The Poor Investor

Investigatory Value Investing

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Turn Your Portfolio Inside-Out

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

Thank You Facebook and Morgan Stanley

There is much to be said about the Facebook IPO but suffice it to say it was a huge disaster.  There was even talk in the Wall Street Journal about how the whole debacle may have hurt overall investor confidence.  Not surprisingly, the average Joe is probably more than likely to avoid IPOs in the future.  But would the average Joe be right to do so?  Maybe investors should thank Facebook and Morgan Stanley for botching the offering and turning them away from IPOs.

“Three out of four have been long-term disappointments,” said famed investor Peter Lynch of IPOs.  Let’s see if he is right.

From November 1st, 2010 to May 26, 2011 there were 157 IPOs for which I found accurate data.  If you had invested $100 in each of them at their initial offering price, you would have $14,735 today— a total loss of $965.  If you include brokerage fees, assuming $7 per stock bought, you’d be in the red by $2064, not including the fees to sell.  Your chance of investing in one of those 157 IPOs and actually making money (>$1): 36.3%.  Doubling your money or greater: 5.7%.  Hitting a ten-bagger: 0.0%.  Losing 50% or more: 24.2%.  Losing it all: 1.9%.

Turns out Peter Lynch wasn’t too far off.  Out of the IPOs investigated, approximately 3 out of 5 turned out to be long-term disappointments.

After looking over the data it’s unlikely that you’re going to do well with an IPO.  The odds are stacked against you.  Even worse, most companies are too new to have a history to go off of.  There’s also no guarantee that you’re going to get the IPO price.

When asked which stocks he’d avoid in the market at the Berkshire Hathaway annual meeting, Charlie Munger replied, “new issues.”  Perhaps investors should heed that advice.


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