You Don’t Need to Know What a Stock’s Worth to Know It’s Cheap

by Geoff Gannon


Someone emailed me asking what sources they needed to study to get better at valuing stocks.

My answer was that the ability to come up with accurate valuations for public companies is overrated.

Why? Because…

It's rarely important to know how to value a company. What's important is the ability to recognize when a company is clearly selling for less than it's worth and then acting on that knowledge.

For example, in a write-up I did on my member site (Focused Compounding) explaining why I put 50% of my portfolio into NACCO (NC) when it completed the spin-off of Hamilton Beach (HBB), I said that:

"I think of each share of NACCO as an inflation adjusted stream of free cash flow. As I’ve shown, I think the stream has a ‘coupon’ of greater than $3.25 and I bought it at $32.50. So, the yield is 10% or more and that’s effectively a ‘real’ yield.

The average U.S. stock has a free cash flow yield in the 4% to 5% range and that yield is not as well protected against inflation.

It’s true that NACCO’s yield will eventually decline as coal power plants shut down (although, in recent years, the tons of coal supplied has risen rather than fallen). However, I think of my ‘margin of safety’ as being the fact that it isn’t 100% certain these plants will shut down and they haven’t shut down yet. Till they do, cash will build up on the balance sheet of NACCO (the parent company) or it will pay out dividends, buy back stock, or acquire businesses unrelated to coal mining (as it did in the past)."

It's important to note that:

1) I never said that NACCO's cash earning power is $3.25 a share. I said it's at least $3.25.

2) I never said that the right multiple for NACCO is 10 times FCF. I just said that a normal stock trades for 20-25 times FCF (a 4% to 5% FCF yield) and NACCO trades for no more than 10 times FCF.

In fact, in that same article, I walk through ways of estimating what cash earnings would be in a normal year for NACCO (now that's it just the coal business). The range of earnings estimates these different methods give you actually cluster around $4.75 to $5.50 a share (not the $3.25 figure I cite). However, I didn't think those numbers were important when the stock was at $32.50.

Why? Because…

Earnings of $4.75 to $5.50 on a $32.50 stock are overkill. You don't need to know if a stock has a P/E of 6 to 7. What you need to know is how certain it is that a stock doesn't have a P/E any higher than 10 to 11.

So, I spent more time focusing on the fact that the method of estimating earnings that was most conservative - using this year's tons of production and multiplying it by the lowest ever profit per ton the company achieved in the last 25 years - still gives you about $3 a share in cash earnings. The thing I thought was a lot more important than correctly valuing the stock was proving that the stock was almost certainly priced at 11 times cash earnings or less when I bought it. If the average stock trades for at least 20 times cash earnings and I am buying something at no more than 11 times cash earnings, I'm getting a 45% discount.

When buying a stock: the important thing isn't whether you’re getting a 45% discount or a 75% discount. It's establishing how certain you are that you really are getting a 45% discount. 

The relevant Ben Graham quote here is:

"You don't have to know a man's exact weight to know that he's fat."

It's not that important to know the exact value of anything in the stock market. What's important is knowing there's a big gap between some value you think it's highly probable a stock's worth more than and the value you're paying.

So, say the average stock trades for 25 times its after-tax free cash flow (when it's unleveraged). And then you find a stock that you think is equal to or better than the average public company in terms of quality, durability, safety, etc. Fine. What you do then is you say: well if the average stock is worth 25 times cash earnings right now and I think this stock is probably a bit better than the average stock - then I can be very sure it's worth at least 15 times earnings. So, you build a 40% discount right into your initial assumptions about the stock.

And then, what you try to do is force yourself to wait till the stock is trading not at 15 times earnings (where you feel certain it's not expensive) but at more like 10 times earnings (where you know it's cheap). You take your initial conservative assumption that forms your belief about the stock and then you insist on an extra margin of safety before you turn that belief into action.

So, now you've taken your initial 40% discount in terms of how conservative you were in valuing the company. And then you've built an extra 35% discount of inaction into your investment. 

Honestly, that's how you'll make money in the stock market. It's not by knowing exactly what anything's most likely worth that matters. It's knowing what something is almost certainly worth more than that matters. 

In value investing: technique isn't very important. Discipline is.

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Why Smart Speculations Still Aren’t Investments

by Geoff Gannon


I got an email in response to my earlier post about the line between investment and speculation. It’s a good email, so I want to quote it in full:

 

Really interesting post today, but I was wondering how you would evaluate the Weight Watchers (WTW) situation. 

 

It seems like an investment that turned into a speculative situation.

 

I think there are a couple of cases like this where a seemingly safe investment turns into a very speculative situation. Fossil (FOSL) is another one that comes to mind. Even though it had some debt, nobody would think that it would have an existential crisis at some point due to changes in business and the weight of its debt. I don't think anybody would have called it a speculation 3 years ago at over $100 a share. But on the other hand, it's speculative now at under $7 a share.

 

On the other hand you have situations like Facebook (FB) which IPO’d at an extremely speculative price but the business turned out to be so strong that even at that price, it morphed into an excellent investment had the margins not expanded so much.

 

I'm not saying that's the case for Amazon or Netflix today, but maybe it's not so easy to distinguish between investment and speculation in some cases because there are factors that we cannot foresee or do not yet understand. If you have the knowledge that it's almost certain the company will grow into and beyond the current valuation, then perhaps it would be a good investment at what others may consider to be a speculative price. 

 

If you know that a business could potentially come under hard times and the modest amount of debt it has could compound the problem, then a company with a very modest valuation may morph into a speculative stock at even 1/10th the original price a few years down the road.

 

In the end, a lot of it depends on what you really know I think.”

 

George Orwell wrote an essay called “Politics and the English Language”. One passage from that essay is helpful to quote here:

 

The word Fascism has now no meaning except in so far as it signifies ‘something not desirable’. The words democracy, socialism, freedom, patriotic, realistic, justice have each of them several different meanings which cannot be reconciled with one another. In the case of a word like democracy, not only is there no agreed definition, but the attempt to make one is resisted from all sides. It is almost universally felt that when we call a country democratic we are praising it: consequently the defenders of every kind of regime claim that it is a democracy, and fear that they might have to stop using that word if it were tied down to any one meaning.”

 

The word “democracy” has an actual definition, etymology, and history we can trace. The etymology is Greek. It means literally something like “people-power” or “people-rule” in the sense of “the people” as a group and not “people” as individuals (persons). The history is Athenian. The term “democracy” is first used to describe the government of Classical Athens specifically in opposition to monarchies, tyrannies, and “mixed” governments (what we’d now call “republics”) like Sparta, Carthage, and Rome.

 

In the modern, Western world the term “democracy” is almost universally considered positive. And two of the most commonly copied systems of government, those of the U.K. and the U.S., like to refer to themselves as democracies. But neither has much in common with the government of Classical Athens. And when being precise, we modify the “democracy” of the U.K. by saying it is a parliamentary democracy and we modify the “democracy” of the U.S. by saying it is a federal, democratic-republic.

 

The knee-jerk definition of democracy is “good”. The sloppy definition is “like the U.S., U.K., etc.”. The precise definition is “like the government of Classical Athens, only those elements of the U.K. government which are not specifically parliamentary, only those elements of the U.S. government which are neither specifically federal nor republican.”

 

In other words: we are capable of thinking about democracy very quickly and fuzzily (all heart no head), somewhat quickly and fuzzily, or very slowly and sharply.

 

We can think about investment and speculation the same three ways.

 

As value investors, our knee jerk definition of investment is “good, right, sound, what I do, etc.” and our knee jerk definition of speculation is “bad, wrong, risky, what everybody else does, etc.”

 

We equate speculation with gambling. But, true gambling is different from speculation just as true speculation is different from investing.

 

Let’s think slowly and sharply about “investing” and “speculation”. What is the definition, etymology, and history of these two terms?

 

In my last post on the line between investment and speculation I cited a post by Richard Beddard which in turn cited “The New Speculation in Common Stocks” by Ben Graham. You can google “The New Speculation in Common Stocks” and find a PDF of Graham’s speech.

 

Graham’s point was that investors had bid up the price of some common stocks enough that though the firms themselves had been investments, they became speculations at this higher price. In that talk, Graham introduces the term speculation by saying:

 

“The dictionary says that ‘speculate’ comes from the Latin ‘specula’, a look-out or watch-tower. Thus it was the speculator who looked out from his elevated watch-tower and saw future developments coming before other people did.”

 

Graham had earlier defined investment and speculation in his 1934 book, Security Analysis:

 

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

 

The other definition that I would offer is that if investment is in some sense an antonym of speculation – if speculation is rooted in the future, then investment must be rooted in the present and the past.

 

In other words, an investment is a stock purchase that can be fully justified on the evidence provided by the current financial position (balance sheet) and past earnings record (income statements and statements of cash flows) of the business.

 

A speculation is an operation that can’t be fully justified on the evidence provided by the current financial position and past earnings record of the business.

 

I am not making a distinction between quantitative and qualitative factors here. I am making a distinction between a business’s recorded history and its projected future.

 

Let me quote from another email I received about the line between investment and speculation:

 

“…this was the worst (post) I ever read from Geoff…I don’t think he understands Amazon at all…and it is obvious that he has not tried to objectively analyze Amazon. I think there is a real chance that OMC is more speculative than Amazon…I actually think Amazon looks cheap and I consider myself a hardcore value investor. You probably think I’m crazy so I’ll stop right here.

 

I don’t think the person who wrote that email is crazy. And if he had said “I think there is a real chance that Amazon stock outperforms Omnicom stocks” instead of “I think there is a real chance that OMC is more speculative than Amazon” I’d agree with him. There is a real chance Amazon will outperform Omnicom. But, that doesn’t make Amazon an investment. And it’s possible for Amazon to “look cheap” and still be a speculation.

 

Let’s look at why I called Amazon a speculation. First, here’s what I wrote about Amazon in that earlier post:

 

And we would also say that Amazon (AMZN) and Netflix (NFLX) are speculations. The enterprises themselves aren’t speculative. They are proven money makers. But, the prices investors now put on these stocks make them speculative. There is no measure – P/E, P/B, EV/EBITDA, etc. – by which either Amazon or Netflix are within spitting distance of an average price. So, a buyer of either Amazon or Netflix stock is not just betting that these businesses are above average. He is betting that they are better enough to offset paying a higher than average price for the stock.”

 

The last two sentences are what defines Amazon as a speculation for me: “a buyer of Amazon stock is not just betting that the business is above average. He is betting that the business is better enough to offset paying a higher than average price for the stock.”

 

Buying Amazon stock is an exercise in handicapping. Let’s look at how much extra weight this horse is carrying.

 

I will take data from GuruFocus. Amazon shares now trade at $1,130. Revenue per share is $328. EBITDA per share is $29 a share. However, “cash flow from operations” is 16% higher. That’s not “free cash flow”. Just “cash flow from operations” before any cap-ex. As the email writer said, I haven’t tried to objectively analyze Amazon. So, it is possible “cash flow from operations” is a more accurate gauge of Amazon’s cash generating ability than EBITDA. Note that it is very difficult for a company’s “owner earnings” to be higher than both EBITDA and cash flow from operations. And also note I am starting by using a figure that is 8 times Amazon’s reported earnings for this last year. I know it is not appropriate to use Amazon’s reported earnings. I’m not using that number at all here.

 

So, we will start with Amazon’s “cash flow from operations” per share of $33 as the maximum possible proxy for current earning power. Let’s assume Amazon grows this $33 per share in “cash flow from operations” at a rate of 20% a year for the next 20 years. That gives you cash flow from operations per share of $1,265 at the end of 2037. Assume this is equivalent to EBITDA per share (it’s not, it’s lower). And apply a normal EBITDA multiple of about 8 times (an EBITDA of 8 times tends to roughly equal a P/E of 15 for an unleveraged company paying a 35% U.S. tax rate). This gives you a future share price of $10,121 at the end of 2037. The compound annual growth rate needed to get you from a share price of $1,130 today to $10,121 is 11.6% a year. So, Amazon stock would return something like 12% a year over 20 years if it grew its earning power per share by about 20% a year for the next 20 years.

 

How difficult is that to do?

 

Amazon would have to grow its size relative to the economy by about 12 times if the economy grew at about 6% a year for the next 20 years while Amazon grew 20% a year. So, however much clout Amazon has today – imagine it has 12 times more clout.

 

The path I’ve laid out here is difficult for Amazon to accomplish. The company is too big already to easily achieve that. Once a company has meaningful market share in an industry, it becomes more and more difficult to grow faster than that industry. Within 20 years, things like online retail and probably cloud computing as well will be mature industries. They won’t be growing much faster than the economy.

 

Are there other ways Amazon stock can return something like 12% a year over the next 20 years?

 

Yes. It can buy back stock to allow it to grow slower companywide – but the stock is too expensive for that to work right now. In fact, Amazon has historically diluted its share count. So, I’ve actually underestimated the necessary increase in the size of the overall enterprise in my example above. To achieve a 20% annual growth in earning power per share – companywide earnings would have to grow even faster. Maybe all of the company’s spending on research and development is really profit. It’s necessary to spend $42 a share on research and development right now – but maybe in 20 years, Amazon will no longer have to spend a penny on R&D if it’s done growing.

 

The stock could also pay less in taxes, trade at a higher EBITDA multiple in 2037, etc. These are all possible.

 

But they’re speculative. The only potentially non-speculative argument here is that Amazon is expensing items which are actually profits that are being re-invested in future growth. So, for example, what if all of the company’s R&D was treated more like growth cap-ex on the cash flow statement.

 

If you count all of the company’s cap-ex and all of the company’s research and development as being purely for the purpose of further growth – none of it is needed to maintain the current sales level – you can get to a price on the company today that is about 15 times this adjusted free cash flow figure. That’s a leveraged number. But, the number including debt wouldn’t be much higher.

 

So, the stock could actually be trading at about 15 times (heavily adjusted) owner earnings right now?

 

There’s a problem with that assumption. The company is spending on research and development. So, it has to grow at the sorts of rates I laid out to justify the investment in R&D for as long as it keeps making those investments. As long as you are spending $15 billion a year on cap-ex and $21 billion a year on R&D, you have to grow sales by $36 billion a year.

Let me explain why this is.

 

For an “investment” in R&D or cap-ex to be worth as much as profit you have in cash today, you would need to get something like a 10% after-tax return on that money. Otherwise, shareholders would be better off receiving a dividend and finding another stock that can return 10% a year. Even if you add back Amazon’s R&D expense, you still only get an adjusted operating margin of about 15% which works out to about 10% after-tax. For Amazon to grow its earnings – before R&D expense – by about $3.6 billion a year, it needs to grow sales by about $36 billion a year. That’s because $36 billion of added sales creates $3.6 billion of added profit (before any R&D expense but after taxes), which is about 10% of the $36 billion Amazon is investing in cap-ex and R&D right now. The company has $161 billion in revenue right now. So, adding $36 billion to that would be an increase of about 22%.

