January 2023: Lessons From a Bear Market
I’m told I haven’t been in a very good mood today. I don’t particularly like 1 January. The Christmas holidays are over and I start to think about all the responsibilities I have to deal with in the rain, cold and dark that is January in England. Incidentally, it’s the perfect time to go on vacation.
What I should probably do then is to think back on the last year, to be thankful for the year I’ve had and also to identify any experiences I can learn from.
In this issue of the newsletter, I’d like to run through some thoughts on what I’ve learned from the bear market of 2022.
Contents
Performance
2022 in brief
Lessons from a bear market:
Dealing with drawdowns
When to trade
When to take profits
Maximum position sizing
Leverage
Options
Contrarian investing: when to switch to compounders
Portfolio
Final thoughts
Performance
2022: +1%
2021: +10%
2020: +49%
2019: +51%
2022 in brief
My plan going into 2022 was to hold a concentrated portfolio, to keep the stocks for the long term and make very few trades or changes. It hasn’t worked out that way… Embarrassingly, I’m now holding NONE of the stocks I started out last year with!
I became convinced high-multiple compounders and technology companies were unlikely to perform well amid rising inflation, rising interest rates, the war in Ukraine and lockdowns in China. In the Q2 newsletter, I discussed how companies with high free cash flow yields and capital returns would likely result in better investments in an inflationary environment.
At the same time, I was confident of the bull case for energy equities. Over the year, I switched to a portfolio made up almost entirely of oil and gas exploration and production companies.
So far, these have been the right macro calls, but my timing and stock performance have disappointed. To finish the year at +1% wasn’t what we’d hoped for, but it wasn’t bad compared to the major indexes.
And I’m happy to report, at least, that trading had a net positive effect in 2022. Let’s see how the January 2022 portfolio would have worked out if left alone.
2022 performance of January 2022 portfolio:
MU (26% position): -46%
TPL (23% position): +88%
TELL (19% position): -45%
BABA (14% position): -26%
AMZN (10% position): -50%
SRG (7.3% position): -11%
In total, the portfolio we started the year with would have returned around -9%, with TPL growing to half the portfolio.
Lessons from a bear market:
1. Dealing with drawdowns
I’m sure we learn best, or only really learn at all, when things are tough. 2022 has been a lesson for me in how low stocks can fall.
A joke from energy analyst Paul Sankey:
Q: “What’s a stock that’s down 90%?”
A: “A stock that was down 80% that got cut in half.”
I bought Stronghold Digital Mining (SDIG) when it was down ~85% from its peak. SDIG then went down another 90% from there! (I count myself extremely lucky to have got out at a profit!)
This reminds me of the Peter Lynch line that goes something like this:
Q: “It’s down 90%: what can I lose?”
A: “Well, you can lose 100%!”
On a portfolio level, even if we’re relatively conservative stock investors, we’re going to have to deal with significant drawdowns at points in our investing careers of 50% or more. I’ve seen my portfolio draw down 30% since the highs of the year.
On dealing with drawdowns, Warren Buffett’s advice is a godsend – to think in terms of being the owner of businesses; Mr. Market gives us a quote every day, but we do not have to sell. If we’re confident about the future cash flows of the business, we don’t have to be concerned at all about being quoted a low price today.
Of course, we have to choose good businesses at reasonable prices for this to apply!
2. When to trade
When I buy a stock, I almost always aim to hold it for at least a couple of years, with a caveat that it should work out well as a long-term investment in case the market doesn’t comply over the medium term. Some compounders I’d like to keep forever – if I can find that potential 100 bagger!
However much I would have liked to have stuck with the same handful of stocks and barely touched the portfolio, that requires that I chose right in the first place. I also need the flexibility to be able to change my mind and sell if the available information changes – which it did on the macro level (including inflation affecting companies’ profit margins and returns on capital in real terms) and on the individual stock level with some of the holdings.
Falling in love with a story and blocking out negative information is not conviction but blindness – you see it all the time on FinTwit (financial Twitter).
I have sold some things for the ‘wrong’ reasons. I sold Marathon Oil (MRO) to add to a huge Vermilion (VET.TO) position, when I was very confident about MRO. Should have just kept it.
Texas Pacific Land, an oil and gas royalty company, I sold down over the course of the year, exiting my still sizable position at the end of October when the valuation got very high, combined with disappointing growth, a lacklustre growth outlook for the Permian and serious concerns about management and capital allocation. This one was the best performer by far of the year, so selling it down detracted from performance considerably. However, it still produced my biggest dollar gain in the history of the portfolio – and I don’t necessarily believe selling it was a mistake; it was done for the right fundamental reasons, and I hope it looks like a good decision further down the line.
3. When to take profits
I’m not one for taking profits simply because a stock has gone up.
Perhaps that strategy could have worked quite well this year in the energy sector with all the volatility, but it doesn’t make sense to argue it would add value in the long run.
If you think the stock will go down, why not sell the whole position rather than trimming? If you’re wrong about it going down just half the time, you lose from trading fees alone. And being right half the time is difficult to achieve when competing in the market short term against the professionals with better equipment and data. You’re becoming a trader – good luck and hats off to you if you can do it!
I do believe in taking some profits and reducing the position size if:
Our conviction in the stock is lessening due to fundamental reasons (including the expected return due to the price going up).
We find something FAR better.
A position size becomes uncomfortably large.
