This article is excerpted from Tom Yeung’s Profit & Protection newsletter dated July 28, 2022. To make sure you don’t miss any of Tom’s picks, subscribe to his mailing list here.
Growing up, my family’s hamburger grilling looked like this.
Ground beef? Check.
Salt, pepper and spices? Of course.
Then add bell peppers, onions, saltine crackers and an egg for good measure? Umm… That too.
It was only after the internet came around did I learn we weren’t supposed to turn our burger patties into wads of meatloaf. Many of the world’s top chefs create award-winning concoctions with only three ingredients: ground beef, salt and pepper.
The amateur practice of overdoing things extends to investing too. There’s always a temptation to have 30… 50… 100 open positions to avoid the feeling of missing out. And rather than shine, these gargantuan portfolios eventually look like a bland mishmash of uninspiring ingredients.
Getting Rich Without Really Trying
The secret to winning portfolios, of course, is to concentrate bets in a handful of high-conviction positions. A study by Dresdner Kleinwort found that investors only need ten random stocks to achieve over 80% of potential diversification. Thirty stocks brings you close to 100%.
As a rule of thumb, I suggest investors concentrate bets in 15-20 positions, rather than juggle hundreds of tiny bets.
Sometimes, these high-conviction investments are specific stocks. Top Profit & Protection pick Desktop Metal (DM) makes the cut because the high-growth 3D printing company trades so close to its liquidation value.
Other times, this can mean parking significant amounts of cash in diversified index funds like the Vanguard S&P 500 ETF (VOO). These are low-cost ways to bet on the health of an entire asset class.
Regardless, the trick to keeping only high-conviction stocks is to know when to say “yes…”
…But also when to say, “no”
As in, “let’s not add bell peppers to our burger recipe today.”
10 Stocks to Sell Before They Die
That brings me to InvestorPlace’s Eric Fry, one of the masters at eliminating losers from his portfolio.
Over the years, he’s recommended short positions in companies like Countrywide Financial (down -87%), Providian (-91%) and Ariba (-99%). Unlike many stock pickers, he’s just as comfortable telling investors to sell as he is in saying “buy.”
Now, he’s created a new report of 25 very popular companies that you should make sure you sell immediately.
“Please: Make sure you DO NOT own these companies now, and DO NOT buy them in the future, no matter how cheap they get.”
To access the list of these stocks, click here to sign up for Fry’s Investment Report.
Meanwhile, Profit & Protection readers also have a secret weapon:
The Profit & Protection stock selection system.
That’s because the quant-based system works both ways. Run the system in reverse, and you quickly get companies that are likely to underperform over the next twelve months.
Companies on the Wrong Side of History
Many well-run firms can find themselves on the wrong side of history.
Blockbuster… Sears… Kodak… Polaroid…
These former blue-chip companies would eventually find themselves fighting unwinnable battles. No amount of managerial talent can save a firm that’s in the wrong business.
Fortunately, these sunset stocks are easy to identify by their low Profit & Protection “growth” grades:
- Tootsie Roll Industries (TR) | Growth Grade: C. Some of these slowing firms fail to innovate and introduce new products. These companies eventually look much like Tootsie Roll Industries, with flat revenues and shrinking income.
- Peloton Interactive (PTON). Growth Grade: C. Other firms have the misfortune of hitting on one-off customer fads. Much like Fitbit and GoPro, Peloton’s success in stationary cycles turned out to be more about luck than skill.
- Cato Corp (CATO). Growth Grade: C. Then there are those that operate in cut-throat industries like fashion retail. Cato Corp’s weak growth looks much like a repeat of Ascena Retail Group, J. Crew and countless other bankruptcies.
- Peabody Energy Corp (BTU). Growth Grade: C. Finally, companies like coal producer Peabody Energy can eventually find themselves running out of lives. Though the company was my top pick at the end of 2020 when it was trading at $2, firms in sunset industries can’t avoid bankruptcies forever.
Frauds, Allegations and Questionable Conduct
Then there are firms with questionable histories. Many of these will score “C” grades for quality, and you’ll often find short-sellers writing short novels panning the business.
- Cassava Sciences (SAVA). Quality Grade: C. I’ve long worried about Cassava Sciences, a firm with questionable science behind its Alzheimer’s drug. This week, those concerns were confirmed when the U.S. Justice Department opened a criminal investigation into the company. Though no wrongdoing has been proven yet, these investigations are generally red flags for biotech investors.
- Sorrento Therapeutics (SRNE). Quality Grade: C. Meanwhile, companies can also run risky business models. In 2020, I warned investors that Sorrento’s management was “playing the lottery with other people’s money” by buying up high-risk therapies with no proven performance. Shares have since lost 75% of their value as blockbusters have failed to materialize.
- SOS Limited (SOS). Quality Grade: C. The enormous popularity of meme stocks like SOS Limited, Asia Broadband (AABB) and Luckin Coffee (LKNCY) can often hide significant corporate governance issues. Some firms like Riot Blockchain (RIOT) eventually survive by overhauling its entire management team. But more often, these firms end up like Enron, Sino Forest and other eyebrow-raising picks that go to zero.
Finally, management can often take outsized risks with a company’s balance sheet. These overstretched firms quickly become sitting ducks as bonds come due.
These firms are easily identified by low Altman-Z or credit scores.
- Gap (GPS). Sometimes, financial disasters are years in the making, as apparel companies from Gap to Aeropostale have found. These companies can accrue billions in operating lease liabilities from real estate rents, putting them at risk of bankruptcy if sales suddenly decline.
- WeWork (WE). Other times, these disasters happen when companies expand too quickly. WeWork managed to accumulate $20 billion in lease liabilities by the time it went public in 2021. The firm now burns $2 billion per year, a rate that would deplete its cash pile by Christmas.
- Lordstown Motors (RIDE). Finally, rising interest rates are testing zero-revenue startups like Lordstown Motors that rely on fundraising. These cash-burning companies are finding it harder to raise capital, forcing them to cut back on R&D. A feedback loop makes it harder to attract more investment and so on.
Just Sell… Don’t Short
Hedge fund manager Julian Robertson once told investors, “Our mandate is to find the 200 best companies in the world and invest in them, and find the 200 worst companies in the world and go short on them. If the 200 best don’t do better than the 200 worst, you should probably be in another business.”
The concept of long-short investing is a fundamental idea of hedge fund strategies. By avoiding net market exposure, traders can show off their innate skills without taking systemic market risks.
In practice, however, this strategy rarely works for ordinary investors. Short positions need constant monitoring to prevent a portfolio blowup. Even Mr. Robertson’s Tiger Fund would lose billions in a dollar-yen trade that blew up in 1998.
To gain the benefits of short-selling, investors can instead simply avoid certain stocks. If you’re lucky enough to pick 15 to 20 above-average performers, the final portfolio can’t help but to beat the market. It’s a far safer way to play the market, and certainly one that helps people sleep more soundly at night.