2023 Mid Year Portfolio Review

I left the corporate job forty five months ago and we’ve mostly lived off the portfolio since declaring FIRE.  While I have earned some self employment income, almost all of that income has gone into funding the tax liability on Roth IRA conversions.   The portfolio has now survived two bear markets and raging inflation yet our net worth is slightly higher on an inflation adjusted basis then when we retired.  

I wanted to provide a detailed look inside the portfolio to my readers as well provide some thoughts and open it to comments.  The portfolio return through the first half of the year is 8.7% vs. 16.2% on the S&P 500 and 12.1% on a three year basis vs. the S&P of 14.6%.   Unsurprisingly, the defensive position of this portfolio felt better in 2022 than it has in 2023 as technology has outperformed over the last six months.

Asset Allocation

Our portfolio is equity heavy at nearly 78% equity and another 3% in preferred stock.   Real estate makes up 10.5% between individually owned REITs and private syndications with the remaining percentages in bonds. 

1) If we were following the equity glidepath method of going from 40% bonds to 0% bonds over the first five years of early retirement, the portfolio would be on target at +/- 10% between year four and year five of FIRE.   I am not sure if 100% equities is for me long term as I enjoy a lower volatility portfolio. 

2) Today’s rates on fixed income instruments are attractive.   Treasuries pay 4% to 5% depending on the term.  Corporate bonds can earn 6%.   Perpetual preferred stocks from solid banks can yield 6% to 8% right now and pay a tax advantaged yield.   If our withdrawal rate is running 2.5%, a 6% to 8% fixed income instrument can provide a solid income stream.  

Mutual Fund Holdings

Just under 45% of our portfolio is in mutual funds, primarily low cost index funds and ETFs. 

1) The large cap value and dividend holdings are $VIG and $VTV.   The thought behind this holding has always been that I prefer to anchor the portfolio with the large and profitable companies of the S&P 500.   There’s a long debate about value vs. growth investing and growth has outperformed over the last decade, but I prefer the lower volatility and security of the value side of the market.   I can accept a slightly lower return to not own the side of the index that could take a 50%+ reduction in price based on the companies returning to historical valuations.  

2) The small cap value holdings are a combination of FISVX, IJS, and VSIIX.   I’m a fan of Paul Merriman and other’s work and believe in the historical outperformance of small cap value.   The current Price to Earnings ratio on IJS is 10.5x, so with no growth this means I’m buying a 9%+ earnings yield today.   That’s a significant discount to the 20x earnings / 5% earnings yield on the S&P 500 fund.

3) The balanced fund is a legacy holding of VWELX.    This is Vanguard’s flagship managed fund, combining a large cap value fund with a bond fund for a 0.25% expense ratio.  I could sell this, but I’m locked out from buying it again because it can only be purchased directly from Vanguard.  

4) The Total Market Index is in FZROX and VIIIX.   There isn’t much explanation needed for these funds.

5) The bond fund is a lousy Dodge and Cox fund that is the only “low” cost bond fund available in my deferred compensation plan.   This plan pays out in full over the next ten years, so it’s important I hold a portion of our bond allocation here for price stability in the account.  

6) The remaining holdings are FEMKX for international / emerging markets exposure and IJH.  I like FEMKX because I believe in active management for emerging markets, an index can get concentrated with state owned banks and oil companies that become piggy banks for politicians (think Russia), so I’d rather have a logical manager in that space between my money and the companies.   IJH is a long term mid cap fund we bought once, haven’t touched, but also haven’t seen a reason to add more to it. 

Individual Equities

1) Costco comes in #1 on our individual equity holdings.   We bought a good bit of Costco twice over the last twelve years.  

• $85 – $160/share between 2011 and 2015

• $310-$315/share in early 2021.  

Even though we’ve sold some over time, it still makes up just over 10% of our overall portfolio and a third of our individual stock holdings.   As I write this Costco is around $540, will likely see low single digit same store sales growth over the next year, and still trades at a healthy multiple.   I’m torn between trimming this position and accepting that it has a bond-like risk profile since the company has more cash than debt and owns most of its locations.  I also think the next decade will be the golden age of Costco as the late 80s / early 90s babies all buy houses and have families.

