A Differentiated View on Diversification

Theme and Background

This chapter discusses the performance of the Patient Opportunity Equity strategy in the first quarter of 2025, along with the author's assessment of a recovery in the "classic value" sector. The market environment exhibits a divergence pattern where large-cap growth stocks lead while small-cap stocks lag. The author believes that after the burst of the innovation bubble, the market is returning to a focus on cash and profits.

Core Thesis

The author's core investment argument is: The recovery of the classic value sector (low P/E stocks) will persist. This sector has been outperforming the market again since the end of 2020, yet most investors have not fully recognized this trend. A counterintuitive judgment is that the strong performance of the Magnificent 7 has not hindered the recovery of classic value; the two can coexist.

Key Arguments and Data

1. Historical Performance of Classic Value: Since 1951, the lowest quintile of stocks by P/E ratio has delivered an average annual return of 15.1%, significantly outperforming the S&P 500's 11.0% and the highest quintile's 9.4%.

2. Recent Recovery Data: Since the end of 2020, the lowest quintile of stocks by P/E ratio has posted an average annual return of 12.0%, again outperforming the S&P 500's 10.0% and the highest quintile's 5.0%.

3. Comparison with Innovation Bubble Burst: The ARK Innovation ETF (ARKK) delivered an average annual return of +52% in the three years before 2020, but an average annual return of -25% in the three years after 2020, as capital flowed back from the innovation sector to the value sector.

4. JP Morgan Case Study: Since September 2011, JP Morgan has achieved an annualized return of 19.7%, outperforming the S&P 500's 15.3%, demonstrating that high-quality companies are undervalued during market panics.

Metric	Lowest P/E Quintile	S&P 500	Highest P/E Quintile
Average Annual Return Since 1951	15.1%	11.0%	9.4%
Average Annual Return Since End of 2020	12.0%	10.0%	5.0%

Companies/Assets Involved

• JP Morgan: A representative of classic value, held for over a decade with an annualized return of 19.7%, a high-quality company mistakenly perceived by the market as "high risk."
• Delta Airlines: The author believes it is similar to JP Morgan—a high-quality company misunderstood by the market.
• Amazon: An early-stage investment case, once mistakenly viewed as a retail company, but its actual business model is closer to Dell's distribution business, with AWS growth generating excess returns.
• Coinbase: A current early-stage investment, viewed by the market merely as an exchange, but the author sees it as a crypto platform still in its early evolutionary phase.
• Farfetch: A failed case; the author acknowledges the mistake but emphasizes risk control through small position sizes.
• Illumina: A compound growth company that offers buying opportunities during growth scares.

Investment Implications

1. Increase Allocation to Classic Value: Low P/E stocks have been outperforming the market again since the end of 2020, and the recovery trend is expected to continue. Investors should focus on undervalued sectors overlooked by the market.

2. Leverage Volatility: Short-term volatility in cyclical companies creates opportunities, as seen in the JP Morgan case after the European debt crisis. The author recommends buying high-quality companies during panics.

3. Use Leverage Flexibly: The author repaid most margin debt at the end of the quarter to allow for adding positions during market declines. Given that current valuations, debt costs, and sentiment are higher than after the financial crisis, leverage should be used more opportunistically.

4. Diversify Investment Types: The portfolio should include compound growth companies, classic value, and early-stage companies, reducing volatility through returns from different sources.

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Theme and Background

This section primarily presents the performance of Patient Capital's two strategies—Opportunity Equity and Patient Strategy—as of March 31, 2024, along with historical return data for low price-to-earnings (low valuation) stocks. Through performance comparisons and long-term data, the author attempts to demonstrate the effectiveness of its value investing strategy, particularly in the current market environment.

Core Thesis

The author's central argument is that low-valuation (low P/E) stocks have outperformed high-valuation stocks over both the long term and the recent period, supporting the rationale for adhering to a "classic value" strategy. The counterintuitive insight is that, despite the market's enthusiasm for high-growth, high-valuation "innovative" stocks, data shows that low P/E stocks have delivered an average annual return of 15.1% since 1951, significantly outperforming the S&P 500's 11.0%. Moreover, since the end of 2020, low P/E stocks have averaged an annual return of 12.0%, again beating the S&P 500's 10.0% and high P/E stocks' 5.0%. The author believes that the market's focus on cash and profits is returning, and the value recovery is likely to continue.

Key Arguments and Data

1. Performance Comparison: Both Opportunity Equity and Patient Strategy outperformed the S&P 500 in the first quarter of 2024.

• Opportunity Equity (net of fees) QTD return: 11.77%, higher than the S&P 500's 10.56%.
• Patient Strategy (net of fees) QTD return: 14.39%, significantly higher than the S&P 500's 10.56%.
• Over the long term, Opportunity Equity has an annualized return of 7.28% since inception (December 30, 1999), slightly below the S&P 500's 7.40%; however, Patient Strategy has an annualized return of 13.42% since inception (December 31, 2014), above the S&P 500's 12.57%.

2. Historical Performance of Low P/E Stocks:

• Since 1951, stocks in the lowest P/E quintile have averaged an annual return of 15.1%, versus 11.0% for the S&P 500.
• Since the end of 2020, stocks in the lowest P/E quintile have averaged an annual return of 12.0%, compared to 10.0% for the S&P 500 and just 5.0% for stocks in the highest P/E quintile.

Comparative Data Table:

Time Period	Average Annual Return of Lowest P/E Quintile Stocks	S&P 500 Average Annual Return	Average Annual Return of Highest P/E Quintile Stocks
Since 1951	15.1%	11.0%	Not provided
Since End of 2020	12.0%	10.0%	5.0%

Companies/Assets Involved

This section does not mention specific company names, instead using indices and factors (e.g., P/E groupings) as the objects of analysis. The asset classes involved include:

• S&P 500 Index: Used as the benchmark for large-cap stocks.
• Russell 2000 Index: Used as the benchmark for small-cap stocks (mentioned only in the performance table, not analyzed in detail).
• Magnificent 7 (Apple, Google, Microsoft, Amazon, Meta, Tesla, Nvidia): Representing high-valuation, high-growth stocks, but the author does not directly short them; instead, the data comparison implies valuation risks.

Investment Implications

• Adhere to Value Investing: Investors should focus on stocks with low P/E ratios and high earnings yields, as such assets have demonstrated excess returns over both the long term and the recent period.
• Beware of Innovation Bubbles: High P/E stocks (e.g., the Magnificent 7) have averaged only 5.0% annual returns since the end of 2020, far below the 12.0% of low P/E stocks, indicating that the market's tolerance for high valuations is declining.
• Flexible Opportunistic Style: Patient Capital's strategy shows that during a value recovery cycle, actively managed, flexibly allocated portfolios (such as Patient Strategy) can significantly outperform indices.