 

Once again, we come to about the same conclusion. To guarantee a 10%+ return in the stock, Amazon has to grow at about 20% a year.

 

Of course, that’s only if the company keeps investing in R&D and capital spending. It could stop investing in those things and slow its growth considerably and generate similar returns for shareholders. But, it either has to reduce investment in R&D and cap-ex and grow slower or grow at 20% a year or so and keep investing. It can’t keep investing and grow slower while delivering adequate returns for shareholders. That’s the one combination it’s not allowed.

 

Let’s compare this to the example I gave of an investment: Omnicom (OMC) at $68 a share. Right now, the stock has a P/E of 13, a 3.25% dividend yield, and a 2.25% annual rate of reduction in shares outstanding. A P/E of 13 is a smidge below the long-term historical average of around 15 for U.S. stocks. A 3.25% dividend yield and a 2.25% share buyback rate combined give you a 5.5% annual return if the company itself neither grows nor shrinks and the P/E multiple neither expands nor contracts. If you consider a 10% annual return adequate, the math works out as follows: 10% - 5.5% = 4.5%. The stock can deliver a 10% annual return if the company itself grows at 4.5% a year. The economy is likely to grow – in nominal terms – at something like 4% to 5% a year. So, if Omnicom as a company grows at the same rate as the economy and the stock becomes neither more or less expensive over time – investors who buy the stock today should expect a 10% annual return for as long as they hold it.

 

This is why I call Omnicom an investment. The most common-sense way of looking at the company based on the present situation and the past record suggests the stock will return about 10% a year.

 

The Amazon case is trickier. It assumes that large amounts of money spent on research and development and cap-ex will continually generate after-tax returns in excess of 10% a year. That’s a speculation. Is it a good speculation?

 

Up to a point, I think it is. I don’t think it’s an unreasonable speculation to say that Amazon can commit $20 to $40 billion a year on projects that will generate 10%+ after-tax rates of return in 2018 or 2019.

 

The problem is the 18 years after that. I don’t know of any historical examples of R&D on that scale that have generated adequate returns for the company doing them. At the rate Amazon is going, it would be spending $50 billion a year on R&D in 5 years and $120 billion a year on R&D in 10 years. Or…

 

Or, it would stop.

 

And here is the other part of the speculation: Jeff Bezos.

 

You could speculate that management is focused on return on capital rather than just growth. Amazon spends on growth now because it gets good returns on capital by doing so. But, it’ll stop spending in the future when it stops getting good returns on that spending.

 

I wouldn’t bet against that kind of management-based speculation. I wouldn’t bet against Amazon either as a company or even as a stock (and even at this price level).

 

But, I would call Amazon a speculation. Amazon can be a good enough speculation and Omnicom can be a bad enough investment that Amazon outperforms Omnicom. But, that doesn’t mean in hindsight that Amazon was an investment.

 

Let me return to the email I started this all with:

 

“…but maybe it's not so easy to distinguish between investment and speculation in some cases because there are factors that we cannot foresee or do not yet understand….”

 

If we cannot foresee or do not yet understand factors, those are speculative factors. They’re important factors to consider if you’re speculating. And I’m not saying people shouldn’t speculate. If you think you have really sound reasons for believing the world will be different in the future than it is now – you can make such a speculation.

 

For example, several years ago – when Brent was at about $110 a barrel – I was interested in researching companies that used fuel as a commodity input but were otherwise pretty stable, understandable businesses. I looked at oil prices and couldn’t come up with good reasons for why oil should be at $110 a barrel instead of $70 or less per barrel. So, there was a speculation here on my part that might uncover a potential investment.

 

Likewise, there is a speculative element any time you are considering an investment with a “catalyst”. So, when I was researching Barnes & Noble (BKS) in 2010, the investment case was the high free cash flow from the stores versus the low market cap of the company. The speculative element was the proxy battle between Ron Burkle and Len Riggio that might serve as a catalyst which would re-direct the free cash flow to uses that I favored. I was wrong on that speculation. Riggio stayed in control of the company. And Barnes & Noble directed the free cash flow from the stores into the Nook. I sold out once I saw the profit from the stores would not come in the form of cash but rather would come in the form of R&D and start-up losses on the Nook. I could evaluate what cash was worth. I couldn’t evaluate what the Nook was worth.

 

And then there is the point about investments turning into speculations:

 

If you know that a business could potentially come under hard times and the modest amount of debt it has could compound the problem, then a company with a very modest valuation may morph into a speculative stock at even 1/10th the original price a few years down the road.”

 

This is the “fallen angel” concept. And it relates to Graham’s talk on “The New Speculation in Common Stocks”. There have always been high yield bonds. But, during Ben Graham’s career high yield bonds were “fallen angels”. The bonds had good credit ratings at one time, adequate interest coverage, and could be considered “investments”. But then the enterprises who issued these bonds fell on hard times and the bonds fell in price. In hindsight, the bonds were bad investments when initially issued but could often be good speculations when bought when the company was distressed and the bonds sold at pennies, dimes, or quarters on the dollar. Later, after Ben Graham retired from investing, bonds began to be issued as high yields from the start. This was speculative grade stuff. Not because the company issuing the bonds was distressed, but because the amount of debt issued made the situation speculative. Bond investors were willing to speculate as long as the potential returns were greater (the yield was higher).

 

The potential upside in Amazon stock is much, much greater than the potential upside in Omnicom stock. But, the likelihood of an adequate return in Omnicom stock is higher than the likelihood of an adequate return in Amazon stock. This is not because Omnicom is a safer business than Amazon. It’s because Omnicom is trading at a much lower price relative to actual free cash flow – cash that will (this year) be used to buy back stock and pay dividends – than the price Amazon trades at.

 

Amazon may be reasonably priced versus some form of adjusted earnings. But consider the form these adjusted earnings come in. They are R&D and capital spending. The certainty that $1 of money spent on additional R&D and capital spending is worth at least $1 in market value is much less than the certainty

that $1 of cash spent on buybacks and dividends is worth at least $1 in market value.

 

Graham speculated.

 

He bought – as a group operation – into a variety of arbitrage situations and other “workouts”. Some of the workouts were investments in inherently cheap businesses. But, some weren’t. Sometimes he was buying into a stock purely on the odds that an acquirer would successfully close the deal at the announced price. That’s speculation. It’s smart speculation with a calculable “edge”. But it’s still speculation.

 

Warren Buffett has speculated too. In his 1988 Letter to Berkshire Hathaway Shareholders he described his arbitrage operation in Arcata:

 

Arcata Corp., one of our more serendipitous arbitrage experiences, illustrates the twists and turns of the business. On September 28, 1981 the directors of Arcata agreed in principle to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR), then and now a major leveraged-buy out firm.  Arcata was in the

printing and forest products businesses and had one other thing going for it: In 1978 the U.S. Government had taken title to 10,700 acres of Arcata timber, primarily old-growth redwood, to

expand Redwood National Park.  The government had paid $97.9 million, in several installments, for this acreage, a sum Arcata was contesting as grossly inadequate.  The parties also disputed the interest rate that should apply to the period between the taking of the property and final payment for it.  The enabling legislation stipulated 6% simple interest; Arcata argued for a much higher and compounded rate.

 

Buying a company with a highly-speculative, large-sized claim in litigation creates a negotiating problem, whether the claim is on behalf of or against the company.  To solve this problem, KKR offered $37.00 per Arcata share plus two-thirds of any additional amounts paid by the government for the redwood lands.

 

Appraising this arbitrage opportunity, we had to ask ourselves whether KKR would consummate the transaction since, among other things, its offer was contingent upon its obtaining “satisfactory financing.” A clause of this kind is always dangerous for the seller: It offers an easy exit for a suitor whose ardor fades between proposal and marriage.  However, we were not particularly worried about this possibility because KKR’s past record for closing had been good.

 

We also had to ask ourselves what would happen if the KKR deal did fall through, and here we also felt reasonably comfortable: Arcata’s management and directors had been shopping the company for some time and were clearly determined to sell. If KKR went away, Arcata would likely find another buyer, though of course, the price might be lower.

 

Finally, we had to ask ourselves what the redwood claim might be worth.  Your Chairman, who can’t tell an elm from an oak, had no trouble with that one: He coolly evaluated the claim at somewhere between zero and a whole lot.

 

We started buying Arcata stock, then around $33.50, on September 30 and in eight weeks purchased about 400,000 shares, or 5% of the company.  The initial announcement said that the $37.00 would be paid in January, 1982.  Therefore, if everything had gone perfectly, we would have achieved an annual rate of return of about 40% - not counting the redwood claim, which would have been frosting…”

 

I have also made speculations. Years ago, there was a case in which a state government took land belonging to a publicly traded company. The issue went to trial. And I started following the story. At that point: it was possible to figure out what other pieces of land in the same area sold for per acre, it was possible to see what compensation the company was seeking for the land, etc. But, I didn’t have faith in my ability to predict an outcome at trial. It was just too hard to tell if the company had a 45% chance of winning or a 95% chance of winning. Once the company won the trial, the stock jumped a great deal. But, it didn’t jump to anywhere near the actual level of cash the company would eventually be awarded once the state had exhausted its appeals. At that point – although the potential upside was now much lower – it was possible to see the company’s chance of winning the appeal was much closer to 95% than 45%. So, I was now ready to buy the stock.

 

That purchase was a speculation – not an investment. It was purely based on my belief that I could more correctly judge the odds of a decision being upheld on appeal than other investors could. I think it was a sound speculation. I read the decision, I talked to lawyers, I looked for examples of similar decisions being overturned on appeal, etc.

 

This was not gambling. But, it was speculating.

 

To understand the difference, we have to think about: subjectivity and edge.

 

If I play a hand of blackjack at a casino, I am gambling because I’m certain the house has an edge. It’s a small edge – but it’s against me. As long as I knowingly put money down in which I know the edge is against me – not with me – I’m gambling, not speculating.

 

Speculating is when I believe I have an edge. However, I believe that edge has to do with a future event. When Buffett thought the redwood claim could be worth somewhere between “zero and a whole lot” he thought he had an edge about a future event: a court decision. Likewise, when I bought stock – after the trial but before the appeal – in the company that had land seized, I thought I had an edge about a future event: the appellate court decision. If I had believed that Ron Burkle would win the proxy fight with Len Riggio at Barnes & Noble, I would have been betting on an edge I thought I had in predicting a proxy election. If I had invested in a company that was now trading at 20 times earnings when oil was at $110 a barrel but would be trading at 10 times earnings when oil was at $65 a barrel, I’d be betting on an edge I thought I had in predicting a future event: at some point oil prices would fall.

 

Subjectivity means that – in judging whether an action would be a gamble, a speculation, or an investment – I am not omniscient. I am limited by my lack of knowledge of future events. I am limited by only being able to consider information that is accessible to me at the time.

 

It may be that Amazon is – today – an investment from God’s perspective. However, it’s still a speculation from my perspective. An investment is an action that I (the subject) take. We can’t consider whether something is gambling, speculating, or investing apart from when I’m making the decision and what I’m capable of knowing. In hindsight, it may be that I will know things about Amazon that weren’t possible for me to know now but which – had I known them now – would have made me realize Amazon was an investment rather than a speculation. Those things don’t count. If they did, we’d simply call all decisions that were right in hindsight “investments” and all decisions that were wrong in hindsight “speculations”. By this logic, hitting on 17 could be an “investment” if we later learned the next card was a 4.

 

You can judge whether something is an investment or a speculation by keeping those two concepts in mind: edge and subjectivity.

 

What do I (the subject) believe my edge comes from? Do I have a positive edge? If I have a positive edge: I’m not gambling. If my edge comes from predicting a future event: I’m not investing. I’m speculating.

 

Now, some people reading this will be saying “wait: isn’t every stock purchase a speculation? Aren’t you always betting on future events?”

 

The outcome always depends on future events. However, saying that the outcome depends on the future is very different from saying your edge in an investment comes from a future event.

 

There’s a simple way to think of this: “invert”. Flip your analysis. Don’t ask: what has to happen for this investment to work out for me? Ask: what has to happen for this investment not to work out for me?

 

Are the risks “investment” risks or “speculative” risks?

 

The risks in Omnicom at today’s price are all speculative. For you to be wrong, we have to speculate that Omnicom will grow slower than the overall economy.

 

The risks in Amazon at today’s price are all investment risks. For you to be wrong buying Amazon, you simply have to be wrong about the long-term return on the company’s spending on R&D and cap-ex. If Amazon was to grow at the same rate as the overall economy, you’d lose a lot of money. If Amazon was to get the same returns on its R&D and cap-ex as other companies do, you’d also lose money.

 

Now, you could say this is the wrong way of looking at it. All Amazon needs to do is to continue its present trend.

 

This is usually the argument made for why speculative stocks are really investments. If they continue at the current rate of growth, they will justify today’s prices. If they continue generating the same returns on capital, they will justify today’s prices. It’s possible for returns on capital to be persistently high. It’s also possible for growth rates to be persistently high (though only for a time). But, it’s very hard to maintain high returns on capital at high rates of growth for long periods of time.

 

No high growth trend can continue indefinitely.

 

Assumptions about stocks maintaining a certain dividend level, stock buyback rate, and growth in line with the economy can, in fact, continue indefinitely. There’s nothing about those assumptions that isn’t infinitely repeatable.

 

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In 2017: What is the Line Between Investment and Speculation?

by Geoff Gannon


In a recent post, Richard Beddard mentions Ben Graham’s speech “The New Speculation in Common Stocks” and particularly how it ends with a quote from the Roman poet Ovid:

“You will go safest in the middle course.”

At the end of that talk, Graham adds: “I think this principle holds good for investors and their security-analyst advisors.”

What Graham is saying is that investors should avoid both stocks that are speculative because the underlying enterprise is speculative and stocks that are speculative because the price is speculative.

I agree with Graham on this one. And I think it helps clear up some confusion that readers have with my own approach to investing. I get a lot of questions from investors – each coming from one of the two opposing philosophical camps – that go something like this: “When I look at the stocks you own, I wonder are you really 100% a value investor?” That’s the question from the Ben Graham value camp. And then the other question goes something like: “When I look at the stocks you own, I wonder are you really 100% a wide moat investor?”

My answer to these questions tends to go something like this:

If you look back at all the stocks I’ve bought, how many times in my life have I ever really paid more than about a P/E of 15?

And, if you look back at all the stocks I’ve bought, how many times in my life have I ever really bought into a company with a weak competitive position?

Those – to me – are the two speculations the average investor slides right into without much thought.

1.       He speculates that this business he likes is not just better than other businesses but better enough to more than offset paying a higher than average price for the stock (that is, a P/E over 15).

2.       And he speculates that this business he likes will withstand the ravages of competition that are an ever-present part of capitalism.