2) Bank Stocks:  22% of individual stock holdings.   Outside of one company I’ve owned for four years, these are additions in 2023.  I know the industry well but until this year, valuations haven’t been attractive enough to enter in.  This is more of an industry bet, so I’ve split this among seven different individual stock holdings to limit some of the individual company risk that can come with micro cap holdings.   I worked throughout the Southeast and found the right combination of value in the northern sunbelt / lower mid-Atlantic.  The names I own in this basket are three smaller regionals (FHN, PNFP, and SCOF), four decently run community banks (SMMF, SKLB, BOTJ, and SMMF), and one deep value (aka poorly run company) under an activist campaign (ASRV). 

The industry is dealing with noise because of the *pace* of rate increases, but long term higher rates equal higher returns for banks.   This has allowed me to buy businesses that consistently generate 15% returns on equity at or below book value.   I plan on holding these positions and enjoying that 15% return as it makes its way back to shareholders or exit these when the price to book multiple expands to 1.5x or more from it’s current +/- 1x.  

3) Home Depot:  This has not been the greatest holding over the last two years, but I remain bullish long term on the country’s aging housing inventory and what it means for a home improvement store.  I expect they’ll have to grind through a challenging 2023 before returning to high single digit / low double digit earnings growth.  In the meantime, it can still return 6-7% without any growth in total earnings.  This is a long term holding of mine that I’ve added to over the last year as its valuation became more reasonable.   Similar to Costco, I think the millennial generation coming of age against an the country’s housing inventory will keep this business plugging along. 

4) Bank of America: This is a megabank but it’s core business is simple – Be the #1 retail deposit account provider and loan that money to large companies.  I think the valuation today on Bank of America is stupidly cheap and driven by bond and mortgage backed security concerns.   Those concerns are valid if Bank of America were to have to liquidate those, but the company has an incredible funding cost advantage and diverse deposit base that will win long term.   The same applies to Bank of America as it does the smaller banks:  The pace of rate increases is not great for banks, but higher rates are better than lower rates long term.   This is a 4+ year holding of mine and in hindsight I should have liquidated when it’s price reached more than 2x tangible book value.  

5) Berkshire and Markel are really more like actively managed large cap value and small cap value funds wrapped in an insurance company.   I view these as essentially mutual fund holdings that are ideal for a taxable account since they don’t generate any distributions.

6) Disney is the toughest of our individual stock holdings.   We’ve been shareholders for over ten years and the company has a laundry list of struggles.   Pandemic shutdowns, overspending on streaming, overspending on sports, cutting the dividend, abandoning then trying to return to the cash firehose of traditional movies, union / labor struggles, weird CEO transition and return, and getting into unnecessary political fights.  I believe Disney has the greatest IP in the world, but it’s tough to continue to hold this and watch the level of dysfunction. It’s unfortunate this investment has been dead money for almost a decade now.   My only hesitation on selling it is that the company always seems 6-12 months away from getting their house in order and I’d hate to miss the 50%+ move in the stock price when that happens.   2023 box office will be the best since 2019 and that revenue stream returning in full is what drives Disney.  Can these returns trickle down to the shareholders?

Alternative Holdings

Syndications:   We are invested in four different properties with two syndications.  I personally like investing in single story “flex” properties with surface parking and exterior entrances.   There’s a narrative about offices being dead, but if a property has surface parking, an exterior entrance, and is in a decent area, the property is full.   Three of the four properties I’m invested in sit at 100% occupancy and the fourth is strategically turning over tenants while remaining at 80%+.   The investments are concentrated in Georgia because I know the area from my time working / lending there.

Two of the properties are 10yr target investments that generate a 6.5% cash return a year and the borrowers put long term fixed rate debt on them to sustain this distribution rate.  These were nice yields in 2021 and early 2022, now it’s kind of mediocre with treasuries.  These have more of a fixed income risk profile.  The other two properties are shorter term investments where the sponsor is entrepreneurial and finds a broken or obsolete property that needs to be repositioned.  I knew one of the two partners from my prior career and have been impressed with their hustle and work ethic.  One of these is about to return a double in two years and the other is a new investment.  These are more of equity / venture capital type risk and it’s fun to watch the entrepreneurs make something great happen.    

If you want to know the syndicators, shoot me a message and I’ll be happy to share their contact information.

