The Poor Investor

Investigatory Value Investing

Category Archives: Investment Philosophy

Turn Your Portfolio Upside-Down

Often people tell you exactly what stocks they’re buying—what stocks you should buy—but, you don’t often hear others tell you what stocks not to buy.  Charlie Munger often quotes Carl Gustav Jacob Jacobi by saying, “Invert, always invert.”  This quote merely states that the solution to a problem might be in its opposite.  So how can this apply to stocks?

There are many ways in which this is applicable.  One of the most important things to consider is the fact that nowadays you have nearly unlimited opportunities in the market.  Anything you want to invest in nowadays, you probably can—from Swiss gold to soybeans.  Furthermore, you can buy and sell whenever you please, especially with today’s low transaction fees.

Well, what about the opposite?  What if you didn’t have nearly unlimited opportunities?

Warren Buffett often talks about the idea of having a “punch card” with only 20 punches on it.  He posits that if investors had only 20 investment decisions they could make in their lifetime and each time they made an investment they had to “punch” their card, would they make the same decisions?  If you were forced to invest in this way, would you buy the stocks you are buying now?

Well, let’s think about the opposite.  With only 20 punches, what types of investments would you not want to invest in?  Well, to first think about what not to invest in, you need to first think about what you would want to invest in.

To keep it simple, I would want to invest in companies that have all of the following qualities:

  • Strong, durable competitive advantage(s)
  • Large profit margin to sustain difficult times
  • Long operating history showing interest for shareholders
  • Business model not subject to changes in technology
  • Reasonably valued

So, what companies do not have the above qualities?

Car companies are a good case-in-point for the first two aspects.  For one, no car company, besides Tesla, really has any unique quality.  Car companies may have recognizable brands but no one company really offers anything truly different from any of the others.  I’m actually surprised GM is a Buffett investment.  As far as the auto industry goes, Tesla is the only company that stands out as being “different” from the crowd and has any real durable competitive advantage outside of brand recognition.  Thus, I’d stay away from all automobile investments excluding Tesla.  I certainly wouldn’t use one of my card punches here.

The second point, having a large profit margin, is another problem for car companies.  Some of the large auto companies’ net margins for 2014 are as follows: Ford- 2.21%, Honda- 4.85%, Toyota- 7.10%, GM- 1.8%, Fiat- 1.04%.  Apart from Toyota, none of these companies had a large net margin.  And over the last 4 years Toyota also struggled.  Toyota’s net margin was 1.11% in 2010, 2.15% in 2011, 1.53% in 2012, and 4.36% in 2013.  Clearly, there’s not much room there to make mistakes as a car company.  The profit margins are just too slim.  I’m not going to punch my card for slim margins, are you?

Car companies do have long operating histories though.  Here, they get a pass.  But what investments exist today that do not have long histories?  Generally, these are found in the technology sphere.  There’s Box, Inc. founded in 2006, LinkedIn launched in 2003, Facebook in 2004, Twitter in 2006, Groupon in 2008, Zynga in 2007, King Digital Entertainment (markers of Candy Crush) in 2003 and Yelp in 2004.  While these companies may seem like they’ve “been around a while,” generally we want to look for companies that have been around for decades with a stable operating history.  Companies with stable operating histories give you an idea of how they treat shareholders.  For example, you want to ask questions like: Have they raised dividends consistently?  Were they efficiently allocating capital?  Were they honest with shareholders?  Did they buy back shares?  This is not to say the above companies won’t do those things, but there’s just not a long enough timeline to answer these questions adequately.  Ask yourself again, are you willing to bet your punches on it?

To put this in perspective, let’s look at some lesser-known companies: Hawkins was founded in 1938, Cincinnati Financial in 1968, Stepan Company in 1932, United Guardian in 1942, C.R. Bard Inc. in 1907, Nucor in 1940 (with origins dating back to 1900).  These are the types of timeframes I’m referring to when I think of a long operating history.  The history shows not only what management has accomplished, but also that the company has a solid business model that will sustain it over the years.  Also, many of these companies have both been giving and raising dividends regularly for over 25 years.  It’s usually the names you never heard at first that turn out to be your truly great investments.

In contrast are the technology companies mentioned above (the names you know), there’s a good chance these companies won’t be around very long.  There is good reason for this and it brings us to the next point: business model not subject to changes in technology.  Almost all technology companies will have trouble withstanding the test of time due to the fact that technology is always changing.  Warren Buffett often says his favorite holding period is forever.  Do you think you could hold the technology companies mentioned above forever?  Think about the 20 punches on your card.  Do you want to use a few of these punches on technology companies?  That’s for you to decide but “no thanks” over here.