Now, there are other kinds of speculations you can make. Readers are quick to point out that I own NACCO (NC) which is basically a speculation that no more than one of the coal power plants the company supplies will be shut down in the truly near-term future. I also own BWX Technologies (BWXT) which is a speculation that the U.S. Navy will continue to use aircraft carriers, ballistic missile submarines, and attack submarines – and that those 3 classes will be nuclear powered. I own Frost (CFR) which is a speculation on higher interest rates in the sense that if the Fed Funds Rate was never to rise from the level it is at today, my returns in Frost would be middling.

But when you stretch the word “speculation” that far, you demolish any distinction between investment and speculation in the way Graham used those words. The future is always uncertain. But, we have to be able to define the words “investment” and “speculation” in such a way that we can all agree lottery tickets are speculations and savings bonds are investments; that stock options are speculations and investment grade corporate bonds are investments.

How would we apply this distinction between investment and speculation to stocks today?

Well, we would say that Tesla (TSLA) and Twitter (TWTR) are speculations, because the enterprises themselves are speculative (they have yet to make money). These stocks would be speculative at any price. It is – as yet – impossible to make an “investment” in them.

And we would also say that Amazon (AMZN) and Netflix (NFLX) are speculations. The enterprises themselves aren’t speculative. They are proven money makers. But, the prices investors now put on these stocks make them speculative. There is no measure – P/E, P/B, EV/EBITDA, etc. – by which either Amazon or Netflix are within spitting distance of an average price. So, a buyer of either Amazon or Netflix stock is not just betting that these businesses are above average. He is betting that they are better enough to offset paying a higher than average price for the stock.

What then is an investment?

I would say Omnicom (OMC) at $67 a share is an investment. The competitive position is not speculative. And the stock’s price – at 13 times earnings – is not speculative. So, it is an investment. I would also say The Cheesecake Factory (CAKE) at $44 a share is an investment. The competitive position is not speculative. And the stock’s price – at 16 times earnings – is not speculative.

What wouldn’t I say?

I wouldn’t say that Omnicom and the Cheesecake Factory at $67 and $44 a share respectively are better stocks than Amazon and Twitter at $1,120 and $19 respectively. Amazon and Twitter may be good speculations. And Omnicom and Cheesecake Factory may be bad investments. Reasonable people can disagree about that. The future is always uncertain. But that does not mean the line between investment and speculation is invisible.

Amazon and Twitter are speculations. Omnicom and Cheesecake Factory are investments.

There is a real danger some of us will forget that. Amazon’s future may be brighter than Omnicom’s. But, when we make a statement like that – we are comparing two entirely different classes of financial assets. Amazon’s future needs to be many, many times brighter than Omnicom’s to preserve even a fraction of the capital you put into it today. Just because society has several hundred billion dollars riding on a certain stock doesn’t make that stock any less of a speculation.

Is it wrong to speculate?

Should you ever speculate?

My own investment process is based on finding investments not speculations. So, my answer would be that you should train yourself to distinguish between good and bad investments and ignore speculations all together.

Having said that, I wrote about Hostess Brands warrants (TWNKW). At today’s price of $2.66 for a pair of warrants (owning a pair of warrants gives you the right to buy one share of TWNK common stock at $11.50 in late 2021), I think they might be a good speculation.

They aren’t an investment.

And I think it’s important to remember that. No matter how good a speculation those warrants are – a Hostess Brands warrant at $1.33 is a speculation and Omnicom stock at $67 is an investment. The Hostess warrants can outperform the Omnicom stock. But that should never fool us into thinking a speculation has become an investment.

Words have meaning.

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Buy Unrecognized Wonder; Sell Recognized Wonder

by Geoff Gannon


It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

-          Warren Buffett

Richard Beddard has an excellent post worrying about whether the stocks in his Share Sleuth portfolio are becoming too popular.

I want to use his post as an opportunity to talk about how an investor – or, at least an investor like me – needs to cycle out of stocks that are getting recognized for what I believe them to be and into stocks that aren’t getting recognized for what I believe them to be.

I like “wide moat”, predictable businesses. But, I can’t afford to pay the kind of prices that stocks with recognized moats and recognized predictability trade for. So, I need to find unrecognized moats and unrecognized predictability.  

The top three stocks I own are: NACCO (NC), Frost (CFR), and BWX Technologies (BWXT). The best performer among that group is BWX Technologies. That good performance is the result of increased recognition of what BWX Technologies is. When I bought Babcock & Wilcox pre-spinoff (and then later sold my BW shares but kept my BWXT shares) I was seeing the company differently than the market was. Today, the market sees BWXT the same way I do.

Let’s look at this in chart form.

Today, the market values BWX Technologies about 120% higher than it valued the combined Babcock & Wilcox. The stock you are seeing here spun something off (so it disposed of value) and yet it still more than doubled its market price.

The stock now has a P/E of 32. The return here is due to multiple expansion. BWX Technologies – as part of Babcock & Wilcox – went from being valued as an average company (a P/E around 15) to being valued as a wide-moat, predictable company (a P/E around 30). BWXT’s biggest business is being a monopoly provider to the U.S. government under cost plus contracts indexed to inflation. That’s not new information. The market just sees the same old information differently now that BWXT is reporting its own clean, independent EPS and giving long-term guidance for EPS growth as far as 3-5 years out.

The price on this stock (a P/E of 30+) indicates the market sees this business much the way I see this business. If we have the same understanding of the business – it’s time for me to consider selling.

Now, I don’t sell a stock just to have cash. But, if I want to buy anything new – I should buy something that’s a wide-moat, predictable business that has yet be recognized for being that and fund the purchase by selling BWXT which is also a wide-moat, predictable business but is now recognized as such.

The next chart is Frost. You can read an explanation of how I see the stock here.

The stock has about doubled. Here, though, it is not appropriate to use the P/E ratio for Frost (because earnings rise faster than deposits as interest rates rise). The better way to value Frost is price-to-deposits. So, that’s share price divided by deposits per share. For Frost we use “earning assets” – which are loans, bonds, and money left at the Federal Reserve – as a proxy for deposit funded assets. At Frost, these assets are about 93% funded by deposits (the rest is funded by shareholder equity). When I bought Frost, it had about $25.91 billion in earning assets and 63.18 million shares outstanding. So, it had $410 a share in earning assets. I bought at a price just under $50 a share. So, I paid 0.12 times earning assets ($50 / $410 = 0.12). Today, the bank has $28.34 billion in earning assets and 63.16 million shares outstanding. So, it has $449 in earning assets per share. The stock price is just under $98 a share. So, the market now values Frost at 0.22 times its earning assets ($98 / $449 = 0.22).

Again, the rise in the stock price is due to multiple expansion. Frost’s stock price is now 96% higher than when I bought it. However, the amount of earning assets per share is just 10% higher. Where did the other 86% increase in market value come from? The market now values Frost at 0.22 times its earning assets instead of 0.12 times its earning assets.

So, has the market fully recognized what I saw in Frost about two years ago?

Not fully, no. In the report I wrote on Frost, I said that a valuation of 0.35 times earning assets (not 0.22 times like today) would be appropriate for Frost in “a normal interest rate environment”.

That phrase is key. Frost trades at a P/E of 19. So, it is fully recognized as a good bank given today’s interest rates. However, I believe a “normal” Fed Funds rate is about 3 times today’s Fed Funds Rate. I see a 3% to 4% Fed Funds Rate as normal. The market does not. So, the market doesn’t yet see Frost quite the same way I see Frost.

Since the market doesn’t fully recognize everything I see in Frost – the way it does with BWXT – I should cling harder to my Frost shares than I would to my BWXT shares.

What would cause me to sell Frost?

Well, we have a good example of that. About a month ago, I got the chance to buy NACCO at $32.50 a share. I sold one-third of my Frost shares to help fund that new position.

What does this mean?

It means I think I see something in NACCO that is not as recognized by the market as what I see in Frost.

Do I like NACCO better than Frost?

That’s not the right way to ask the question. The market operates on a handicapping system. Everyone thinks Netflix has a brighter future than Viacom – they “like” Netflix better as a business. But, Netflix stock is saddled with an incredibly high price (its enterprise value is more than 8.2 times sales) while Viacom isn’t carrying much weight at all (its enterprise value is 1.5 times sales). The question is whether Netflix can outrun Viacom when Netflix is carrying more than 5 times as much weight.

So, what’s the right question to ask?

You can ask – at the same price – would I prefer BWXT over Frost and Frost over NACCO?

Probably.

But they’re not at the same price.

NACCO is my biggest position, Frost is my second biggest position, and BWX Technologies is my third biggest position – because I think the market recognizes all of what I like about BWXT but only recognizes some of what I like about Frost and doesn’t recognize any of what I like about NACCO.

It’s a great goal to own the best businesses you can. But, you can’t afford to pay the price everyone else pays for wonderful businesses and still hope to do better than everyone else.

Don’t just look for wonderful businesses. Instead, look for businesses where you see something wonderful about them that the market doesn’t yet recognize.

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My New 50% Stock Position is NACCO (NC)

by Geoff Gannon


Someone on Twitter mentioned it’s been 32 days since I put 50% of my portfolio into a new stock and said: “I’ll reveal the name of this new position on the blog sometime within the next 30 days”. Since, I promised 30 days this time, I’ll reveal the name now. In the future, I think I’m going to wait a full quarter (3 months) between the time I mention a stock on my member site (Focused Compounding) and on the blog. I want to be open with blog readers. But, I also want the people who provide me financial support through their monthly subscriptions to get real value for their money. The only reason I can afford to spend time writing content on this blog for free is because there are subscribers on the member site. So, the member site will always hear about my new stock ideas first.

Anyway….

On the morning of October 2nd, I put 50% of my portfolio into NACCO (NC) at an average cost of $32.50. That was the first day the North American Coal Company was trading separately from Hamilton Beach Brands (HBB).

NACCO operates unconsolidated (their debt is non-recourse to NACCO) surface coal mines that supply “mine-mouth” coal power plants under long-term cost-plus contracts that are indexed to inflation.

You can learn more about NACCO by reading:

The company’s investor presentation

Clark Street Value’s post on NACCO

NACCO’s first earnings report as a standalone company

You can also listen to the company’s earnings call here

Finally, you can buy a book that provides a complete corporate history of NACCO from 1913 through 2013. The title is “Getting the Coal Out”. The author is Diana Tittle. It’s available used at places like Amazon.  You may also be able to order it from the company. I’m not sure about that.

Yes, I do own a copy.

My NACCO position was posted immediately on the member site. I’ve written several articles about it there over the last month, mostly in response to questions from Focused Compounding members.

So, as of October 2nd, my portfolio was:

NACCO (NC): 50%

Frost (CFR): 28%

BWX Technologies (BWXT): 14%

Natoco: 7%

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The Best Investing Books for a Budding Value Investor to Read

by Geoff Gannon


Value and Opportunity just reviewed a book “100 Baggers” that I’ve read (and didn’t particularly like) which is basically an update of another book I own called “100 to 1 In the Stock Market” (which is outdated, not available on Kindle, but I probably like better). The fact that I’ve read both these books reminded me that I actually do read a lot of investing books and yet I don’t write much about books on this blog.

There’s a reason for that.

I get a lot of questions about what investing books people should read. My advice to most is to stop reading books and start doing the practical work of slogging your way through 10-Ks, annual reports, etc. There seems to be a tremendous appetite for passive reading among those who email me and no appetite for active research. It’s better to read a 10-K a day than an investing book a day.

But, there are good investing books out there. And, yes, I read a lot of books. Still, I’m going to give you a simple test to apply to yourself: if you’re reading more investing books than 10-Ks, you’re doing something wrong.

Assume you’re reading your fair share of 10-Ks. Then you can read some investing books on the side. Which should you read?

Practical ones.

 

How to Read a Book

A book is only as good as what you get out of it. And there’s no rule that says you have to get out of a book what the author intended. The best investing books give you plenty of case studies, examples, histories, and above all else – names of public companies. While you read a book, highlight company names, names of other investors, and the dates of any case studies. You can look into these more on your own later. Also, always read the “works cited” or “bibliography” at the back of any book you read. This will give you a list of related books you can read next. Since I was a teen, I’ve always read the works cited or bibliography to come up with a list of related titles. And I’ve realized talking to other people as an adult, that most people ignore those pages. They’re very useful. Read them.

 

 

My Personal Favorite: “You Can Be a Stock Market Genius”

If you follow my Twitter, you know I re-tweeted a picture of ”You Can Be a Stock Market Genius” that my website co-founder, Andrew Kuhn, posted. It’s one of his favorite books. And it’s my favorite. If you’re only going to read one book on investing – read “You Can Be a Stock Market Genius”. The subject is special situations. So, spin-offs, stub stocks, rights offering, companies coming out of bankruptcy, merger arbitrage (as a warning), warrants, corporate restructurings, etc. The real appeal of this book is the case studies. It’s a book that tells you to look where others aren’t looking and to do your own work. It’s maybe the most practical book on investing I’ve ever read.

 

My Partial Favorite: “The Snowball” – The 1950 through 1970 Chapters

I said “You Can Be a Stock Market Genius” was my favorite book. If we’re counting books in their entirety, that’s true. I like “You Can Be a Stock Market Genius” better than the Warren Buffet biography “The Snowball”. However, I might actually like some chapters of “The Snowball” more than any other investing book out there. The key period is from the time Warren Buffett reads “The Intelligent Investor” till the time he closes down his partnership. So, this period covers Buffett’s time in Ben Graham’s class at Columbia, his time investing his personal money while a stockbroker in Omaha, his time working as an analyst at Graham-Newman, and then his time running the Buffett Partnership. These chapters give you more detailed insights into the actual process through which he researched companies, tracked down shares, etc. than you normally find in case studies. That’s because this is a biography. The whole book is good. But, I’d say if you had to choose: just re-read these chapters 5 times instead of reading the whole book once. Following Buffett’s behavior from the time he read The Intelligent Investor till the time he took over Berkshire Hathaway is an amazing education for an individual investor to have.

 

Often Overlooked: John Neff on Investing

I’m going to mention this book because it’s a solid example of the kind of investing book people should be reading. And yet, I don’t see it mentioned as much as other books. John Neff ran a mutual fund for over 3 decades and outperformed the market by over 3 percent a year. That’s a good record. And this book is mostly an investment diary of sorts. You’re given the names of companies he bought, the year he bought them, the price he bought them at (and the P/E, because Neff was a low P/E investor), and then when he sold and for what gain. This kind of book can be tedious to some. But, it’s the kind of book that offers variable returns for its readers. Passive readers will get next to nothing out of it. But, active readers who are really thinking about what each situation looked like, what they might have done in that situation, what the market might have been thinking valuing a stock like that, what analogs they can see between that stock then and some stock today, etc. can get a ton out of a book like this. Remember: highlight the names of companies, the years Neff bought and sold them, and the P/E or price he bought and sold at. You can find stock charts at Google Finance that go back to the 1980s. You can find Wikipedia pages on these companies and their histories. A book like this can be a launching point into market history.