Preferred Stock:   I wrote about preferred stocks earlier this year and bought quite a bit when yields were higher.   Outside of a little First Republic that I took a loss on, this has gone very well.   I bought and subsequently sold a larger amount of preferred stock, but the risk/return on a few of the names just didn’t make sense to hold after the securities increased 40%.   The remaining holdings here consist of FHN-F and two preferred stock ETFs, PFF and PFFR.   

REITs:   I’ve trimmed the REITs over time as the yields and risk/return profile no longer looked attractive.  Most of the remaining holdings are in EPR, an entertainment / single tenant focused REIT that yields over 7% with a reasonable debt load.    There’s a small amount of O and STAG I have not liquidated and might hang on to.   Generally I don’t view REITs as attractive today since yield can be found elsewhere and these businesses are exposed twice to rising rates, once with the underlying properties they own declining in value and secondly when the debt the REITs carry reprice.  

Mid Year Thoughts:

1) “How’s that working out for ya?”   It feels good when the portfolio is outperforming the market, but not so great when it underperforms.   The first half of 2023 feels a lot like the second half of 2020.   NVidia is trading at 39x sales, Apple is a three trillion dollar company with headwinds in it’s market, Tesla is up 250% YTD,  and a laundry list of unprofitable or near ponzi companies are up 100% YTD based on short squeezes.   It doesn’t make sense to me, but I have to accept I don’t participate in momentum driven upside s in exchange for missing out on the downside risk.

Why am I underweight the S&P 500?  25x earnings seems rich in a world with 5% risk free rates and companies in the United States dealing with a longer term environment of labor inflation.  I think valuations will matter more this decade.   Outside of megacap technology, the S&P multiple is +/-16x, which seems more reasonable.   I suppose this is the point where I should complain about the fed or something?

2) Valuing Simplicity:   The portfolio is still a bit too complicated.  I’ll take two steps forward and one step back when working on the individual stock percentages or consolidating fund holdings.  I trimmed many back or eliminated positions last year only to see what I think is a once in a decade opportunity come around with financial stocks.  Instead of blindly buying a financial index, I chose to create a basket of stocks with the industry knowledge I have.  

I may want to consolidate some overlapping mutual funds and slowly trade in some individual stock share for mutual funds.

3) Buying vs. Selling:  In order to invest in individual stocks (or time the market), you have to be good at both buying and selling.   So far I would conclude I’m decent at the first and not so great at the second.   We knew Costco was getting ahead of itself at $600/share, but didn’t sell.   I’m regretting not unloading Disney when it spiked above $130 knowing the company had profitability issues ahead.    Bank of America traded for 2.25x book value and hit $48/share and I didn’t sell.  Those are at least short term mistakes in hindsight.  The challenge with this is anyone who invests in individual stocks has single stock positions they sold too early.  I thought Apple got way ahead of itself the first time it hit $140 and I exited and that turned out to be a poor result.

4) How much should I allocate to bonds and preferred stock?   Our withdrawal rate is around 2.6% now, which could support a 100% equity allocation.  At the same time, getting 5% to 8% with minimal risk is attractive, today that’s enough to cover the withdrawal rate and a +/-4% inflation hit without the risk of a long duration drawdown.   We’ve made it through the riskiest part of FIRE, today we have secured our biggest expense (housing), worked our Roth IRA balances up, are closer to receiving a pension plus social security, and I have a decent consulting gig setup where I can earn more money on 90-120 day projects if / when I want.   All those things say “sure, go ahead and take some risk” while at the same time I’ll never forget losing 11% of our portfolio balance in a single day in March of 2020.   My number one goal is to keep work optional, after that there’s not a lot else that we need / want with the additional funds we can earn.*  

Wrapping Up

I’m trying to balance earning at or near market returns in the portfolio while reducing the overall risk / volatility.   This has worked well in some years and frustratingly been behind in other years.  I’m slow to make significant changes, but am willing to make adjustments to this over time.  

Now I’ll open this up to the readers:  What thoughts do you have about the allocation?  What would you change about the portfolio?  What else should I consider?

*  Okay, so “nothing else” with the money isn’t not entirely true.   We would still like to try living in Hawaii, but housing inflation of 40% on a 2-3 bedroom place and 7%+ mortgage rates makes that prohibitively expensive / risky today.  We also moved too much last year and will likely stay put for another couple years before considering this again.