Even whole industries can be vulnerable.  A problem likely to occur with car companies is that they won’t withstand the test of time.  New competitors are moving in (like Tesla) to revolutionize the car market.  Even Apple is thinking about entering the market.  The last 50 years won’t be like the next 50 years in the automobile industry.  Always be on the lookout for underlying paradigm shifts like these.

Next brings us to the point of reasonable valuations.  It is easy to readily point out some of the technology companies mentioned above.  LinkedIn trades at 15 times sales, 10 times book value, 132 times EBITDA, and its earnings are negative.  Can it grow its earnings fast enough to sustain these levels?  Perhaps, but I’m not going to waste one of my 20 punches on it.  Nor will I waste my punches on Twitter selling at 21 times sales with no earnings, Facebook at 18 times sales and 73 times earnings, Box at 12 times sales and 16 times book, and Yelp at 100 times earnings, 9 times sales and 130 times EBITDA.  I’m not saying these companies won’t do well—they may do fabulously— I’m just not going to bet my punches on it.

Think about your current investments.  Did you waste one of your 20 punches?  Would you bet one of your punches on a whole industry?  Do you own a company in one of those industries that you wouldn’t use a punch on?  It’s always good to turn things upside-down and look at them in completely the opposite way.  For instance, do you have a case for shorting any of the stocks in your portfolio?  If so, what’s the potential downside?  And what if you could never sell any of the stocks you purchased, would you have bought any of them?  Reevaluate your decisions.  Think critically.  And invert, always invert.

Disclosure: Long UG

Would You Invest in Yourself?

First off, no, I am not talking about saving for retirement. I am asking, would you literally invest in yourself?

This may appear to be a rather silly question, although, I think it is an important one, whether you’re an investor or not. However, in essence it boils down to the oft-heard Plato quote, attributed to Socrates, “the life which is unexamined is not worth living.” And to take it one step further, if you would invest in yourself, how much? Are there people you know you’d rather invest more in? Why? Lastly, if you wouldn’t invest in yourself, why not?

A few reasons you might want to invest in yourself are: you have a good job, you have a good income, you’re a person of integrity, you’re healthy and you’re wise beyond your years. If you wouldn’t want to invest in yourself, maybe it is because: you’re an alcoholic, you spend all your free time watching TV, you have a low income, you have too much debt, you’re in poor health or you’re not that smart.

The good news is, whether you would invest in yourself or not, you can still increase your personal brand equity. And why not? Why wouldn’t you want to be a good investment? You can increase your knowledge and educate yourself, strengthen your integrity and start becoming a better person, get off the couch and start exercising more. Whatever it is, you can improve it. Even if you already consider yourself a great investment, as a human, there is always room for improvement. You can always be a better person, more friendly, more knowledgeable, more wise. Think bigger.

Odds are, there is probably someone you’d invest in more than yourself. So why is this? You’re the one in control of your life, yet you’d rather put your hard-earned money in another person? This, logically, seems absurd. Your investment is out of your control. Yet, I bet there are many people who would rather invest in others than themselves. Are these people more generous? Are they more friendly? More virtuous? Have more integrity? Are they smarter? What is it that they have that you admire so much? Take that person, subtract yourself, and what are you left with? Become those things you find you’re missing.

Reverse engineer your life. What is it you want to be and how do you plan on getting there? No one knows how many days they have, but on average, there are about 30,000 days to make this life into something great. How many of those days have you already wasted? Do the math. How many of those days do you have left to turn yourself into the greatest investment on the planet? Calculate it out. Plan. Use each of those days you have left wisely.

Are you content with mediocrity?

You only get one trip around this Earth. You should be the kind of person you, as well as others, would want to invest in.

Become that person.

Notes: Growing your wealth is a great thing but means nothing if you don’t grow your internal wealth. Like your external investments, internal investments grow exponentially. As more and more external success comes to you, there is greater and greater need for internal enrichment. The internal and external must be balanced or the external will slip away. There’s a good chance that externally you aren’t where you expected to be because internally you weren’t ready. By investing in your internal self you can ensure that your external success doesn’t slip through your fingers or go wasted.

Higgs Boson, Markowitz, and Graham

From Roumell Asset Management’s quarterly report— I feel this exemplifies the philosophy I espouse on this website quite well.  

