider selling the company, and there are certainly examples of that in my portfolio currently.

I think a good example to follow this logic on is Costco. The market is beginning to whisper that Costco is overvalued and based on the following comps, I could see why analysts might be reporting that. Costco has historically sold at a premium when compared to competitors like Target (Amazon is perhaps not the best comp but it will be important in the following discussion).

For the international audience that isn’t familiar with Costco, Costco is a US grocery and retail outlet that specializes in bulk purchasing. Costco is a massive warehouse type store with products packaged in large quantities. I would generally characterize the target customer as large families looking to buy quality goods at a value. Costco delivers on that value proposition by, as stated earlier, making it so you buy large quantities of the good all at once. That is how Costco manages to bring the per unit cost of the goods you buy there down.

Now we can already see that the company’s price to earnings ratio has increased since my purchase of the company in 2014. The P/E ratio simply states how much do I have to pay to get one dollar of this company’s earnings. However the P/E ratio on its own cannot tell you if a company is overvalued. Comparing the P/E ratio to its competitors might offer a better indication if that is the case, but it should be said that there is no perfect metric for deciding if a company is at or above/below its fair value. Ultimately the collective market will decide if the future earnings prospects of the company are reflected in the current price. This is again perhaps one further reason why I do not rely on valuations to make sell decisions.

So focusing on the qualitative aspects of the company, Costco is attractive for several reasons. First of all, people pay a membership fee just to shop there. If your customers are willing to pay an up-front fee to walk into your store, you are offering value beyond what other players in the industry can offer. That value I think can be found in the quality of Costco’s products and the standard by which it holds its suppliers on behalf of the customer, but also in the prices at which those can be purchased. Especially for families, Costco provides a unique value proposition in being able to buy certain goods in bulk and therefore providing further savings. Walmart certainly offers low prices on goods and it delivers those goods at those prices by using its power with suppliers to negotiate deals, along with saving money by optimizing its supply chain. Costco offers you high quality goods at low prices by just asking customers to buy a lot of it. Both Walmart and Costco are generating large volume on goods that are generally offering low margins, but they are trying to do so at different points of quality and with a different consumer in mind. That is not to say that people don’t both shop at Walmart and Costco. But consumers who shop at both Costco and Walmart will go to Costco for certain things and they will got to a Walmart or a Target or another retailer for the rest. That is what is powerful about Costco.

Now we’ve mentioned several of Costco’s key competitors such as Walmart and Target. But those are certainly not companies with the power or business model to fundamentally undermine Costco’s advantage with its target customers. The company that more investors are worried about is Amazon, especially after its purchase of Whole Foods. Amazon has been trying to push itself more into the grocery sphere with the launch of Amazon Fresh. The acquisition of Whole Foods certainly makes this new delivery business model more compelling and challenging to the brick and mortar grocery industry. Amazon has the additional threat of these voice activated systems that try to keep you intertwined in Amazon’s sphere of influence. That is another component that is interesting to think about in terms of how people might view shopping, even for groceries in the future. So the question that needs to be answered is does Amazon’s business model pose a fundamental threat to the future of Costco’s business?

To answer that question, we need to go back to who shops at Costco. I stated earlier that when I go to Costco I generally see families looking to purchase certain items and produce in bulk. There are certainly other demographics or reasons for shopping at Costco, but if that is the most important demographic to Costco’s business model, than we need to understand how online grocery and the Whole Foods play might offer those customers a better or more value added shopping experience. Personally, I love the idea of online grocery for several reasons. First, I don’t like going to the grocery store. That might just be me being an introvert so I don’t think that is an accurate data point. But what I do know is that I view going to the grocery store as something I have to do because I need groceries. However if I could save time and effort, that would be value additive for me.

However, I am not part of the Costco target demographic. So would families rather save the time and effort and not go to the store? Would they prefer not having to do that and instead pay a hefty delivery fee or prices that are higher to avoid the experience? Furthermore, is Whole Foods in direct competition with Costco or does it offer a different value for its customers?

I think where I’m going with this is again that Costco and Amazon have different customers looking for different value propositions. If you shop at Whole Foods, you are looking for environmentally friendly, naturally raised, and sustainably farmed products that are healthy and nutritious. Not that you cannot get those items at Costco but this is just a discussion of the perception. Ultimately, you are willing to pay a premium for those goods and you will accept that higher price point. You might also be a working professional or someone who doesn’t feel like they have the time to go shopping, and therefore getting your groceries delivered for an additional cost might be your preference. Generally, I think I’m describing younger working professionals.

For the Costco shopper, I believe that going to the store is part of the family experience. That might sound silly on its surface, but my family plans a Costco trip every Sunday. While I was growing up, we would go to church in the morning, followed by pizza/hot dogs at Costco and shopping for the week. Getting those necessities wasn’t so much a chore but a family activity. That is purely anecdotal evidence and that is not enough to ascertain that Amazon and Costco are operating in different spheres. But I will continue by saying that Costco and Whole Foods offer different price points on goods. This is another way in which Whole Foods/Amazon and Costco provide a different value to different customers in terms of grocery. To simplify, Costco offers quality products at a low per unit cost through its bulk purchase model. Whole Foods offers high quality goods whose characteristics have a high level of value for certain customers based on different reasons. Perhaps they want the best or most nutritious ingredients. Perhaps they want to be environmentally friendly. But regardless the Whole Foods customers who want those offerings value those things highly and are willing to pay that premium.

At the moment, I do not think that Amazon’s play in online grocery or the purchase of Whole Foods is a fundamental threat to Costco’s business model. At the moment, I do not think that Amazon and Costco offer the same value to the same customers. While they both may offer groceries, that is much to overly simplistic of an understanding of these two businesses. That does not mean that Amazon will never be a threat. I certainly find Amazon’s push into grocery compelling, but for the next three to five years I do not envision Amazon as a significant threat to Costco. As a result, I will continue to hold the stock and keep an eye on Amazon’s position as it develops.