 

A More Modern Example: Investing Against the Tide (Anthony Bolton)

There are fewer examples in Bolton’s book than in Neff’s book. But, when I read Bolton’s book, it reminded me of Neff’s. A lot of Neff’s examples are a little older. Younger value investors will read some of the P/E ratios and dividend yields Neff gives in his 1970s and 1980s examples and say “Not fair. I’ll never get a chance to buy bargains like that.” As an example, Neff had a chance to buy TV networks and ad agencies at a P/E of 5, 6, or 7 more than once. They were probably somewhat better businesses 30-40 years ago and yet their P/Es are a lot higher today than they were back then. Bolton’s book is more recent. You get more talk of the 1990s and early 2000s in it. So, it might be more palatable than Neff’s book. But, this is another example of the kind of book I recommend.

 

Best Title: There’s Always Something to Do (Peter Cundill)

This is one of two books about Peter Cundill that are based on the journals he wrote during his life. The other book is “Routines and Orgies”. That book is about Cundill’s personal life much more so than his investing life. This book (“There’s Always Something to Do”) is the one that will appeal to value investors. It’s literally an investment diary in sections, because the author quotes Cundill’s journal directly where possible. Neff was an earnings based investor (low P/E). Cundill was an assets based investor (low P/B). He was also very international in his approach. This is one of my favorites. But, again, it’s a book you should read actively. When you come across the name of a public company, another investor, etc. note that in some way and look into the ones that interest you. Use each book you read as a node in a web that you can spin out from along different strands to different books, case studies, famous investors, periods of market history, etc.

 

You’re Never Too Advanced for Peter Lynch: One Up On Wall Street and Beating the Street

Peter Lynch had a great track record as a fund manager. And he worked harder than just about anyone else. He also retired sooner. Those two facts might be related. But if the two themes I keep harping on are finding stocks other people aren’t looking at and doing your own work – how can I not recommend Peter Lynch. He’s all about turning over more rocks than the other guy. And he’s all about visiting the companies, calling people up on the phone, hoping for a scoop Wall Street doesn’t have yet. The odd thing about Peter Lynch’s books is that most people I talk to think these books are too basic for their needs. Whenever I re-read Lynch’s books, I’m surprised at how much practical advice is in there for even really advanced stock pickers. These are not personal finance books. These are books written by a stock picker for other stock pickers. The categories he breaks investment opportunities into, the little earnings vs. price graphs he uses, and the stories he tells are all practical, useful stuff that isn’t below anyone’s expertise levels. These books try to be simple and accessible. They aren’t academic in the way something like “Value Investing from Graham to Buffett and Beyond” is. But, even for the most advanced investor, I would definitely recommend Peter Lynch’s books over Bruce Greenwald’s books.

 

An Investing Book That’s Not an Investing Book: Hidden Champions of the 21st Century

I’m going to recommend this book for the simple reason that the two sort of categories I’ve read about in books that have actually helped me as an investor are “special situations” (from “You Can Be a Stock Market Genius”) and “Hidden Champions” (from “Hidden Champions of the 21st Century”). It’s rare for a book to put a name to a category and then for me to find that category out there in my own investing and find it a useful tool for categorization. But, that’s true for hidden champions. There are tons of books that use great, big blue-chip stocks as their examples for “wonderful companies” of the kind Buffett likes. This book uses examples of “wonderful companies” you haven’t heard of. In the stock market, it’s the wonderful companies you haven’t heard of that make you money. Not because they’re better than the wonderful companies you have heard of. But, because they are sometimes available at a bargain price. As an example, Corticeira Amorim (Amorim Cork) was available at 1.50 Euros just 5 years ago (in 2012). That was 3 years after this second edition of the book was published. Amorim is now at 11.50 Euros. So, it’s a “seven-bagger” in 5 years. More importantly, if you go back to look at Amorim’s price about 5 years ago versus things like earnings, book value, dividend yield, etc. – it was truly cheap. And yet it was a global leader in cork wine stoppers. Amorim is not as great a business as Coca-Cola. It doesn’t earn amazing returns on equity. But, it’s a decent enough business with a strong competitive position. And it was being valued like a buggy whip business. That’s why learning about “hidden champions” and thinking in terms of “hidden champions” can be so useful. There are stocks out there that are leaders in their little niches and yet sometimes get priced like laggards. As an investor, those are the kinds of companies you want to have listed on a yellow pad on your desk.

 

The Canon: Security Analysis (1940) and The Intelligent Investor (1949)

Do you have to read Ben Graham’s books? No. If you’re reading this blog, visiting value investing forums, etc. you’re sick and tired of hearing about Mr. Market and margin of safety. Those concepts were original and useful when Ben Graham coined them. I’ve read all the editions of these books. People always ask me my favorite. So, for the record: I like the 1940 edition of Security Analysis best and the 1949 edition of The Intelligent Investor. I recommend reading Graham’s other work as well. Fewer people have read “The Interpretation of Financial Statements” and collections of Graham’s journal articles that can be found in titles like “Benjamin Graham on Investing: Enduring Lessons from the Father of Value Investing”. Don’t read any books about Ben Graham but not written by him. Instead look for any collections of his writing on any topics you can find. He was a very good teacher. I especially like his side-by-side comparative technique of presenting one stock not in isolation but compared to another stock which is either a peer, a stock trading at the same price, or even something taken simply because it is alphabetically next in line. It’s a beautiful way of teaching about “Mr. Market’s” moods.

 

Out of Print: Ben Graham’s Memoirs, “Distant Force” (A Book About Teledyne), and 100 to 1

I own all these books and like all these books. Do I recommend them? Not really. You have to buy them in print. The price on some of them (even heavily used) is not cheap. And they aren’t as good as the books I’ve mentioned above which you can get cheaper (and on your Kindle).

Still, if you don’t own these books, you’re probably wondering: what am I missing?

Well…

You can replace 100 to 1 with “100 Baggers”. That’s probably why “100 Baggers” was published in the first place.

Ben Graham’s memoirs include only a few discussions of investing limited to a couple chapters. I found them interesting, especially when I combined the information Graham gives in his memoirs with historical newspaper articles I dug up. Some of the main stories he tells relate to operations he did in: 1) the Missouri, Kansas, and Texas railroad, 2) Guggenheim Exploration, 3) DuPont / General Motors, and 4) Northern Pipeline. The Northern Pipeline story has been told elsewhere. In some cases, I’ve seen borderline plagiarizing of Graham’s account in his memoirs. But, if you’ve ever read a detailed description of Graham’s proxy battle at Northern Pipeline, it was probably lifted from this book.

What about “Distant Force”? Some people find this book extraordinarily boring. I found it interesting more as a “source” for putting together a picture of how Teledyne worked rather than just a book to be read in isolation. There are old business magazine articles you can find on Teledyne and there’s a chapter length description of Teledyne in “The Outsiders”.

Although I’m not going to recommend you dig up expensive, out of print, used, and often boring books – I am going to warn you about the “copy of a copy of a copy” syndrome. A lot of value investors will cite something about habits, or checklists, or Ben Graham, or Teledyne that is from a more popular / more recent book. That book is “popularizing” a primary (or in some cases actually a secondary) source. Like popular science, the author is making certain tweaks to the presentation of the idea to better fit the concept their book is about and to simplify the ideas they present. Some authors do this in a way that shows they probably understand the original material really well but are just presenting it simplified for your benefit. Other authors give some hints that they may not really understand the primary source that well. Something like “The Snowball” simplifies certain ideas because it’s not an investing book. It’s a biography. However, the simplification in that book is done really well. Sure, I’d love to have more detail. Alice Schroeder gave a talk about Mid-Continent Tab Card Company that would’ve been a great addition to the book. But, I’m not worried that Alice Schroeder is really garbling what she’s reporting even when she’s presenting it for a general audience whose main interest might not even be value investing.

I’m not going to name names. But, there are value investing books out there that aren’t as good. Wherever possible, try to read the primary sources.

If you find a book with good concepts in it, but find the detail lacking – read through the works cited for the sources that book is using.

And if you really want to know what Ben Graham thought, read the 1940 edition of Security Analysis and the 1949 Edition of The Intelligent Investor. Don’t read a modern book that just has Ben Graham’s name in the title.

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A Note on Under Armour: Always Prefer UA to UAA

by Geoff Gannon


Under Armour (UA) stock dropped a lot in the last 24 hours. So, some value investors may be looking at it. If you do look at it, make sure you consider buying only the class “C” shares trading under the ticker “UA” instead of the class A shares trading under the ticker “UAA”. The “UA” and “UAA” shares are identical in all respects except that the UAA shares have 1 vote and the UA shares have no voting rights. As Under Armour is effectively a controlled company (the CEO and founder holds Class B shares with super voting rights that give him a 65% share of total votes), there should be almost no premium on the UAA (voting) shares over the UA (non-voting) shares. However, as I write this, the “UA” shares trade at a price 9% lower than the UAA shares.

So, when you think Under Armour always think of the ticker as “UA” and never “UAA”.

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Seeking Out Strange Stocks: How to Create a Value Investing Basket that MIGHT Get Decent Returns Even When the Market Falls

by Geoff Gannon


Someone emailed me this question:

“I know you are a stock only person.

But just for a minute I need your knowledge...I don’t look for 15% per year. I look for 6% a year for the next 5-7 years…on my money.

What would be the best/safest way to get it? Will a certain ETF, a dividend stock? SPY?  Japan ETF? India or Russia?”

I don't know of anything that can safely guarantee you anything like 6% a year. To give you some idea, even junk bonds now yield about 5.5%.

And I wouldn't call junk bonds safe. Their prices would fall as interest rates rose and the economy entered a recession. Both of these things will happen at some point. Will it be in the next 5-7 years? I don’t know. But, you can’t buy assets like that at today’s prices if you’re hoping to make 5-7% a year over the next 5-7 years even if the stock market does badly.

However, you can certainly find things that should return at least 5% to 7% a year over the next 5-7. It's just that:

 

1) Some of them will be specific stocks - not ETFs

2) Some of them may return a lot more than 5% to 7%

3) Some of them will lose money

4) It will take a lot of work on your part to find them

5) You will need to use a basket approach

6) Actually: I’m going to recommend a “basket of baskets” approach

 

I don't diversify widely. But, if you're looking to find something that will return 5% to 7% a year over the next 5-7 years, your best bet is to own a basket of very cheap (probably obscure) stocks. If these stocks are cheap, small, obscure, illiquid, etc. - it's less likely they will move with the overall market. Special situations (like spinoffs and other things mentioned in Joel Greenblatt's "You Can Be a Stock Market Genius") should also help get you closer to your goal of 5% to 7% annual returns over 5-7 years no matter what the market does.

The reason I’m starting off a discussion with “cheap, small, obscure, and illiquid stocks” is that I'm not at all confident I can find an entire stock market for you that will return 5% to 7% a year over 5-7 years given today's starting price. Although, in a moment we will discuss the possibility of putting 20% to 40% of your portfolio in things that are either directly or indirectly “funds” rather than specific stocks. More on that later.

But, first, let’s start with the specific stocks.

If you aren't doing a lot of intense stock picking that results in you only owning maybe 3-5 stocks at once (like me), you need a process for finding investments that is a more formulaic, “wide-net” approach.

A fund manager has to worry about putting large amounts of money to work. So, they lean in the direction of owning even more stocks than are really beneficial for "business risk" diversification purposes. You're an individual investor. So, you can just go with sort of the "optimal" amount of diversification in the sense of finding the point where adding additional stocks to your portfolio would have very little benefit in reducing volatility. That point is probably something like 20 to 30 stocks. The difference in volatility between a portfolio with 30 stocks and 100 stocks may be noticeable. The difference in volatility between a portfolio with 30 stocks and 50 stocks isn't.

So, no more than 30 positions for you.

And, we could do it with as few as 20.

For the sake of simplicity: I’m going to talk in terms of 5 baskets of 5 positions each. So, that’s a 25 stock portfolio.

I think your best bet would be to pursue a few sort of formulaic value strategies - "rule based" strategies - let's call them instead of using your judgment. So, what you'd do is go out and screen by hand to find the specific situations but those situations would each fit in one of maybe 5 strict bucket approaches.

So, I might suggest you set out to create a 25 stock portfolio with five buckets:

 

* 5 net-nets

* 5 spinoffs

* 5 closed-end funds/holding companies/etc. trading at a discount to NAV of their publicly traded holdings

* 5 stocks trading for less than the fair market value of their real estate (so stocks that own real estate but probably aren’t REITS)

* 5 cheapest ETFs/Country closed-end funds you can find in terms of Shiller P/E ratio

 

You mentioned yield.

Can you buy stocks where most of the returns come from dividends?

You could. So, you could have one bucket that is stocks with a dividend yield about the same as long-term corporate bonds but with a strong balance sheet, low volatility in the stock, etc.

Examples would be...

Village Supermarket (VLGEA): 4.1% 

George Risk (RSKIA): 4.4%

I don't think there's anything particularly wrong with buying stocks like that if you're looking for 5% to 7% returns over 5-7 years. Those stocks have somewhat higher dividend yields than big cap stocks that pay dividends and yet their balance sheets show they are more overcapitalized and their stock trading histories show they are less volatile than big cap dividend payers like: Kimberly-Clark (KMB) with a 3.5% yield. Their business is not as diversified or predictable as Kimberly-Clark though. We could compare them to utilities. Those two stocks pay dividend a little bit higher than utilities. And utilities have a lot of net debt and no cash. These companies have low debt and high cash for the industries they are in.

So, would I include a dividend yield bucket?

Only if you found enough situations like the two I listed above. And I think asking you to assess individual dividend payers among more obscure stocks would be giving you a demanding task. It’s harder to apply a formulaic approach here. You need to understand the underlying businesses. So, I think it might be more trouble than it's worth to look for dividend payers.

What about the other buckets?

 

Spin-offs

There were several spin-offs this year including Hamilton Beach (HBB) from NACCO (NC) at the start of this month, Cars.com (CARS) from TEGNA (the TV side of the old Gannett). I own BWX Technologies (BWXT), because I bought into Babcock & Wilcox pre-spinoff and then I kept the BWXT shares and sold the BW shares. 

You can see a list of upcoming spinoffs here.

If you are going with 5 buckets that each have 5 stocks in them, I'd suggest making one of those buckets a spin-off bucket and keeping 5 spun-off stocks in there at all times.

Read and re-read Joel Greenblatt's "You Can Be a Stock Market Genius". The case studies from that book are all you need to know about how to invest in spin offs.

 

Holding Companies Trading at a Discount to NAV

The obvious example here is Pargesa. You can find a detailed description of the company’s net asset value here.

And you can find the stock's price and net asset value updated here.

