The Art of Stock Picking Returns

A Tale of Three Markets & An Abundance of Opportunity

“We’ve had 40+ years where all the money went into broadband, or internet, or Netflix or the cloud and no money went into basic productive capacity…”

–Robert Friedland, CEO, Ivanhoe group of companies

“During the latter stage of the bull market culminating in 1929, the public acquired a completely different attitude towards the investment merits of common stocks… Why did the investing public turn its attention from dividends, from asset values, and from average earnings to transfer it almost exclusively to the earnings trend, i.e. to the changes in earnings expected in the future? The answer was, first, that the records of the past were proving an undependable guide to investment; and, second, that the rewards offered by the future had become irresistibly alluring.

“The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis… An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world. It was only necessary to buy ‘good’ stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic.”

–Graham & Dodd, Securities Analysis, 1934

“Men…recover their senses slowly, one by one.”

–Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds

Those quotes led Pilgrim Global’s recent missive to investors. Since 2015, Pilgrim’s founder, Darren Maupin, has generated a gross IRR of 41% per annum: a staggering 11x invested capital. We do not highlight Pilgrim’s approach due to the outsized returns but rather to highlight the method of achievement. The firm embraces a concentrated deep-value approach predicated on embracing a margin of safety.

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Intellectual affinities aside, Pilgrim shares KCR’s belief that capital allocation has consequences. Few quotes better epitomize that belief than the ones above. As we explained in our piece on ARKK vs. QQQs, recent market action has seen a speculative resurgence nearly identical to the whipsaws seen in the fallout from the dot.com bubble. We believe this resurgence in speculation will be temporary and end poorly for participants.

The upside is that evidence-based, conservatively inclined investors are drowning in opportunity.

What follows is KCR’s attempt to create a simple walk-through of the risks and opportunities offered today. We believe both the structure and implications of this paper are easy to grasp. Yet implementation could be difficult for some as it requires investors to do the following three things:

1. Silence the speculative urge that still courses through markets today
2. Reduce exposure to index funds, the most consensus investment strategy in the history of public markets, and reduce exposure to private equity with high fees, leverage, and low reported volatility
3. Recognize volatility in public markets is a gift, price distortions are at the widest levels in 40 years, and embrace disciplined, low-cost, evidence-based stock pickers

For many, these ideas are heresy. A decade from now, we believe they will be seen as obvious.

Let’s rewrite those three concepts in more colloquial language and see if you agree:

1. Avoid speculating on stocks promising profits in the distant future
2. Don’t follow the crowd in the stock market and stop paying high fees for opaque private products that require lots of leverage with empirically dubious reporting
3. Hire active managers who pick stocks using proven methods

KCR believes the crisis of capital misallocation is upon us. For those married exclusively to groupthink, the risks are myriad and conventional failure is likely. The opportunities have rarely looked better for those willing to embrace the evidence.

Part 1: Avoiding Speculation Made Simple

KCR spent much of 2020-2021 highlighting the surfeit of obscene speculation. For new readers, our piece Short Term Stock Speculators Beat a Hasty Retreat offers a cornucopia of charts documenting the epic misallocation of capital. The inventory of the absurd on those pages defies belief.

Possibly more remarkable is the scope and persistence of these speculative shares.

The chart below shows the percentage of the Russell 3000 that either lose money or have interest expenses greater than operating income.

Over 33%, or ~1,000 of America’s largest listed companies, lose money or cannot afford to pay their interest expense. Let that sink in.

We have dubbed this group the “Loss Makers and Zombies.”