2022 has been tough on the average portfolio. If you’re like many investors, you’re looking at your holdings, wondering if some of them need to go. This type of portfolio analysis can be a great thing. Suffering some mild losses in a stock can alert you that it’s time to dump it before those mild losses turn into something much uglier. The challenge is how do really know which stocks to hold versus which ones to prune? After all, a market downturn can ding even the strongest stocks temporarily. That’s what our macro specialist and the editor behind Investment Report, Eric Fry, details today. As he writes below, “You don’t want to pursue investment success by betting on flukes. Instead, you want to stack the odds in your favor as much as possible.” If market volatility has revealed that you have some “flukes” in your portfolio, this is the Digest for you. I’ll let Eric take it from here. Have a good weekend, Jeff Remsburg

“Sparking Joy” Begins With Torching Losers

By Eric Fry

While the current market downturn may be offering a chance to grab some shares of your favorite company, it may also be a chance to de-clutter your portfolio a bit.

It pays to be picky – especially when it comes to your investments.

Marie Kondo, the “decluttering” guru, has made millions of dollars by devising and popularizing a common-sense method for purging a home of unnecessary and unwanted “stuff.”

Kondo’s decluttering strategy – called the KonMari method – follows six basic steps. It begins with an explicit commitment to tidying up and features one essential question: Do the items you wish to keep “spark joy”?

Those items that do spark joy should remain; those that don’t should go away. And this method isn’t just limited to the dusty, unread books in your collection, the waffle maker you haven’t used since you got married, or the contents of your attic…

Investors can also adopt some of Kondo’s cleanup tactics.

Even some of the most seasoned and savvy investors fail to tidy up their portfolios as they should. That’s because tidying up a portfolio requires an explicit commitment to do so… along with a dispassionate analysis that asks a version of the question, “Does this item spark joy?”

Not every worthwhile investment will “spark joy,” of course, but it should spark some sort of powerful and obvious positive reaction.

Remember, like the KonMari method, your goal is to identify the items you wish to keep, not the ones you wish to discard. The discard pile is simply the by-product of what you wish to keep.

Spark “Yes!”

If you examine each stock in your portfolio and ask yourself honestly, “Will this stock build wealth?” or “Will this stock be a 10-bagger?”, the answer should always be a resounding, “Yes!”

But if the answer is “No,” the stock doesn’t belong in your portfolio, even if it’s a solid blue chip or a popular household name.

Those sorts of investments may be fine. But very few investors set their sights on just “fine,” because in the investment world, “fine” is synonymous with “opportunity cost.”

That’s certainly not fine in my book.

“Opportunity cost” is a term of regret that ruefully refers back to “what could have been”; it describes the consequences of making a misguided or suboptimal choice between competing possibilities.

Analyzing opportunity cost can and should be part of an investment discipline that insists on buying extraordinary investments, rather than ordinary or “fine” ones.

Obviously, none of us knows exactly what the future will hold. Therefore, analyzing opportunity cost is an inexact science. In fact, it’s an educated guess.

Based on decades of stock market history, we know a few key details about what produces investment success over time. For example, we know that:

• Fast-growing companies tend to produce better investment results than slow-growing ones…
• Cash-rich companies tend to produce better investment results than heavily indebted ones…
• And companies that possess a formidable “moat,” as Warren Buffett calls it, tend to produce better investment results than companies without any special competitive advantage.

So, when we examine the stocks in our portfolios, we should favor those that possess one or more of these winning traits.

Now, some stocks that possess serious flaws will buck the odds and perform well anyway. Sometimes heavily indebted, slow-growing companies find a way to reverse their declining fortunes and become major successes. But companies like that are rare outliers.

You don’t want to pursue investment success by betting on flukes. Instead, you want to stack the odds in your favor as much as possible.

And I’ve discovered a way to do that…

The “Portfolio Purge” Formula

Calculate the size of a company’s net debt, and then divide that figure by the company’s annual revenue… to produce a simple ratio:

[Net Debt Divided by Trailing 12-Month Revenues]

Generally speaking, the higher the ratio, the worse a stock is likely to perform over the following five years. The lower the ratio, the better a stock is likely to perform over the following five years.

That’s it. That’s the entire process.

I routinely use this simple test to identify potential investments. (Obviously, my research does not end there.) But once I identify a potential investment, I qualify that stock by conducting additional targeted qualitative and quantitative research.

Some investment candidates make the cut. Most don’t.

But here’s the crazy thing: This simple two-part test, all by itself and without any additional research, can produce impressive investment results.

As you know, investors are always compounding something – either successes… or mistakes… or boredom. That’s why intelligent stock avoiding is as important as intelligent stock picking.

Knowing which stocks to avoid can work wonders for your portfolio – and can protect you from the perils of opportunity cost.

That’s what a portfolio purge is all about – avoiding underperformers so that you can make room for outperformers. That’s a process that can spark a lot of joy.

Eric Fry