Pargesa shares currently trade at about 65% of their net asset value. That kind of discount - 35% - isn't unusual compared to the trading history of the stock versus its NAV over the last 20 years.

The discount isn't necessarily fully justified though. Pargesa's NAV has underperformed its benchmark over the last 2-10 years. But, it's outperformed over the last 20 years and is beating it this past year too. The stock also pays a dividend.

I wouldn't put my own money into Pargesa at a discount of 35% to its net asset value. But, I would recommend it as part of a bucket where you have 5 closed end funds / holding companies / etc. trading at discounts to their net asset values. That's only if you're also using other, different buckets like spin offs.

Other publicly traded companies that trade sometimes at a discount to the shares they own include Urbana (in Canada), and now Altaba (AABA). Each situation is different. Urbana is partially publicly traded stocks like Pargesa but partially not. And Altaba is non-diversified in the extreme (it’s mostly Alibaba and somewhat Yahoo Japan). Management there has stronger incentives to close the gap between share price and NAV though.

There are tons of closed end funds out there. Many may deserve to trade at a large discount to NAV. I’d consider closed-end country funds more in another basket I’m going to talk about later. If you can find a country with a beat down stock market that has a low Shiller P/E and there’s a closed-end fund there that’s trading at an especially big discount to NAV because the country is so unpopular – that’s just a plus. So, I’d think more of holding companies trading at a discount to NAV for this bucket and then look for closed-end funds more in the low Shiller P/E country bucket I’ll discuss later. But, sometimes there are closed-end funds with discounts that seem large given what they own. You could put one of those in this bucket.

I used the example of Pargesa, because it has a diversified enough portfolio (20% type position sizes) in big, public European companies and it publishes very clear information on what it now owns, where the stock trades, etc. So, it’s the “cleanest” holding company I could come up with as an example.

 

Trading for Less than the Fair Market Value of their Real Estate

Warren Buffett owns shares of Seritage (SRG) in his personal portfolio. This is the company spun-off from Sears (SHLD) that still has Sears as a tenant (often paying below market rents). If and when Sears enters bankruptcy, there's concern Seritage will be insolvent (I imagine it will also get sued by Sears's creditors at that point). Will someone step in offering to recapitalize it and take control? Will someone want to acquire the whole thing? I don't know. I wouldn't put my own money in Seritage. But, as part of a bucket of 5 stocks that appear to be trading for less than the property they own/control (have long-term leases on). I think this makes sense.

In the past, I've mentioned a couple other companies that will - at certain prices - come close to qualifying for this group. You should watch them. They are: J.W. Mays (MAYS), Ingles Markets (IMKTA), and Green Brick Partners (GRBK). These aren't my top suggestions for this bucket (though J.W. Mays is something to look at very hard). They're just examples of stocks I've mentioned at some point on the blog that have a substantial amount of real estate relative to the market cap the companies sometimes trade at.

Again, I wouldn't spend a lot of time speculating about the future of these companies like you would if you were making individual stock picks for an overall portfolio. Instead, I'd look at something like J.W. Mays which is illiquid, has no correlation to the overall market, etc. and just try to figure out if the properties it owns/controls are worth more than the market cap. If they are, add it to your "stocks trading for less than the fair market value of their real estate" bucket. And then try to keep 5 stocks in that bucket at all times. Don't sell one till you have something new to take its place in the bucket. That’s true for all these buckets. Hold each position till you can find a “sixth” position that could replace it. Only then sell out of anything in the bucket.

 

Net-Nets

These are incredibly hard to find in the U.S. They are often so illiquid even individual investors may have trouble getting enough shares. Around the world, like in Japan, it can be easier to find net-nets. Don't buy into frauds or companies clearly on the brink of insolvency. Don't buy into any company that is actually Chinese but lists in the U.S.

Honestly, I’d suggest just finding 5 Japanese net-nets right now, because that will be easiest. This would, however, put your portfolio 20% in Japan. You might not want to do this. Though, I actually think it’s fine. As long as you are creating the kind of value buckets I’m talking about here, I think you can put 20% in one country and not hedge the currency. I’m going to talk about 5 countries to invest in later and I’m not going to mention hedging the currency there either.

But, what if you really wanted to hold U.S. net-nets instead.

What are some current examples of the kind of stocks you can put in your net-net "bucket"?

- Paradise (PARF)

- Richardson Electronics (RELL)

There are others out there. The traditional - Ben Graham - rule is to buy these stocks at two-thirds of NCAV and then sell them when they reach NCAV (for a 50% gain). Ignore this. Any stock trading near NCAV is incredibly cheap, has to be unloved, obscure, etc. Once a stock gets down to the price level of being a net-net just focus on whether it's a fraud, whether the financial strength (F-Score and Z-Score) is adequate, and whether the company has been around a long time and made money in the past.

Just keep this bucket - like your other buckets - full of 5 stocks at all time. So, when you identify other net-nets that can take the place of the existing ones, you're allowed to sell the old ones. But, don't leave an empty slot in this bucket.

Once you buy any position – in any of these buckets – I’d also encourage you to make that position “off-limits” as a sell for a full year. So, just review old positions to be replaced with new positons once a year. People spend too much time deciding how quickly to sell their spin-offs, net-nets, etc. when they start moving. Let them run a year. Then decide.

 

Cheapest Countries Bucket

You can find mentions of the Shiller P/E ("CAPE") for various countries on some websites and in some articles. Here are two examples:

GuruFocus

Article in The Telegraph

Right now, these kinds of articles / sites are going to suggest you buy ETFs/closed end funds in markets like:

*Russia

*Brazil

*Turkey

*South Korea

*Spain

Etc.

I wouldn't put my own money in any country funds. But, if you are only allocating 20% of your portfolio into country funds in total and you always keep 5 countries in this bucket, you'll be putting 4% into each country. That's an acceptable risk. Don’t bother hedging anything.

So, if you want to try to find an approach that is more likely to get you 5% to 7% returns over the next 5-7 years regardless of what the market does, I'd suggest using 5 buckets with 5 stocks in each of them.

So that’s: 5 low Shiller P/E country funds, 5 holding companies trading at a discount to NAV, 5 stocks trading at less than the fair market value of their real estate, 5 net-nets, and 5 spinoffs. That will give you 25 stocks that should have a chance of returning 5% to 7% a year over the next 5-7 years even if the market doesn't.

Join Geoff’s Members site: use the promo code “GANNON” and get $10 off a month


Working My Way Through Your Stock Write-Up Requests

by Geoff Gannon


I just sent out replies to everyone who requested a stock write-up. I got a lot of requests. So, it may take me several months to work through the backlog.

People have asked if I will open myself up to requests for stock write-ups again. The simple answer is: it depends on how this first batch goes. How long does it take me to do them? How much do the people who receive them like or hate the write-ups?

(And, of course, how many people actually pay me. I’m doing the write-ups up front and getting payment – only if the requester is satisfied – after I send them the write-up. We’ll see if that was a dumb idea on my part.)

If I open myself up to requests again: 1) The price will probably be higher and 2) The request window will probably be shorter. Or maybe I’ll come up with some better way to ration things so the backlog doesn’t get this big again.

For those who requested write-ups, I’m sorry that the volume of requests means I can’t promise a reasonably quick turnaround time. If your stock request is time sensitive, I may not be able to help you.

Sorry.

Ask Geoff a Question


How I “Screen” For Stocks – I Don’t

by Geoff Gannon


I get asked a lot how I screen for stocks. And the basic answer is that I don’t. I sometimes run screens, but I rarely find ideas off them.

I can rephrase the question though. When most people ask me how I screen for stocks, what they’re really asking is something more like: “How do you decide which 10-K to read next?”

In other words: “How do you come up with new names to research?”

 

Other Investors Tell Me What They’re Interested In

I meet about once a week with my Focused Compounding co-founder, Andrew Kuhn, to just talk stocks. We both read a specific 10-K and analyze that stock. We bring our notes, Excel sheets, etc. to a local restaurant. And then we have a cup of coffee together and take 2-3 hours to go over the idea. Recent ideas Andrew has wanted to talk about include: Hostess Brands (TWNK), Cars.com (CARS), Green Brick Partners (GRBK), and Howard Hughes (HHC). I wouldn’t have researched these stocks if Andrew hadn’t pick them as our next meeting topic.

I also talk via Skype’s text messaging system with investors around the world who I’ve never met in person.

I spend several hours a week doing all this.

But I guard my time pretty closely. If you’ve ever asked to chat with me this way – you’ve probably noticed two things: 1) I don’t talk on the phone (or do audio on Skype) with anyone no matter how nicely you ask and 2) I insist we agree on a specific stock to talk about. I’ll talk about whatever you want to talk about, but I’m not interested in any sort of general discussion.

These are anti-time wasting rules I’ve learned to adopt through experience.

 

I Mine My Favorite Blogs for All They’re Worth

I’ve mentioned before that my favorite blogs are:

Richard Beddard’s Blog

Value and Opportunity

Clark Street Value

Kenkyo Investing

I go through all their archives and make up lists of stocks they’ve written about. Some of them also have “portfolio” type pages (Value and Opportunity, Richard Beddard) that help generate a list of stocks they’ve covered.

Now, I’ll tell you a secret. Although I love these bloggers and the way they look at things – there’s one situation where I specifically don’t read what they’ve written. It’s when I’m interested in a stock they’re writing about.

So, let’s say I’m reading Clark Street Value’s write-up on the Hamilton Beach (HBB) spin-off from NACCO (NC) or one of Richard Beddard’s articles on Howden Joinery and something in that post makes my investing antennae twitch. I stop reading the post the second I hit that line. I just go off and research the stock myself. Then – and only then – I come back and read what one of my favorite bloggers has written.

This brings up a bigger point. Once you know an investor you think is a clear thinker owns a stock or considered owning that stock – that’s often more useful than knowing exactly why he bought the stock. The blogger, famous investor, etc. is giving you the “name” as an initial lead. After that, the work is all yours.

 

Spin-Offs

I will look at any stock that is being spun-off. I will look at the parent too. If I hear a spin-off is planned, I will add that stock to my research schedule right away. I’ve even researched stocks like Hawaiian Electric (HE) – it’s a utility that owns a bank – in anticipation of the possibility of a spin-off that never happened.

 

IPOs

I’ve never bought an IPO. About the closest I ever came was a stock called OpenTable (it was later acquired by Priceline and then written off).  And even then I never really came very close to buying it.

However, I do read what companies file when they go public. Companies put out a lot of information that may be useful to have a few years down the road. So, I read a surprising amount of IPO documents.

 

Anti-Competitive Practices (Blocked mergers, etc.)

I am interested in companies with “market power” which I define as:

Market power is the ability to make demands on customers and suppliers free from the fear that those customers and suppliers can credibly threaten to end their relationship with you.

As a result, any article that mentions anti-competitive concerns gets me interested in an industry / company / etc.

On Twitter, I recently linked to a Bloomberg article about the Luxottica / Essilor deal. This is the kind of article that – if I’d never head of Luxottica or Essilor – would immediately cause me to research the company, because it mentions concerns that regulators in the U.S. and E.U. have with the deal.   

A while ago, I also linked to a Bloomberg article “Is the Chicken Industry Rigged?” about chicken producers sharing production data. That can reduce competition in such a short-cycle industry. Any time I see a hint that competition is low in an industry or is going to decline – I put companies in that industry near the top of my research list.

I did some research on Staples back when that company was public. What got me interested in Staples was the company’s strong position with U.S. business customers (its delivery business). I wasn’t interested in the Staples stores. When Staples tried to merge with Office Depot, the merger was blocked. That kind of news – a blocked merger – is typical of the kind of thing that would get me interested in a stock.

 

Peers

This is the biggest source of my “new names”. Whenever I research a stock, I try to come up with at least 5 peers. Whatever price ratios I calculate to determine the cheapness of the stock I’m actually interested in – I also calculate for the peers.

So, by researching Fossil (FOSL) I get interested in Movado (MOV). By researching Village (VLGEA) I get interested in Kroger (KR). By researching Nike (NKE) I get interested in Under Armour (UA).

This is my best “screen”. Why?

It’s extremely time consuming and risky to research the first stock in an industry you’re unfamiliar with. The research process becomes progressively faster and less risky as you work your way through a series of companies in the same industry.

It is much easier to research your seventh straight regional bank stock in the U.S. than it is to research your first. The same is true of supermarkets. Local businesses are an especially good source of “new names”, because every state needs to have a local bank, supermarket, etc. In most cases, you won’t have researched this company or any direct competitor before. And yet you will have researched companies with similar business models in other states.

 

A Steady Diet of Specific Stocks

This is kind of just my catch-all term for trying to fill your eyes, ears, etc. each day with specific stock names instead of general investing news. For example, while working at my computer, I try to only listen to old episodes of “The Value Guys” podcast. Some of the episodes are more than 10 years old. Odd as it sounds: I find 10 year-old mentions of specific stocks much more useful than today’s economic news.

I don’t have CNBC on mute. I don’t read newspapers like The Wall Street Journal, The Financial Times, etc. Whenever possible, I try to identify any time I spend exposed to general financial news and replace it instead with exposure to discussions of specific stocks.

 

Real Life: Finding Stocks “Out in the Wild”

People who know me in real life and don’t care about business / investing find this habit frustrating. I’m often saying things like “How many square feet do you think this store is?”, “How many employees have you seen in here so far?”, etc. I research public companies I come in contact with through my day-to-day life.

For example, I live in an apartment complex. When I first moved here, I searched to see if my landlord was publicly traded. It is. So, I read the 10-K. If I eat at a Zoe’s Kitchen (ZOES), I research Zoe’s Kitchen as a stock. If I got to an AMC movie theater, I research AMC as a stock. If I go to Dave & Buster’s (PLAY), I research Dave & Buster’s as a stock.

Historically, finding stocks “in the wild” has been an excellent source of ideas. But, the ratio of stocks researched from this group to stocks I actually buy is quite high. You're going to read about 100 stocks and buy maybe 1 using a finding stocks in real-life approach.

Long ago, I found:

·         Village Supermarket (VLGEA) because I worked in one of their stores as a cashier

·         Coinstar (it later became Outerwall) because I saw people using Coinstar in the store I worked at

·         Blue Rhino (it was later acquired by Ferrellgas) because I preferred using the company’s propane tank exchange over having to re-fill a propane tank

The bad thing with ideas you find “in the wild” is that it’s a needle in a haystack approach. You’re finding them for reasons that don’t have to do with the stock’s price, the business’s quality, etc. Basically, you’re going just off product quality.

The good thing with ideas you find “in the wild” is that you’ll have a firmer understanding of the business model, more confidence in the company, etc. if and when you do choose to invest. It can be difficult to imagine what a company really does just from the 10-K.

First-hand experience of the product combined with a close reading of the 10-K is usually the easiest way to truly understand a business.