A “unified theory” has long been the Holy Grail in theoretical physics that could account for both subatomic and universal realities. It appears the field has made a giant leap forward with the recent discovery of the Higgs boson particle, commonly referred to as the “God particle.” Higgs boson accounts for the various strains of information, analyses, and data that physicists, working with different approaches, have gained over the years from their efforts to better understand our universe. While some physicists prefer to focus on big-picture questions like how time and space interact, others prefer to ask why some particles have mass, while others, such as light, do not. Different starting points, same goal: knowledge.

Although investing is certainly not a hard science, it too has long pursued its own unified theory. On the one hand, financial planners and advisers use asset allocation to construct portfolios with multiple asset classes in order to spread risk and reduce volatility. Harry M. Markowitz is known for his pioneering work on Modern Portfolio Theory. Markowitz’s Portfolio Selection, which he wrote in 1952 while a graduate student at the University of Chicago, serves as the framework for planners using asset allocation as the primary portfolio construction tool. Markowitz argued that a portfolio should be designed using uncorrelated asset classes to maximize returns with the greatest efficiency (reduced volatility).

The shortcomings of the asset allocation model include today’s high level of correlation among asset classes. In addition, performance is tied to overall market returns and leaves little opportunity to exploit market inefficiencies. Of course, many investors in this camp believe security prices reflect all known information and are thus always efficiently priced.

In contrast to the investment allocators are individual securities investors. For value investors like us, Benjamin Graham wrote the gospel with its emphasis on specific security characteristics, margin of safety, and the temperament to see the process to fruition. Graham elegantly stated in 1934, “The field of analytical work may be said to rest upon a two-fold assumption: first, that the market price is frequently out of line with the true value; and, second, that there is an inherent tendency for those disparities to correct themselves.” The mantra for security-specific investors is that market price diverges from intrinsic value often enough to add investment value, particularly in smaller overlooked and/or out-of-favor securities.

As decided adherents of the security-specific, bottom-up value investment camp, Roumell Asset Management does not begin with a belief that we should own a little of everything. Rather, we begin by searching for value in the marketplace, wherever it may be. We firmly believe that obsessing about price paid has a far greater impact on securing respectable returns than gauging what John Maynard Keynes referred to as “the average opinion of the average opinion.” There are multitudes of analysts, commentators, and investors putting forth their opinions about the upcoming direction of gold bullion, U.S. Treasury bonds, and the stock market. We have nothing of substantive value to add to this conversation. It’s not what we do.

A subtle but highly important distinction in reviewing market efficiency literature is necessary, in our view. To paraphrase Warren Buffett, the difference between markets being mostly efficient and always efficient is the difference between night and day.  Interestingly, Berkshire Hathaway seeded additional capital to its two recently hired portfolio managers and gave them authority to manage the funds “exactly as they see fit.”

The reasonable question to ask then is how much should a portfolio be constructed with an emphasis on hitting all the major asset-class boxes (large cap growth, small cap value, emerging market stocks, corporate bonds, etc.) versus putting together a portfolio of security-specific-focused managers with the latitude to go anywhere in their search for value? In other words, rather than arguing about who’s “right” perhaps it’s more reasonable to simply ask: How much Markowitz and how much Graham does an investor want in his or her portfolio? An allocator only need believe that markets are inefficient enough to warrant some exposure to security-specific, bottom-up investors, be they growth or value oriented.

We do not seek to change any investor’s mind regarding investment philosophy. Rather, we want our investors to understand our investment philosophy. Our clients can trust that 100% of our own investment capital will remain invested in our portfolio options because determined research, a deep appreciation for value, a contrarian bent, and a steady temperament are what make the most sense to us.

Notes from The Poor Investor:

 It never hurts to reiterate your basic investment philosophy or tenet to see if your actions correlate with that philosophy/tenet.  If they are out of sync either: a) change your actions, or, b) change your philosophy.  However, as a word of caution, before you start investing heavily on your own you should have a philosophy that is sound (meaning it stands the common sense test), proven (is backed up by reliable data/facts), and unchanging (is time-tested and perfect enough that it does not have to be modified).  If you are constantly changing you investment philosophy and/or method of investing then you are setting yourself up for failure.

And with that I’ll leave you with a quote from James P. O’Shaughnessy:

“…we can see the simple truth that using simple, straightforward and time-tested investment strategies leads to the best overall results in virtually all market environments.”

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