I haven’t done a good job of finding new ideas.
Before last year, I had never researched NACCO (NC). And then I did research and buy that stock. So, that counts as one new idea. It wasn’t my idea. I didn’t come up with it myself. I read a blog post about it. But, there are no points for originality in investing. A well stolen idea is as good as an idea you found off some custom screen you ran.
Finding new ideas is also a big problem for the people who email me. I get a lot of emails from people who have heard of this stock, might be interested in it, etc. and want my thoughts on it – but, they have yet to sit down and read the 10-K. They’re not sure if reading this particular 10-K is worth their time and effort.
How do you decide if you should spend your limited time on reading this particular stock’s 10-K as opposed to some other 10-K?
Let's talk in terms of 3 things: 1) What do you need to know to value a stock? 2) What can you figure out quickly? and 3) What do you already know about this stock before you even start?
Try to Make Key Simplifying Assumptions
This is a hard one to explain. The best use of your time is something where you can do a quick sanity check. It’s important to simplify – yes, often by just guessing – early on in your research process. There are thousands of stocks out there. Even if you read one 10-K a week like I recommend, you are passing up the chance to research something like 99% of the stocks you could be looking at.
Last week, I wrote an article about General Electric (GE) for my Focused Compounding website. The two most important things I did in that article was say:
1. I want a 35% margin of safety (if GE is worth $10, I want to pay no more than $6.50 for it)
2. Historically, Aviation and Power were the business segments that contributed the most to GE’s profits
I looked at the past 5 years of results at GE. I saw that two business units – Aviation and Power – may have contributed something like 60% to 75% of the company’s “industrial” profits in recent years. I only looked at industrial profits, because trying to value GE Capital would take a lot of time and effort and might not even be possible. Healthcare might be worth more than Power for all I know. But, starting off, I can’t make a lot of assumptions about the future. I have to start with the past.
So, what I did is some quick math. I said, if GE’s Aviation and Power businesses add up to something like 65% of the company’s value (we’re being real rough here) and I want a 35% margin of safety – then, I’m basically saying I’d only be interested in GE if the entire market cap of the company as of this moment was below my combined appraisal value of Aviation plus Power. Another way to put this is that I’d be willing to consider the stock if I thought all the other businesses (trains, oil and gas, renewable energy, lightning, etc.) could offset any negative value from a pension deficit, GE Capital, etc. and still leave me with some margin of error. So, I asked what kind of multiple would I have to appraise Aviation and Power at to equal the current market cap. If I got a number that said I needed to use a pre-tax earnings multiple of 20 – then, I’d drop the stock right there. But, if I got a number that said I only needed to use a pre-tax earnings multiple of 10 – well, then, GE was an idea I could follow-up on.
GE is a big, complicated business. It’s not the kind of thing I’d normally look at. But, that’s the way you check to see if an idea is simple enough or not. In this case, the idea might – I stress might – be simple enough. It is true that an investor could – if they were excited enough about Aviation and Power and maybe Healthcare – invest in GE without really needing to calculate the value of the other parts of the company. There’s a price where that would be true.
Contrast this with another stock I glanced at recently: Greenlight Re (GLRE). Greenlight Re is a reinsurance company where David Einhorn handles investments. It trades below book value. Any company that holds investment type assets and trades below book value is potentially interesting. But, here we have two problems that complicate things. One, David Einhorn is a long/short investor. It’s hard for me to know what a long/short investor’s returns will be. It would be easier for me to estimate the company’s likely returns on its investment portfolio if it was simply a long-only portfolio. Two, the company is a reinsurer that often operates at a combined ratio above 100. This means “float” costs the company something. Again, this blocks me from a key simplification. If I was looking at an insurer that usually has a combined ratio below 100, I could easily know that at a price below book value – it’s worth researching. For example, I bought Bancinsurance at under 70% of book value, because I knew it had a combined ratio below 100 in 28 of the last 30 years. It’s a safe bet to assume an insurer with a combined ratio under 100 in almost all years is worth more than book value. It’s not a safe bet to assume that if a company usually has a combined ratio above 100. So, Greenlight Re is a hard situation for me to simplify. It’s obviously more of a value investment than General Electric. But, the key simplifying assumptions I wanted to make – assume an investment return of “X”, assume an underwriting profit of “Y” – are difficult to make here. If I went on to study Greenlight Re closely, I might still find it’s a good stock. But, the situation – as it is now – is the kind of thing that tends to lead you to an inconclusive result as far as initial research goes.