 

Things That Might Work For You: Value Investors Club, Corner of Berkshire and Fairfax, “Superinvestor” Portfolios

I’ve spent days digging through Value Investors Club, Corner of Berkshire and Fairfax, and portfolio holdings of famous investors. I’ve never found these sources of ideas any better than just “going A to Z”.

And I have some experience just going A to Z through a stock list. That’s how I found the Japanese net-nets I invested in about 5 years ago. There was no screen. I just went through a list of Japanese stocks. It worker pretty well. But, I knew I was just looking for net-nets. So, I was able to manually "screen" out each stock in a manner of seconds.

Ask Geoff a Question

 

 

 

 

 

 


Last Chance for Now: Write-Up On Demand (Closing to New Requests at Midnight Tonight)

by Geoff Gannon


Since my earlier post, I got a lot of requests to write-up specific stocks. And these requests keep coming in at a daily rate faster than I can research these stocks.

So, at midnight tonight I’m going to stop accepting requests and just work through the backlog. Once I’m done filling these requests, I’ll announce on the blog if and when I’m re-opening to new requests.

Once again, the way this works is:

This write-up can be for the use of you, your family, your firm, etc. You can buy stock in the company, short it, etc. based on my write-up or you can ignore my write-up. The choice is yours.

There is, however, one thing you can’t do.

The one thing you can’t do is share what I write for you anywhere on the internet.

Here’s how it works:

·         Pick a stock

·         I’ll research the stock for you

·         I’ll send you a short write-up summarizing my analysis

·         You’ll send me $100 via PayPal if you’re satisfied with the write-up

Finally, a suggestion. I will certainly try to do my best to research any stock you ask about. However, I have gotten a lot of requests to research companies that are speculative in the sense that:

·         They are in bankruptcy right now

·         They are losing money right now

·         They have never made money in the past

·         Statistical measures like Z-Score and F-Score suggest they are very poor credit risks

I can research these stocks. But, common stock is junior to the company’s obligations. So, in cases like this, my write-up is likely to focus on the company’s weak financial position and the possibility that the stock will be worthless.

The quality of the write-up you get from me will depend to a huge extent on the quality – that is, “research-ability” – of the idea you send me.

Ask Geoff a Question


Stock Write-Up On Demand

by Geoff Gannon


I’m trying something new here. It will be first come, first served. And there’s only going to be room for a couple people this week.

Request a private write-up on a specific stock.

This write-up can be for the use of you, your family, your firm, etc. You can buy stock in the company, short it, etc. based on my write-up or you can ignore my write-up. The choice is yours.

There is, however, one thing you can’t do.

The one thing you can’t do is share what I write for you anywhere on the internet.

Here’s how it works:

·         Pick a stock

·         I’ll research the stock for you

·         I’ll send you a short write-up summarizing my analysis

·         You’ll send me $100 via PayPal if you’re satisfied with the write-up

Request a Stock Write-Up


4 Great Blog Posts

by Geoff Gannon


In this post, I’m going to combine ideas from two recent posts – “The Chains of Habit” and “My 4 Favorite Blogs” – to show how the four blogs I like best do the kind of work you should be doing as an investor.

 

Richard Beddard: Howden Joinery

First up, Richard Beddard’s piece on Howden Joinery. He summarizes the company’s business model beautifully right here:

You can almost parse that description phrase by phrase to come up with the bullet points you need to research Howden Joinery:

·         How much capital does Howdens tie up in inventory to “keep everything…in stock”?

·         What are credit losses like at Howdens?

·         What if the public learns about the mark-up tradesmen are adding on the stuff they buy from Howdens?

·         What if Howdens depots had a different incentive pay system?

I’ve researched Howden Joinery myself and those are 4 of the maybe 6 or so questions I wrote down on my yellow notepad.

 

Value and Opportunity: Topdanmark

Next up, Value and Opportunity wrote a terrifically simple post about Topdanmark. Reading this post felt like reading a case study out of Joel Greenblatt’s “You Can Be a Stock Market Genius.” The idea here is that a company had been buying back stock for almost 18 straight years – there was a little blip during the financial crisis – and now it was going to switch to paying a dividend instead. The market would have to go from valuing Topdanmark as a “cannibal” that eats up its own shares to a dividend yield stock. What would happen?

My favorite part of this post was that such a simple idea was backed up with so much historical evidence:

Clark Street Value: NACCO Industries (NC)

This is a great example of “doing the work”. A lot of the stock write-ups I read don’t show much evidence that the author has actually read the SEC filings (a primary source) rather than relying solely on secondary sources (media reports, other blogs, etc.).

On the surface, what I’m about to quote from Clark Street Value looks like it’s just a business description. But, in reality, you had to read NACCO’s notes on how it prepares its financial statements to be able to lay things out as accurately as Clark Street Value did here:

Now that Hamilton Beach (HBB) has been split off from NACCO (NC), this will be obvious to everyone. NACCO has already released pro-forma numbers for the first 6 months of 2017. But, before the spin off, you had to do some close reading of the 10-K to be able to prepare a write-up like this one.

 

Kenkyo Investing: Weathernews

Here’s an example of the kind of company I wouldn’t have even known existed unless I read blogs like Kenkyo Investing:


The Chains of Habit

by Geoff Gannon


In my last post, I mentioned Twitter is a distraction most investors are better off keeping themselves clear of. I got some responses like:

“Agree (Twitter) can be (a) distraction. I'm careful who I follow, restrict my usage, save leads for later like you!”

But also:

“…if it’s a distraction for him I get it. But you can literally pick who you follow, don’t have to tweet, connect (with) other investors...”

And:

“…get Geoff’s (point) here, but Twitter has led me to some great ideas, resources, convos. Great tool if used correctly.”

All of these responses are right, of course.

Some people I’ve gone on to meet in real life have mentioned the first place they saw my name was on Twitter. It helps that my Twitter profile says I live in Plano, Texas. This has encouraged investors who live in Texas or are passing through one of Dallas’s airports to reach out to me for a face-to-face meeting. In a couple cases, good things have come from that. And I have Twitter to thank for it.

So, why don’t I think Twitter’s so great?

 

Part the First: Wherein Geoff Complains All the Good Playwrights have Gone to Hollywood

I started blogging on Christmas Eve 2005. Back then, I used to read a lot of value blogs. Most of them don’t exist anymore. And not enough good ones have been stared up since. Why? Twitter. Some of the best “would-be” value bloggers spend their time on Twitter instead of blogging.

I talk stock ideas with a lot of people via email, Skype, etc. You wouldn’t know the names of anyone I talk with. But some of them are good. Very good. And they know small, obscure stocks in their home regions – Benelux, Nordic countries, India, Southeast Asia, Hong Kong, Latin America, wherever – so much better than I do or likely ever could. In the past, I’d tell them “you should start a blog.” And sometimes, they would. Now, I tell them “you should start a blog”. And they say: “If I have something to say, I can put it on Twitter.”

And they can. And in terms of visibility, I think they’ll get more out of Twitter. They’ll reach a bigger audience. But, if I can be selfish here for a second…

They are robbing me of depth.

 

Part the Second: Wherein Geoff Complains that All Music Ought Not to be Pop Music

They are robbing me of a considered, potentially contrarian take. Because Twitter is many things. But the one thing it is above all else is: “catchphrase”. To appear on Twitter, an investment idea has to be distilled into a single phrase. And that phrase – if it’s to be re-tweeted widely – has to be catchy.

I’m writing this post in a noisy environment. There are other people here doing other things. And they’re a distraction. So, I have on some good headphones and I have a piano version of “Pachelbel’s Canon in D Major” playing loud on loop. It’s a catchy tune. If you’re not sure if you’ve heard it, you have. If you’ve been on planet Earth any time in the last 30 years, I promise you you’ve heard this song. Parts of it – especially one particular part – crop up in all sorts of music that worms its way into your ears as you go about life (listening to your car radio, shopping in stores, watching TV, going to weddings, etc.)

Here’s the thing. If you search online for Pachelbel’s Canon right now and play it – I’m pretty sure it won’t sound novel to you. I can promise that. You won’t be 100% certain this is the first time you’ve heard this song. None of you will. For some of you, you’ll know exactly where you’ve heard it before. Congrats. But, for others, you’ll know only that you have heard it before – but you won’t remember where.

And then there will be some of you for which this will happen…

You will hit that chord progression (or whatever the famous part is, I don’t know music) and you’ll know only that you are sort of nodding your head on the inside: “Yes, yes this is familiar and catchy and that’s really all I know and really all that matters in this second.”

That’s Twitter. Twitter is Pachelbel’s Canon.

Now, there’s nothing wrong with that if you use it the right way. I’m looping a bit of piano to create a musical cocoon I can write in. If I had a workspace all my own at this moment – I wouldn’t need a piano playing on loop. Likewise, If you’re using Twitter the way investors of old used to start their day with The Wall Street Journal, The Financial Times, etc. and a cup of coffee to ease into the day – that’s fine.

But, Twitter is – like skimming a newspaper – shallow work with a low return on your attentional investment.

I’ve said before that Cal Newport’s “Deep Work” isn’t a great book. But, it is a great idea. Let me plug it again here.

 

Part the Third: Wherein Geoff Complains that Writers Can’t Ever Be Just Readers Again

You don’t know this about me, but I sometimes write fiction to relax. And I sometimes hang out with real fiction writers – novelists who make a living making stuff up. And when you ask these novelists a question you think is really clever – “what’s the one thing about being a professional writer no one ever told you to expect?” – they all pretty much give you the same 3 answers:

1.        It’s physically demanding. At some point, you’re 100% certain to majorly mess up your back.

2.       You read less.

3.       It changes the way you read.

As someone who managed to mess up his back writing before he reached the age of 30, I’d prefer not to dwell on #1. So: why do writers read less once they become professionals?

Writers, not surprisingly, spend a lot of time writing. And writing and reading exercise the same mental muscles. Writing often feels enough like reading that it ends up taking its place.

Amateurs can write or not write. Professionals don’t have that luxury. They have to write. So, they end up cutting reading from their life. No editor or agent has ever called them up saying “so, how’s the reading coming along?” Any prodding they get from others pushes them toward writing – not reading.

What does this have to do with Twitter? I fear that an hour spent skimming stock related Tweets feels a lot like an hour spent reading a 10-K. We all know our time is better spent actively reading 10-Ks, taking notes, doing our own calculations, etc. And yet, what are we being prodded to do?

Twitter prods us to:

·         Quickly agree/disagree (make a knee-jerk logical judgment)

·         Get outraged about something (make a knee-jerk moral judgment)

·         Click that link (I started this post with a link).

·         Read that book (I told you to go out and get “Deep Work”).

·         Watch that interview.

·         Etc.

No one is prodding you to read a 10-K. A terrific investment for a stock picker to make would be to buy a parrot and teach him only those two words: “10” and “K”.  I doubt I could ever give you a morsel of advice that would do as much to improve your actual stock picking as that kind of constant nagging.

Finally, professional writers report that they can’t read the way they used to. They can’t read “just for fun” anymore. They watch a magic trick, and they see the magician at work. Reading for them becomes more about analyzing the artifice of good storytelling than simply surrendering themselves to the tale.

This, honestly, is where you (the reader of this post) and me (the writer of the post) diverge in terms of our attitudes toward Twitter. A writer is more likely to be changed by Twitter than a reader.

A huge problem with Twitter is that I can clearly see which posts of mine “work” and which “don’t work” in terms of the immediate response of new followers, re-tweets, reactions from people, etc.

My goal isn’t really to get a lot of followers, re-tweets, etc. It’s to write stuff that resonates. More than anything, I want to write stuff that translates into some practical improvement for my readers. I don’t want them to agree with what I write. I want them to incorporate something I wrote into their investment process. I want them to get better because of me.

It’s fine to say that. But, our actions aren’t driven by what we claim to believe. Beliefs simmer on the back burner. Actions are determined by more immediate front burner stuff. They’re driven by things like a nagging parrot that squawks “10-K, 10-K, 10-K”. Our actions are driven by reminders. Our actions are driven by habits. Our actions are driven by the stuff we choose to measure.

If I want to lose weight – I don’t actually have to change my beliefs about what food I should be eating. All I have to do is start recording everything I eat throughout the day. That simple act of monitoring my diet will change my diet. Buy a journal, buy a scale, get someone to nag you to exercise – and that’s all it takes. You’re going to lose some weight. Will this “new me” prove durable without the right principles, motivation, etc. to back it up? Maybe not. But it’ll get you started faster than thinking the right thoughts. It’ll get you actually doing the right things. The act of monitoring followers, re-tweets, likes, etc. can change behavior. If you want your behavior to be changed in the same direction as the stuff Twitter measures and notifies you about – that’s great. Your interests and Twitter’s metrics are aligned.

But, if your preferred metrics for success are different from Twitter’s – that’s a problem. Because you’re going to do what you’re reminded to do – not what you believe in but don’t measure.

 

Part the Fourth: Wherein Geoff Tells Investors to Eat Their Vegetables

I told you I know some professional novelists. I’ve read one of the earliest works (unpublished of course) by one of these writers. It’s terrible. I don’t just mean it’s unpublishable. I mean, it would quite likely not make it into the top few slots of your average high school writing class. There isn’t anything there that would give you the slightest whiff of innate ability. No teacher would encourage this writer to write more because they saw something good in what the kid was already doing. The only reason they’d encourage him is because they saw passion and they saw some serious work ethic. In fact, this writer went on to write more completed books – before ever getting published – than some successful novelists write in an entire career. He willed himself to become good. And he did.

I’ve talked to a ton of investors over the 12 years I’ve been blogging. Intelligence is not what separates the successful ones from the unsuccessful ones. Having the “best” investment philosophy isn’t what does it either. The ones with initiative succeed. The lazy ones don’t. The difference between those who made it and those who didn’t comes down to what I’d call “intellectual assertiveness”. I’ve been doing this 12 years – so, I’ve now met people who were in high school or college at first and now have several years of really solid investing behind them. All the good ones today are people who from the moment I first met them were willing and eager to go off and do their own work and come to their own conclusions. They were all people who’d rather spend time with a 10-K than with Twitter.

Does that mean a little Twitter is so bad?

No.

But, I want you to be very honest with yourself here when I ask you this. If you are presented with two next actions to take and one is “quick” and “easy” and one is “slow” and “hard” – what’s your next action going to be?

 

Conclusion: Wherein Geoff Presents Two Expensive, Irrational Habits He Has

I read 10-Ks in a little office I rent about a ten-minute walk from my apartment. It costs me money to rent an office. So, why do I do it?

I use a full service broker I have to call up on the phone to place a trade with. It costs me money to use a full service broker instead of an online broker where I’d enter the trades myself. So, why do I do it?

Twitter is a great tool if you use it right. Online brokers save you a lot of money if you use them right.

I have a lot less confidence in my ability to consistently tackle the slow, hard things when I could instead tackle the quick, easy things than most people do.

Most people judge a tool by how useful it is when put to its best use.

