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Why I Buy Individual Stocks and Bonds

Warren Buffett is widely considered the greatest of all time (GOAT) in investing. But did you know that Buffett himself recommends passive investing for most investors? He once said:

“The ultimate irony of the investment business is that there’s no question that an obstetrician will deliver babies better than the husband or the wife. Or if you take dentists as a whole, they will remove teeth or fill teeth better than if the patients try to do it themselves. But in the investment world, somebody who believes in American business — and who will seek out the lowest way to participate in business and do it consistently — will achieve results that exceed those of investment professionals as a group.” – Warren Buffett

Passive investing means buying and holding a low-cost index fund or ETF that tracks the performance of a broad market, such as the S&P 500. The logic behind this approach is simple: the average professional investor cannot beat the market, especially after fees and taxes. Therefore, the best strategy for most investors is to match the market with minimal costs and hassle.

I respect Buffett’s advice and I agree that passive investing is a sensible option for many investors. I also question the value proposition of most financial advisors who claim to offer active investing but actually deliver closet indexing. Closet indexing means creating a portfolio that closely resembles an index but with higher fees and lower transparency. A typical closet indexer may hold 50+ diversified stocks with a smattering of bond funds, all of which are in such small weights that they won’t make much difference to the portfolio’s performance. The result is a portfolio that mimics the index but is often less tax efficient and comes with lower returns or higher costs. 

If you’re going to invest passively, why not just buy an index fund or ETF directly and save yourself the headache? If you’re going to invest actively, I think you need an advisor with a clear and proven approach to selecting individual securities based on rigorous research and analysis.

Why Don’t I Passively Index?

Even though indexing is the way to go for the vast majority of investors, I think it’s possible for disciplined investors that follow proven approaches to gain an edge on the market. 

One of the reasons I think active investing can work is that most professional investors are too short-sighted. As Seth Klarman said, “Risk for them is not being stupid but looking stupid.” If they try to do something different than the crowd, they risk being fired. John Maynard Keynes said, “It is better for reputation to fail conventionally than to succeed unconventionally.” This pressure forces them to chase the market’s trends and fads rather than stick with an approach that works over longer time horizons. This creates an opportunity for patient or contrarian investors willing to take a long-term view. 

Historical data backs up the fact that a value approach has outperformed the market. The following table shows significant outperformance of a variety of value-based metrics: 

My Investing Background

One of my role models in investing is Ben Graham, who is widely regarded as the father of value investing. Here is how Graham describes the enterprising investor: “The determining trait of the enterprising (or active, or aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort, in the form of a better average return than realized by the passive investor.”

I share Graham’s vision of the enterprising investor and I try to follow his principles in my own investing. I have also learned from other great investors who have applied some version of value investing in their own unique ways, such as Warren Buffett, Walter Schloss, Bob Rodriguez, Joel Greenblatt, and John Templeton. These investors have shown that it is possible to beat the market over long periods of time by being disciplined, rational, and contrarian.

Fortunately for those passionate about investing, many of the best investors have left a veritable treasure trove of information that future investors can learn from. Here are a few of the most valuable books and resources that have informed my investing style over the years:

  • Warren Buffet Biographies (particularly Snowball by Alice Schroeder)
  • Berkshire Hathaway Annual Shareholder Letters
  • Historical Issues of Outstanding Investors Digest
  • Security Analysis by Ben Graham & David Dodd
  • The Intelligent Investor by Ben Graham
  • The Money Masters by John Train
  • The New Money Masters by John Train
  • The Craft of Investing by John Train
  • Value Investing From Graham to Buffett and Beyond by Bruce Greenwald
  • You Can Be a Stock Market Genius by Joel Greenblatt
  • Common Stocks and Uncommon Profits by Philip Fisher
  • The Templeton Touch by William Proctor
  • Value Investing by James Montier
  • The Investor’s Anthology by Charles Ellis
  • What Work on Wall Street by James O’Shaughnessy

I spent a decade at my prior firm honing the craft of investment research and analysis. I spent most of my days focused on researching individual stocks and bonds. When I wasn’t researching individual ideas I spent countless hours reading and learning what had worked for the investing greats. 

When I founded Sophos Wealth Management, I wanted to offer my clients a specialized portfolio approach: one that is based on active investing in individual securities, rather than passive indexing or closet indexing. I believe that this approach can provide a customized, controlled, and opportunistic portfolio tailored to each client’s goals and needs.

When I select individual stocks, I view them as ownership stakes in businesses, not just ticker symbols. I look for undervalued securities that trade with a significant margin of safety to my conservative estimate of their intrinsic value. I use various metrics to assess value, such as normalized free cash flow, sales, tangible book value, or future growth.

Most bond investors rely too much on credit ratings to gauge the risk and return of bonds. Credit ratings are often inaccurate, outdated, or biased. They do not account for the differences among bonds issued by the same company, such as maturity, seniority, or features. This can create mispricing and inefficiency in the bond market.

For example, imagine a company that has $1 billion in cash and has limited liabilities outside of two bonds outstanding. One bond outstanding is $100M and matures in one year. The other bond is a $5B bond that matures in 10 years. Clearly, the one-year bond is much safer than the 10-year bond, because the company can easily repay it with its cash on hand. However, both bonds will have the same credit rating and will be priced accordingly. This means that the one-year bond may be undervalued and offer a higher yield than it deserves, while the 10-year bond may be overvalued and offer a lower yield than it deserves.

When I look for individual bonds, I think of them as loans to companies. I look for opportunities where the credit rating does not reflect the true risk or return potential of the bond. I consider factors such as liquid cash and alternatives, other outstanding debt, bond covenants and features, and cash flow.

If you are interested in learning more about my investment approach and how it can fit your needs, please feel free to contact me for a free consultation.

Scott Caufield, CFA, CPA