Try to Find Stocks Where Part of the Equation is Fixed and Certain
The toughest stocks to analyze are ones where both the issue of the business value you’re getting and the price you’re paying are a little fuzzy. I wrote about another stock, U.S. Lime (USLM), for Focused Compounding. I wouldn’t say the stock price of U.S. Lime is extraordinarily cheap right now. And I can’t say I know exactly what lime demand will be in 5 years. But, I felt I knew there wouldn’t be more lime producers in 5 years and there might be fewer producers. This is a huge, key simplifying assumption. If the industry is low competition, low change, etc. I can assume returns on capital will be fine. So, that means there’s a price where the stock would be a good buy if the capital allocation was good. For an investment in even a no growth wide moat stock to turn out badly, you’d usually need to either pay too high a price or have poor capital allocation by the company. The presence of a moat simplifies things. You shouldn’t buy a wide moat company just because it has a moat. You should buy it because it’s cheap, will grow, has good capital allocation, etc. The moat isn’t going to give you a good result. The moat is just going to increase the confidence you have in getting the good result you would expect from paying a low price, having fast growth, etc.
So, if you know quality is high and constant in the sense that there’s a moat – it’s an easier stock to analyze. But, a price that’s easy to calculate works well too. For example, a company that owns timberland might not be considered a great business – but, I can check what it’s selling for in terms of enterprise value divided by acres of timberland. If acres of timberland often go for $1,200 and this company trades for a price that’s only $800 per acre – that’s a good stock to research next. Of course, there might be a reason this company should have a big discount per acre. But, it’s an easy thing to research. Stocks that own shares in other public companies work the same way. You can see the discount to NAV. So, now the question becomes: is it justified? Why? What could justify such a discount? Is that what I’m seeing here?
You can either ask the question of what stock to research next from the Warren Buffett side of things or the Ben Graham side of things. Does it have a wide moat? Then, it’s easier to research. Does it have a hard value? Then, it’s easier to research. Stocks that don’t have a moat and are valued on earnings rather than assets are usually the toughest stocks to research. This past year, someone asked me about Micron Technology (MU). I don’t know how to value Micron. That would be a very hard stock to research.
Try to Focus on Evergreen Ideas
Any business that changes a lot is hard to value. Also, if such a business isn’t cheap now – your research is unlikely to pay off later. But, if you research a business that stays pretty much the same over time, you might get to use the research you do now to buy the stock years from now. For example, I bought Bancinsurance several years after I first researched it. When I first researched it, I thought it was a good, fine, understandable business – but it wasn’t shockingly cheap. Later, it looked shockingly cheap and I bought it. In between, the company had problems. But, most of the core of what I’d analyzed before those problems was still important when I came around a second time to analyzing the stock.
Wide moat businesses are often good research candidates, because stock prices change a lot and yet wide moat businesses don’t change a lot. Likewise, a company made up of some key assets like certain real estate holdings doesn’t change that much. In 2017, I researched Howard Hughes (HHC). Much of the value in that stock is in a few key developments that will take many, many years to be fully sold off. If you research Summerlin, Nevada in 2017 – much of what you decide about Summerlin is going to have just as much usefulness in making an investment decision in 2022. So, again, evergreen earnings or evergreen assets both work fine.
On the Other Hand: Look for Stuff that Might Be Actionable
If you can’t imagine yourself buying this stock after it’s dropped 20% from today’s price – just move on. This goes against my point about evergreen ideas. If someone thinks Domino’s (DPZ) is an amazing business – why not spend time researching it now?
Domino’s might be a great business. But, if it’s so expensive that you can’t imagine buying it even after a 20% dip from here, your time is better spent looking at stocks like Howden Joinery, Omnicom (OMC), Vertu Motors, and Hunter Douglas. Those stocks are closer to the price where they might seem like an obvious buy. They’re understandable enough and cheap enough that they’re probably a better use of your time right now. If you’re a growth investor who might pay a P/E of 40 for something – this rule doesn’t apply to you. But, I’ve seen a lot of value investors waste time looking at stocks with P/Es of 30 or 40, when I know this investor isn’t going to touch anything till it hits a P/E under 15.