One proposal I’ve heard that rings quite true is to take some chips off the table when we are feeling euphoric, when selling is the last thing on our minds. At Vermilion’s peak in August, I was elated and convinced the stock was going to C$45+ a share in short order. Nothing was further from my mind than selling some.
While this reverse euphoria factor is probably not enough alone to base a trading decision on, in combination with having a huge position, it seems a good indicator to take some profits!
4. Maximum position sizing
After 2022, I’ve changed my thinking on maximum position sizing. Earlier in the year, I was of the opinion that, in an extremely undervalued situation, it can occasionally make sense to put the majority of my portfolio into that one investment – an idea from Buffett and Munger (a “cinch” they would call it).
Vermilion Energy (VET.TO) crashed along with the energy sector in June – the stock appeared to be the cheapest stock I had ever seen and offered the leverage to European gas prices I was looking for. As I was extremely confident and the price kept falling, I put over 50% of the portfolio into it over the summer, and the position size, including a small position in calls, went to well over 70% at one stage. At the end of August, my portfolio was up 38% year-to-date and consisted of just three stocks plus the calls. I was feeling like Charlie Munger!
Vermilion has since crashed down back to its summer lows on the back of the EU windfall tax – the speed of its passing, its widespread adoption and the levels of tax set surprised me – and the European gas price has fallen back to levels pre the Russia-Ukraine war.
Thankfully, I did reduce the position size and diversify into some more companies between September and November at a significantly higher share price than current. I became uncomfortable with the size of the position, although still confident on the stock itself, following the announcement of the windfall tax, and I also wanted more oil-weighted exposure – but it remains the largest position. (I sent out a memo that I had trimmed the position and sold my calls to subscribers of the blog mailing list – a list you can join here.)
The experience with Vermilion so far has taught me that ‘unknown unknowns’ need to be allowed for, and so a 50% position at cost is too high for me. I’m now planning to go back to my old maximum position sizes – 30% at cost, and an absolute maximum size in the portfolio of 50% – and this is only for extreme situations.
5. Leverage
I don’t use leverage in my investment accounts, but I did take on a bit of leverage in 2022 in the form of a low interest bank loan which I invested as well as investing the money I’m due to pay in tax this month for the previous tax year. I did this because I was confident it was likely I could get a positive return on it and, if it didn’t work out, I should still have no problem paying it.
In hindsight, this hasn’t worked out very well to date. I would have been better keeping some cash rather than going the other way and being over 110% long! I probably won’t be borrowing any more money from the bank to invest! It’s not worth the stress!
6. Options
I’ve had a roller-coaster with the Vermilion call options. I put them in at around a 4.5% weighting. I went up 150% on them, didn’t take any profits and then sold at a ~7% loss!
I had a lucky escape not to lose the capital. The calls crashed much further since and, as it stands, are set to expire worthless on 20 January.
However, this experience wasn’t enough for me! After the stock crashed down following Q3 earnings, I put the money from the sale into January 2024 calls – I see the thesis taking another year to play out. I’m now down on these as well!
In hindsight, I should have at least taken back my principal when the options doubled. I should do this in future with options – although I don’t intend to make a habit of using them.
Contrarian investing: when to switch to compounders
The plan for 2023-4 is to stick with the portfolio until oil prices are higher and the energy stocks rerate. Then I plan to trim some energy exposure and diversify into some other areas such as mining, technology and compounders.
As the contrarian investor I seem to have become, I want to be switching back to compounders again once energy equities become better loved and if the compounders are cheap and unpopular. I’m unsure as yet whether quality compounders are cheap enough considering the inflationary environment. I doubt we’re there yet.
Oil and gas, and especially coal, are still almost universally hated and thought to be in terminal decline. If demand persists for longer than hoped for, combined with underinvestment in supply, if you can buy these companies at 3-4x free cash flow and they have 20 years of reserves… it doesn’t take a genius to see the attraction.
We’re seeing now that certain previously hot areas of the market, such as pre-revenue start-ups, SPACs and bitcoin mining, have become almost as hated as energy. This gets me interested. If you gasp in horror at the thought and say, “No, never, not at ANY price! Stay away!”, that gets me even more interested!
I’ve already initiated a position in Embark Technology (EMBK) and added to it. The situation is enticing. The stock is down 99%, it is now trading for a fraction of its net cash position and it has no debt. Its market cap is $76m and, if it is successful in its plan to capture a share of the autonomous trucking industry, its earnings could be in the many hundreds of millions or billions within a few years. It has strong competitive advantages and quality management, it has cash, and so I think it has a good chance to get there. Write up to follow soon!
Portfolio
In December, I trimmed some Whitecap Resources (WCP.TO) and Hemisphere Energy (HME.V) to add to Arch Resources (ARCH) and Embark Technology (EMBK).
I also own some bitcoin which I don’t include the stock portfolio.
Final thoughts
I have nothing else to say this month apart from that I wish you all a very happy and fulfilling 2023 and the best of luck in your investing endeavours!
As you can see, I have my work cut out for me!
Best wishes,
Timothy Lamb.
Written by Timothy Lamb
Blog: www.retailbull.co.uk
Twitter: @theretailbull
Disclosure:
The writer owns shares in VET.TO. SGY.TO, JOY.TO, HME.V, MEG.TO, WCP.TO, ARCH and EMBK at the time of writing.
Disclaimer:
This article is for informational purposes only, does not offer investment advice and does not recommend the purchase or sale of any security or investment product. Please see the full disclaimer on the About page.