There is a tendency to think all future decisions will be made in the clear light of day.

I try to imagine all future decisions will be made when it’s 2 a.m. – I’m a little sleepy, a little hungry, I’ve had a drink or two. What could go wrong?

Ask Geoff a Question


My 4 Favorite Blogs

by Geoff Gannon


I get asked a lot what my favorite blogs are. I started blogging in 2005. Most of my favorite blogs are no longer active.

However, the four blogs I’d recommend right now are:

1.       Anything by Richard Beddard

2.       Value and Opportunity

3.       Clark Street Value

4.       Kenkyo Investing

You can also follow some of these authors on Twitter (but, you shouldn’t). I’m on Twitter. But, again, you shouldn’t be on Twitter.

Why?

I just wrote a post about how you need to go into a room alone with just a 10-K and sit still there for several hours.

You’re not going to do that if you can check your Twitter feed instead.

So, I have three pieces of advice about learning from bloggers:

1.       Read: Richard Beddard, Value and Opportunity, Clark Street Value, and Kenkyo Investing.

2.       Don’t follow any bloggers on Twitter (because you should delete your Twitter account if you’re serious about investing).

3.       Whenever you come across a potentially interesting blog post, print that post out and put it in a folder somewhere that you read all the way through like once a week. Don’t “browse” from one post to another and one blog to another. The way to get a lot out of any reading material is to focus on it and read it closely (like with a pen and calculator). Don’t skim.

Ask Geoff a Question


Roam Free From the Value Investing Herd

by Geoff Gannon


Although allegedly a value investor, my own portfolio is usually idiosyncratic in two respects:

1.       The position sizes I take (right now they’re 50% / 28% / 15% / 7%) are not the position sizes well-known value investors use.

2.       The stocks I own are not owned by well-known value investors.

A lot of readers comment on point #1 (my level of portfolio concentration is by far the topic I get the most emails about). No one ever comments on point #2.

To prove to you that almost none of the stocks I own are owned by well-known value investors, I’ll use Dataroma.

Dataroma tracks the portfolios of about 60 investors. I would call most of them “value investors” and some of them “famous” in the sense that the sort of folks who read this blog would have heard of them.

Here’s my portfolio’s popularity according to Dataroma:

·         Undisclosed Position (50%): One of the investors tracked at Dataroma owns this stock. He has less than 1% of his portfolio in it.

·         Frost (28%): No investor tracked at Dataroma owns this stock.

·         BWX Technologies (15%): No investor tracked at Dataroma owns this stock.

·         Natoco (7%): This is a Japanese stock that Dataroma doesn’t track.

Basically, no famous value investor has a meaningful amount of his portfolio in any stock I own.

This is very different from almost all the stocks I get emails about. People want to talk to me about stocks that a lot of value investors own. They want to talk about stocks that you can find in portfolios over at Dataroma or GuruFocus and that you can read threads about on Corner of Berkshire and Fairfax or read write-ups about at Value Investors Club.

My favorite investing book is Joel Greenblatt’s “You Can Be a Stock Market Genius”. If I can cheat a bit, I’d say my second favorite investing book is the section of “The Snowball” that details Warren Buffett’s career from about 1950-1970.

Both books teach you the importance of doing your own work. In fact, my favorite Ben Graham quote is:

“You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

The key word here is “your” data and “your” reasoning. At some point, you have to go into a room alone with just the 10-K. And when you come out of that room you need an appraisal value for that stock that’s yours and yours alone.

I would say that 90% of the investors I talk to never get this far. They pick their own stocks. But, they don’t do their own work.

Nothing is going to make you a better investor faster than just picking the 10-K of a stock that’s not well-covered and coming up with an appraisal value for that stock on your own. Repeat this every week. And you’ll be a better investor in no time.

To get you started, here are some stocks that aren’t well-covered but are worth learning about:

·         George Risk (RSKIA)

·         ATN International (ATNI)

·         Ark Restaurants (ARKR)

·         Transcat (TRNS)

·         Tandy Leather (TLF)

·         U.S. Lime (USLM)

·         Green Brick Partners (GRBK)

·         Seaboard (SEB)

·         Hostess Brands Warrants (TWNKW) – Not a stock but worth doing your own homework on

I intentionally limited this list to U.S. listed stocks and tried to find some names that have market caps over $100 million (in fact, a couple there have market caps over $1 billion). The easiest way to find things other value investors don’t own is by focusing on stocks under $100 million and including stocks listed outside the U.S.

Let’s talk small caps.

There’s no perfect relationship between market cap and popularity of a stock. But, going in sort of “order of magnitude” intervals, we could say:

·         Under $300 million market cap: Unknown to investors who don’t do their own work

·         $300 million to $3 billion: Known to professionals and serious stock pickers

·         $3 billion to $30 billion: Known to investors generally

·         $30 billion to $300 billion: Known even to people who don’t invest any of their own money

If you look at the portfolio I have now, at the time I bought shares in these companies:

·         Two of the four stocks had market caps of about $300 million or under

·         Two of the four stocks had market caps of about $3 billion or under

So, about 50% of my ideas were in the $0 to $300 million market cap category and 50% of my ideas were in the $300 million to $3 billion market cap category. None were really in the $3 billion to $30 billion or $30 billion to $300 billion categories.

This isn’t a bad rule for you to follow. Certainly, in the U.S.: at least half of all the good ideas out there have a market cap under $300 million. So, at least half of your portfolio should probably be in stocks with a market cap under $300 million.

Ask Geoff a Question


Hostess Brands (TWNK) Warrants

by Geoff Gannon


Note: Hostess stock is down about 8% as I write this; the warrants are down 10%. Make sure you check for an updated quote on both.

My Focused Compounding co-founder, Andrew Kuhn, recently wrote up Hostess Brands (TWNK) common stock on the member site. Today, I put up a link on my Twitter noting that the company’s CEO is leaving and the Executive Chairman (billionaire Dean Metropoulos) will assume additional duties in the interim. From these two facts, you can probably guess Andrew and I have been looking at Hostess.

That’s true. But, this post isn’t going to be a write-up of Hostess stock. It’s a good business with very strong brands (most famously Twinkies). But, it’s also highly leveraged. Hostess Brands is essentially a publicly traded LBO. And, in the past, Metropoulos has flipped the food companies he’s turned around (example: Pabst Blue Ribbon 2010-2014) fairly quickly.

The above suggests there may be two important limitations on Hostess Brands common stock:

1.       The company is so leveraged the stock may be unsafe even if the brands are safe

2.       The company may be sold within 5 years, limiting the stock’s long-term potential

Downside protection and unlimited time for your idea to work out are usually two of the biggest advantages a common stock holder has over an option holder. If, in this case, the common stock itself is a very leveraged bet and is less likely to be public in 5 years than is normal – you might want to consider buying options instead.

Or better yet: long-term warrants.

Hostess has publicly traded warrants (they trade under the ticker TWNKW – that’s TWNK with an extra “W”) that expire on November 4, 2021 (so, just over 4 years from now).

You need two warrants to get one share of common stock. So, I’ll simplify things by talking in terms of a “pair” of warrants. A pair of warrants are exercisable at $11.50 a share. However, they really must be exercised once the stock exceeds $24 a share, as you can see from this quote taken from the prospectus:

“Once the Public Warrants become exercisable, we may call the Public Warrants for redemption: 

in whole and not in part;

at a price of $0.01 per warrant;

upon not less than 30 days’ prior written notice of redemption to each warrant holder; and

if, and only if, the last reported sale price of the Class A Common Stock equals or exceeds $24.00 per share for any 20 trading days within a 30 trading day period ending on the third trading day prior to the date we send the notice of redemption to the warrant holder.”

So, if you buy 2 warrants today, what you get is: 1) 4 years during which you only need to put down the price of 2 warrants instead of the price of the common stock (as of yesterday, the common stock was over $13 a share and two warrants were priced under $4 a share) and 2) the 4-year possibility of upside limited to movements in the stock price between $11.50 and $24.

So, am I recommending you buy Hostess warrants?

No. But that’s because I’m not ready to recommend you buy Hostess stock.

What I am recommending is that you look at Hostess Brands in general and the warrants in particular.

Why?

I was talking to someone who had analyzed Hostess Brands stock recently and asked him: 1) Okay. That’s your appraisal of the stock. Now, what’s your appraisal price for the warrants? 2) If you were going to invest in Hostess, would you do it through the common stock or the warrants?

He didn’t have an answer to those questions. Why? Because, he hadn’t really looked at the warrants at all. Looking at the stock just seemed simpler. 

In my last post, I said “As a stock picker: Your job is to find a great business no one thinks is a great business yet.”

Well, looking at a security that some people aren’t thinking about at all is always a good idea. Other things equal, if you know more people are analyzing the common stock than the warrants – you should start by analyzing the warrants.

Ready to get started? Here is the prospectus for those warrants. And here is Hostess’s 10-K.

 

Ask Geoff a Question


The Dangers of Holding on to Great Stocks

by Geoff Gannon


Someone emailed me a question about Activision (ATVI), a stock I put 100% of my portfolio into a little over 16 years ago (the stock went on to return 22% a year – but, of course, I didn’t hold on to it these last 16 years):

“Would it be fair to say that your returns would have been much better had you just put all your money into Activision at the time you initially bought it… and just sat on your butt until now? Let's assume that this is a fair assessment for now.

So if we brought ourselves back to the year you bought it, early 2000s was it? If we looked at it with the models you currently possess but likely did not possess back then, could you have made a better allocation based on those models alone?”

The only “model” I can think of that would have improved my performance is not letting myself make any conscious sell decisions. In other words, just selling pieces of all the stocks I own in proportionately equal amounts to fund new purchases, never selling just to hold cash, etc.

I wrote an article discussing some of this. Overall, my sell decisions haven’t added much (if any) value to my investing record. My investment results are primarily a result of taking larger than normal positions in some stocks and then secondarily in picking the right stocks more often than I pick the wrong stocks.

With hindsight, I would have done as good or better while doing far less work if I’d just stuck with a stock like Activision that I once (16 years ago) had the conviction to put 100% of my net worth into it.

However, I think there is both: 1) A valuable truth and 2) A dangerous falsehood in this kind of thinking. Basically, what you’ve uncovered here is a good idea. But, a good idea can be taken to a bad extreme. And, I think the combination of 1) abusing hindsight and 2) going off the stock performance rather than the business performance can skew just how good and certain an idea Activision really was in September of 2001 (when I allocated 100% of my portfolio to it).

I couldn't have foreseen that Activision would return something like 20% to 25% a year for the next 15-20 years. At the time, I thought I was able to foresee Activision could return 10% to 15% a year for the next 10-15 years though. Now, it’s true I thought this thought with enough “certainty” that I was willing to put 100% of my portfolio into the stock. But, I didn’t go “all in” on Activision believing I could make 20% to 25% a year. I did it believing I could make 10% to 15% a year (with greater confidence than I had in any other stocks).

Since 2001, Activision’s capital allocation has turned out to very good, or very lucky - or some combination of the two. Should I have known that would happen? To some extent, yeah. A key reason – really, the key reason – for me buying Activision instead of something like EA is that I liked Activision's management and capital allocation a lot better. In fact, I disliked EA’s management so much I’d never consider buying the stock as long as that management team was there. And I really liked Activision’s management a lot. It’s not like I was neutral on the top people there. I thought they were saying the right things about capital allocation at a time (around the turn of the millennium) when no one was saying the right things about capital allocation. I knew that in a business like video game publishing, book publishing, movies, etc. you bet the “jockey” if by “jockey” we mean best capital allocator. That’s because these businesses produce tons of free cash flow, so your return is largely going to be the return on re-invested cash. There’s no requirement to put the cash back into the franchise that earned in. In fact, you often can’t do that. A hit media franchise can never come close to re-soaking up all the free cash flow it gushes.

Okay. So, I should have held Activision longer. Is this part of a bigger pattern for me?

In general, I haven't been much better off selling a stock I bought to buy another. Certainly, of the stocks I sold within about 10-15 months - where things were going well and the price was rising - I would have been better holding for 10-15 years.

You can see this even more recently. For example, I bought FICO about 7 years ago. The stock has returned over 25% a year since then. I didn't hold it from then till now. 

What you have to be careful about here though is multiple expansion. When you buy something like Activision, J&J Snack Foods, FICO, or Village Supermarket (these are all stocks I bought a lot of when they were really cheap) at a low multiple of sales, book value, earnings, etc. you can consider the substantial annual return bonus you get in the stock from multiple expansion to be one-time but fully justified (and therefore not going to be reversed in future years) up to a point

I’m going to spend the rest of this post explaining what “up to a point” means. It’s one of the most important concepts to long-term, buy and hold investors. This idea that you are – if you buy only cheap stocks – entitled to getting one and only one multiple expansion “bump” to your returns is something buy and hold investors need drilled into their heads during the last stages of a bull market. Since we may now be in the last stages of a bull market, let’s talk about how a justified initial multiple expansion in a stock can quickly morph into a totally unjustified subsequent multiple expansion.

Let me give you some examples.

Activision: I bought this stock at something like an EV/Revenue of 1. It now trades at an EV/Revenue of more than 6. This multiple expansion counts for over 10% of the annual return in the stock. How much of it is justified? Activision shouldn't trade at an EV/Revenue of 1, but I'm not sure it should trade at an EV/Revenue of 6 either. Today, the stock would have to fall more than 50% before I'd say it was clearly "cheap".

FICO: I bought this stock at something like an EV/Revenue of 2. It now trades at an EV/Revenue of more like 5. This multiple expansion counts for over 22% of the annual return in the stock. FICO might have to fall close to 70% before I'd say it was clearly "cheap". 

You want to be careful about this, especially as we are now in one of the longest lasting bull markets ever. It's often better to look at your returns in terms of the business results than the stock results. So, judge your returns by the increase in per share sales, free cash flow, etc.

Having said that, you must also take justified multiple expansion into account to some extent if you're a value investor. I bought Village Supermarket (VLGEA) at a P/E of let's say less than 7 and an EV/Revenue of around 0.1. It was reasonable I think to believe that because the business was a perfectly decent one it would eventually deserve a P/E of about 15 and an EV/Sales of about 0.2 or 0.25. Beyond that, you are starting to get speculative. I often think in terms of what I think I can get as a return over the next 5 years if the company's stock takes that long to get valued at what I think is the "right" multiple. For me (a value investor) this means I am usually buying below the market's "normal" P/E and expecting the stock to at least rise to that level. So, I’m buying Village at a P/E of 7 and expecting it to one day trade at a P/E of 15. For some exceptional businesses – like Omnicom, FICO, and BWX Technologies – I may be buying at a P/E of 15 and expecting the stock to one day trade at a P/E of 25. What I’m not doing though is buying at a P/E of 20 and expecting the stock to one day trade at a P/E of 40 – even though, I know, there may come a time where Mr. Market gets overexcited with this kind of wonderful business and really does give it a P/E of 40.