Sadly for value investors, there are some stocks that are definitely good businesses and might even be good stocks but manage to stay above the price level where you’d be likely to ever buy them. Value investors are biased toward paying low prices. So, even if a value investor liked Starbucks during its big growth phase – the stock tended to always be too expensive to buy. On a recent podcast, Andrew and I mentioned Copart (CPRT). He said Copart was a stock that you wait to get cheap enough to buy and it never does. That’s what being a value investor is. Value investors make the mistake of not paying up enough for some stocks. Growth investors make other mistakes. If you have all the time in the world, it’s good to analyze plenty of stocks that aren’t cheap right now. But, most people who read this blog don’t read many 10-Ks. If you’re already reading one 10-K a week, then you might want to alternate between one “cheap” idea and one “good” but expensive stock. You’d still read about 26 cheap stocks a year. So, I don’t have any problem with that approach for someone who is really doing as I recommend and tackling one 10-K a week. Most of you aren’t. So, you probably want to start by focusing on something you might actually buy at a price not too far from today’s price. If you can’t imagine yourself ever paying even a 20 P/E for a stock – don’t look for stocks that currently have a P/E above 25.
Start with Stocks You Know Something About
This one’s simple and surprisingly useful. It’s the Peter Lynch approach of “buy what you know”. I’d re-phrase it as “research what you know”. My office building is run by Regus which is part of the U.K. workspace company IWG. It’s a good idea for me to research IWG. I have more background knowledge about the company’s operations than many investors do. Likewise, I could ask myself: where do I eat? Have I been to Zoe’s Kitchen (ZOES), Potbelly (PBPB), Dave & Buster’s (PLAY) etc.? If I have, it would make more sense for me to research them. My apartment building is owned by a public company as well. It would make sense for me to research that company.
But, it goes beyond that.
You just have to pay extra attention to investing relevant aspects of your everyday life. For example, I was talking to someone here where I live and they said “Why do they have a Sears Auto Center there, that’s so weird.” The presence of Sears at an otherwise nice mall seemed really out of place. And what I said was, “Oh, that’s a Seritage property.” Seritage (SRG) is a spin-off from Sears that controls some real estate and leases it at far below market rates to Sears. The plan is to eventually shift from having Sears as a tenant to having tenants who pay the going rate. In some cases, this will involve re-development of the property. I’m sure many people know the Seritage story. But, if you actually live the experience of having a normal, non-investing type person say to you, “That makes no sense, why is there a Sears here?”, you may have more of an appreciation for the re-development potential in some of Seritage’s portfolio. Of course, there’s the potential for bias. I might live near a better mall than most of what Seritage is at, I might live in a better apartment building that most of what’s in that company’s portfolio, etc. But, at least you have some information to start from. Knowledge of the local real estate market can increase your confidence in making an investment. Andrew bought stock in Green Brick Partners (GRBK). I don’t think he would have put as much into that stock if he hadn’t lived in the same Dallas area where the company does much of its building. Likewise, I lived in North Jersey and had worked at a Village Supermarket (VLGEA) Shop-Rite location. I was more confident than the market – this is back near the turn of the millennium – that competition wasn’t going to intensify all that much for this company, because I knew locations where you could site a large supermarket were rare in that part of the country.
But, remember: that’s no reason to buy a stock. Just knowing a stock doesn’t help. I bought a cheap stock. Village was really, really cheap when I bought the stock. The only thing my local knowledge gave me was confidence that the stock wasn’t cheap because there was going to be a lot of competition coming in. Green Brick Partners was also cheap when Andrew bought it. He would have had confidence that there was nothing wrong with the local housing market.
Local knowledge often retains its usefulness for a long time. But, even that kind of knowledge does diminish over the years. For example, if you asked me now if Village had as wide a moat around its stores as it did in 1999 – I’d say no. There have been new, smaller store formats introduced by some chains (like The Fresh Market) and then to a much lesser extent there’s been more interest in online groceries. For now, it’s the small format stores that would worry me. But, the basic fact remains: it’s still very hard to put a big format store anywhere near an existing Shop-Rite in that area. That’s local knowledge that’s useful to have. However, it’s a lot more useful when the stock trades at a P/E of 6 than when it trades at a P/E of 16.
Value investors underrate Peter Lynch’s advice. He has really smart things to say about bottom up stock picking. And focusing on companies you already know a little about is excellent advice.
You can reach Geoff by emailing him: firstname.lastname@example.org, following him on Twitter: @GeoffGannon, or listening to his podcast. His stock specific write-ups appear on a subscriber supported website: Focused Compounding.