So, does that mean I should sell when it reaches that level? If I expect a multiple expansion from a P/E of 7 to a P/E of 15 for an average business or from a P/E of 15 to 25 for an above average business, should I sell the second a stock I own hits my P/E “target”?

No.

But, even if you look at someone like Buffett's returns - you can see two features. One, he often did fine if he never sold. This is true even of stocks he did sell. For example, Buffett bought General Dynamics (GD) shares in the early 1990s. He sold the stock. But, he would've done very well if he'd hung on to General Dynamics for the last 25 years. Why? Probably because Buffett analyzed the business and saw it was a good one and he saw that capital allocation was going to be good and then the CEO then in place followed through with that kind of capital allocation and the CEOs that followed him copied those practices. So, the two things Buffett saw that he liked: good economics and good capital allocation proved to be durable.

As an example of what’s durable here – the industry structure of defense contractors and the market power they have with respect to their customer (the U.S. government) and their suppliers (often companies who do not deal directly with the U.S. government the same way they do on big projects) is going to tend to stay the same. If market power and capital allocation don’t change – the right business to own in the 1990s will often stay the right business to own in the 2000s, the 2010s, etc.

This is why it's often a bad idea to ever sell a stock you've bought. In a sense, you are making a very tough bet to get right. You're saying that you correctly judged the quality of the company to be high, its future to be bright, etc. but now you are correctly judging that the company's quality, future prospects, moat etc. are not high enough to overcome the current elevated price. That's a tough bet to ever win. The more certain you were of this business in the first place, the more you should doubt ever selling it. This is if you did the sort of in-depth look at moat, etc. that someone like Buffett does or that I often do. If I think WTW has a moat (like its relative size versus competitors), it's hard to later be right in saying the moat has been breached.  If I think BWXT’s industry structure (it’s a monopolist in some areas and an oligopolist in others) and product economics (it rarely has to tie up much capital ahead of time in anything it does) are so favorable it’s the right stock to buy at a P/E of 15 – then, it’s much harder than you might think for me to reverse myself correctly at a P/E of 30 from a handicapping perspective. This requires an ability in precise quantification that I probably lack. How much is the right product economics and the right industry structure worth? It’s hard to say. What I know is I researched these questions in-depth and liked the answers when I first bought the stock. To do what is probably a more superficial (and biased towards “recency”) analysis later that overturns my initial decision – that’s hard to do. Common law legal systems operate on a principle of precedent. If you believe you made a correct precedent setting decision years ago, leave that decision undisturbed now. A lot of investors are making decisions based on beliefs they might have 50% to 75% confidence in. Don’t do that. You want every decision you make – including overturning a prior decision you made – to be decisions you make with 90% to 100% confidence. The likelihood that you’ll ever have 90%+ confidence in a decision that overturns a previous decision you made is extremely low. Who can reverse themselves with 90% confidence?

Okay. So, whenever possible, leave your stocks undisturbed and your prior decisions in place.

But, I did say there were two features you see with the buy and hold practices of someone like Buffett.

The other feature is that while it's true that if you measure from the time he bought a stock till the time he is still holding it decades later, the return is still often good despite him not selling out at an earlier date - the annual returns is often not as good as it once was. This isn't always true. For example, General Dynamics did worse over the first 10 years from the time Buffett bought it versus the subsequent 15 years. However, if we break down the returns in some of Buffett's favorite stocks into two time periods: the first 10 years and then all the other years - we can see the first 10 years sometimes had really amazing results.

Based on information in Berkshire's annual letters, I estimate Buffett's Washington Post stock returned about 32% a year for the first 10 years he owned it. The stock still did fine as an investment for Buffett once you include the next 20-25 (taking it through the 2000s). But, the returns were very strong in those first 10 years.

Coke shows a similar pattern. The return in that stock was something like 25% a year for the first 10 years. That stock hasn't done well over the last 18 years. A lot of people will blame changes in consumer tastes for that. But, really it was Coke's P/E. The company experienced multiple expansion for the first 10 years Buffett owned it that was very extreme. 

This is why people should be careful about the FANG stocks. Not because they aren't great businesses, but because their stock prices have been growing faster than the underlying business value.

Facebook: Over the last 5 years, there's been a 5% boost to the annual return in FB stock due to multiple expansion (EV/S).

Apple: Over the last 5 years, none of AAPL's annual return has been due to multiple expansion.

Amazon: Over the last 5 years, there's been a 12% annual return boost in AMZN stock due to multiple expansion.

Netflix: Over the last 5 years, there's been a 43% annual return boost in NFLX stock due to multiple expansion.

Google: Over the last 5 years, there's been a 7% annual return boost in GOOGL stock due to multiple expansion.

I based all those multiples on sales, which is usually the safest way to do it. Investors often use the P/E multiple. That can be risky though. Because you are then assuming that both higher sales and higher margins (today vs. the past) are normal. Unless you have very strong evidence about the long-term structure of this business as it scales, I would strongly suggest using growth in sales per share or maybe growth in gross profit per share rather than growth in EPS as your guide to intrinsic value growth.

I actually looked pretty hard at Netflix about 5 years ago and couldn't bring myself to buy it because I'm too much of a value investor who focuses on certain multiples you get accustomed to paying in terms of earnings and things like that. But, Quan and I both knew Netflix was cheap and it was going to have a wider moat in 5 years than it did in 2012. 

Should I blame myself for not having the flexibility to break free from some of that value investing dogma that fills my mind and buying Netflix?

Sure. Probably.

But, should I blame myself for missing out on an 80% annual return in the stock?

No. Netflix has only grown its revenue per share by something like 20% a year. 

Two things have happened to expand Netflix's share price result far beyond this. One, it grew debt. Two, investors valued each dollar of sales higher (even when it came attached with more debt). 

A re-rating of Netflix from having an EV/Sales of 1 to having an EV/Sales of 2 or even 2.5 might make sense based on the company's own past history. Knowledge of the historical economics of similar media companies (cable networks, TV stations, etc.) might even get you to a belief that if Netflix would become both dominant and mature it might even deserve a EV/Sales of 4 at that time. However, no analysis I'd be able to come up with would ever tell me that Netflix deserved an EV/Sales anywhere near 8 unless it was still growing phenomenally fast.

The danger here is always that because of the combination of a strong business performance and then a strong stock performance on top of that (due to multiple expansion) we may become more sure of Facebook, Amazon, Netflix, and Google or of Activision or FICO or whatever long-term winner we own in our portfolio. And the truth is that while some of those businesses are certainly on more stable ground today than when I first analyzed them - other aren't. FICO isn't a wider moat, better company today than when I looked at it. FICO should have been priced at the exact same multiple of sales in 2010 and 2017. Instead, Mr. Market is willing to pay 2.5 times more per dollar of FICO’s sales in 2017 than he was in 2010. FICO was too cheap in 2010. And it’s too expensive now. I could’ve gotten a tremendous return – something like 25% a year – in FICO by holding all the way from when I bought it (knowing it was way too cheap) in 2010 and holding it till today (when I know it’s way too expensive).

But: Is that smart? Is it safe?

Nothing happened with FICO that I didn’t pretty much expect to happen over the next 7 years – except for one thing: I never expected the stock to end up with a P/E of 40.

Let’s look at Netflix over the last 5 years. I'm not sure I'd say Netflix's competitive position today is different from where I expected it to be at this point in time. However, the stock is probably 4 times higher than where I would've told you it should be. In other words, I could have correctly – in very rough terms – guessed where Netflix might be in terms of its number of subscribers, how much it was charging, and how much competition it was facing for the acquisition of content (this was always my biggest concern). Now, I was nowhere near 100% certain of my guess as to where Netflix would be in 5 years. Otherwise, I would have bought the stock. But whether I was 51% certain or was I 75% certain of where the business would be – I still never would have guessed where the stock would be today. I’d have guessed that if Netflix hit all the expectations I had for it (as a business) the stock might return 20% to 30% a year over the next 5 years – not 80% a year.

If you look at Buffett's investment in Coke, the P/E on that stock expanded by about 13% a year in the first 10 years he owned the stock. And I'm sure Buffett would say the quality of those earnings deteriorated as well. Now, I don't mean to say that Buffett was wrong buying Coke at a P/E of 15-17 or whatever he bought it at and believing it deserved a P/E of 25 sometime down the road. We can see from the stock's subsequent history that outside of moments of real financial stress in the market - Coke hasn't really had a P/E of 15-17 since Buffett bought it almost 30 years ago. So, he was justified in the belief (if he had any such belief) that Coke deserved an expansion of its P/E ratio. But, Buffett wouldn't be justified in believing Coke deserved a re-rating in the P/E from 15-17 to say 45-51 (3 times expansion). And yet, at times, Coke actually traded at such a P/E and the stock's long-term performance would have looked amazingly good during those periods. 

That brings us to the classic question: Should Warren Buffett have sold Coke in the late 1990s?

He has a different calculus than the rest of us. Berkshire brings in a lot more new cash to invest all the time. So, I think by not buying more of stocks he already owns he is watering them down in much the same way an individual investor would be when he sells all the stocks he owns in equal proportions.

This is the approach I've chosen to take.

You can see that with my latest purchase. At the start of October, I put 50% of my portfolio into one stock. However, I only had about 30% of my portfolio in cash at the time. So, I had to sell something. Instead of selling all of BWXT (the most expensive stock I owned) I sold about one-third of BWXT and one-third of Frost which means I express no preference when it comes to selling. Now, actually I prefer Frost over BWXT at today’s prices. But, I forced myself to ignore that. I’m trying to only express my preferences in buy decisions – not sell decisions, from now on. Basically, I’m trying to “buy right” and then just forget about what I own.

If I continue to apply this rule, it means I will slowly sell down stocks I own over several years making them a smaller and smaller part of my portfolio as they age.

For example, I took a 50% just now. If I buy a new 20% in 2018 and another new 20% in 2019 and then another new 20% position in 2020, and so on…

That would hypothetically (if the 50% position had the same performance as my other stocks) result in the stock I just bought being 50% of my portfolio in 2017, 40% of my portfolio in 2018, 32% of my portfolio in 2019, 26% of my portfolio in 2020, 20% of my portfolio in 2021, and so on.

That’s not a true “buy and hold” approach. But, it both relieves me of having to make sell decisions and yet also gradually clears out my old ideas (which have presumably risen closer to their intrinsic value) and replaces them with my new (and hopefully cheaper) ideas.

This is the approach I think makes the most sense. I think buy and hold makes a tremendous amount of sense and I recommend it to people who have a constant influx of cash into their savings and don't have a ton of time to ferret out new stock ideas.

In fact, for the average stock picker my advice is:

·         Take everything you saved this year

·         Buy just one stock with all those savings

·         Never sell that stock

·         Repeat every year

That might lead you into situations like Activision and lead you to hold them forever. It would certainly cause you to be focused on what I think matters most: your highest conviction buys. 

Superficially, it would also seem that this approach should lead to wide diversification. However, in practice, this is unlikely to happen. Your winners will become much bigger than your losers if you truly never sell the winners.

I think it's important - especially as I write this in October of 2017 - to consider how with hindsight the results of buying and holding the right stocks through a bull market look better than we should perhaps expect we can do in the future. There are stocks that may have looked like Activision and didn't work out. And then there are periods (like 1965-1982) where multiples simply do not expand on stocks. 

However, have I often sold too soon?

Yes. There are definitely chances I missed to buy and or simply hold a business I knew well and liked. But, I'd also say that much of the subsequent return in these stocks is something I couldn't have counted on (an expanding multiple beyond the historical norm).

I think it's reasonable to buy an undiscovered or misunderstood stock at a low multiple and expect a one-time re-rating of the correct price multiple as that stock is discovered and better understood by the public. However, this is a one time and one time only bump in the stock that may take 3, 5, or even 10 years. A multiple expansion from an EV/EBITDA of 6 to 12 may be justified in cases where you know just how great a business is and the market doesn't yet. An expansion from an EV/EBITDA of 12 to 24 won't be justified ever. But, it will still happen to some stocks you own and while you own it this second expansion may not feel that different from the first (fully justified one).

The thing about bull markets both in the overall market and in specific stocks you own too is that a good idea is first latched on to by a few very smart people and then over time some less and less intelligent people doing less and less in-depth work of their own on that stock take this good idea and they take it way too far. 

When I tell the story of BWX Technologies (BWXT) it makes a great deal of sense at half of today's price (about where I bought it). But, that same story makes a lot less sense as a reason to buy the stock today. The story is the same: BWX Technologies is still a high return, monopoly business that can pass inflation along to its customer (the U.S. Navy). It's clear that you should buy such a business at a P/E of 15. At a P/E of 30, it's less clear. And yet it seems more certain (because of the stock's multiple expansion) to people looking at the stock today than when I first wrote about it.

That's the fear I have when talking about some of these businesses. What you want is to buy an above average business at a multiple below what will be justified in the future when the stock is still undiscovered or misunderstood. 

When I ask for examples of great businesses from people, they bring me examples of businesses that are already recognized by the market as being great.

If you read what I write about the stocks I own – Frost, BWXT, etc. – or stocks I would seriously consider buying (Omnicom, Howden Joinery, etc.) you’ll notice that I’m saying both:

1)      I think this is a great business AND

2)      I don’t think the market fully appreciates this is a great business

So, with BWXT I’ll say that unlike with other stocks you have greater visibility into the long-range buying plans of BWXT’s customer in real terms. With the stock at a P/E of 30, this may now be recognized. At a P/E of 15, it wasn’t. With Frost, I always say that this is a far above average bank at a normal Fed Funds Rate. With a Fed Funds Rate at 0% to 1%, I don’t think the market recognizes this. With a Fed Funds Rate at 3% to 4%, it will recognize it.

It’s nice to talk about stocks I bought 15-20 years ago that have worked out well. But, the market recognizes the quality of those businesses today. When I bought J&J Snack Foods (JJSF) like 17 years ago, it wasn’t recognized as being anything other than a mediocre small-cap stock (the P/E was 12). Over the following 17 years, the business changed far less than the stock did. The stock became recognized.

It’s not worth spending even a second thinking about businesses the market already recognizes as great. The problem with FANG stocks isn’t that they aren’t great businesses. It’s that everyone knows they are great businesses.

As a stock picker: Your job is to find a great business no one thinks is a great business yet.

Ask Geoff a Question


Bought a New Stock: 50% Position

by Geoff Gannon


I bought a new stock today. This is the first buy order I’ve placed in about 2 years.

As of this moment, the new stock is just under 50% of my portfolio.

To fund this purchase, I had to:

·         Use my 30% cash balance

·         Sell one-third of my position in Frost (CFR)

·         Sell one-third of my position in BWX Technologies (BWXT).

I’ll reveal the name of this new position on the blog sometime within the next 30 days. 

Ask Geoff a Question