The Poor Investor

Investigatory Value Investing

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Pawn Stars, Shark Tank, and Investing

Two of my favorite television shows are Pawn Stars, on the History Channel, and Shark Tank, on ABC.  These shows entertain, and most importantly, inform viewers.  A lot can be learned from both of these shows.  A lot can also be learned from the characters on these shows.  Rick Harrison, part owner of the pawn shop with his father and son, is one such character;  Kevin O’Leary, from Shark Tank, is another.

Rick Harrison started in the pawning business at age 13.  He co-founded the Gold & Silver Pawn Shop in 1988 with his dad, Richard Harrison, at age 23.   When Rick was 8 he had his first grand mal epileptic seizure and was bed-ridden for most of his childhood.  This proved to be fortuitous as he developed his love for reading during this time.  He read lots and lots of books.  One book series he particularly enjoyed was The Great Brain by John D. Fitzgerald, about a boy who always had new schemes to make money.  No need to explain the irony here.  His love of reading became the foundation of his life as he found his love of curiosity and knowledge.  He finds television boring, also ironic in that his show is one of the top hits, and finds reading to be the most exciting way to pass time.  Described in his own words, from his book, License to Pawn, he says “…much of the enjoyment I’ve gained from life has stemmed from a book — either researching some arcane item or reading to learn how to do something practical with my hands.”

So what can we, as investors, learn from Rick Harrison?

  • His love of knowledge and reading is extremely beneficial.  For him, knowledge of an item is key to buying it for the right price.  He also discovers items at antique stores and other pawn shops because of his knowledge.  It is no different in investing.  You must love reading and knowledge.  This includes reading “arcane” material as often times lesser known information can give you a leg up on other investors.  It can also help you find rare opportunities like Rick.  Many of the most successful investors are avid readers.  Warren Buffett admits to loving to read annual reports.  His partner, Charlie Munger, put it best when he said, “In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time – none, zero. You’d be amazed at how much Warren reads – at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.”
  • He knows how to say no.  Rick always turns down items if the price isn’t right and he can’t make a solid return on his investment, even if he loves something.  In investing, you have to learn to pass on many opportunities.  A company many be attractive but the price may not be right.  Other times, the company isn’t right.  Sometimes, you may really like the company or its products but the management is running it into the ground.  These are just a few of the many reasons to pass on a potential company or stock.  No matter how much you like some investment, or some aspect of any investment, you have to learn to say no.  As Peter Lynch says, in Beating the Street, “Never fall in love with a stock; always have an open mind.”
  • If the price is right, he sometimes takes a perceived gamble.  If Rick sees an item that he thinks could be worth $100 to $2500 bucks, sometimes he’ll buy it for $500 dollars because the potential return is so high it’s worth the risk.  Now, why do I call it a perceived gamble?  It all comes down to expected value.  Rick might have an 80% of losing $400 here and a 20% of making $2000.  His expected value is $80.  On average, if he makes bets where the expected value is positive he comes out ahead.  So, it’s not really a gamble.  He’s also not betting the house here, he’s only risking $500, not $1,000,000.  He’s not going to risk his store on something that might be fake.  As such, sometimes you might decide to go after a stock that’s a long shot but has a positive expected value according to your calculations.  So, putting 1-5% of your portfolio in it might be worth it.  The problem with this is that the math will never be 100% accurate in investing.  This is why I say sometimes.  You do it when you’re more certain about the odds — something that won’t happen very often, if ever.  You cannot build a portfolio, or a business for that matter, going after long shots.  A good analogy is found in baseball.  It’s best to swing at the pitches right down the middle and hit base hits with near 75% certainty than swing for home runs, out of the strike zone, with 5% certainty of hitting one.  You can score a lot more points with the base hits.
  •  He always pays a lot less for something than it’s worth.  If he believes an item is worth $2000 or an expert tells him he can get $2000-5000 for an item, he never pays $2000 for it.  He’ll usually pay something like $1500 for the item to make sure he can profit off of it.  In investing, this is called margin of safety.  You don’t buy stocks to make 1% off of them.  You factor in a larger margin of safety than that, perhaps 20% or so, in case you make a mistake.  Why?  Because you, and Rick Harrison, never know what someone will actually pay for something, be it a stock or a piece of antique furniture.  The stock could actually be worth $1.10, you pay $1.05 for it, but the market might never price it at $1.10.  Just like the item Rick bought might be worth $2000, but he might only be able to get $1800 in the market.  
  • Always factors in the amount of time it will take him to sell something.  When Rick buys an item, like a book, that might take a lot longer to sell than, say, a signed Beatles album, he factors that in to what he’ll pay for it.  It also takes up room in his store for a longer period of time.  Just like if you buy a stock that might take 3-5 years to appreciate in value versus one that might take only 6 months to 1 year to appreciate the same amount, you would want to pay a lot less for the former to factor in opportunity cost, inflation, and the time value of money.

A lot more could be said about the show, and Rick, as it relates to investing, but suffice it to say the show is full of tidbits and useful information that can work to your advantage as an investor.

Likewise, Shark Tank is also a great show for an individual investor to watch.   While I won’t go much into the show and how it relates to investing, as a lot of this is self-explanatory for anyone who watches it, it may, or may not, surprise you to know that Kevin O’Leary, known as “Mr. Wonderful” on the show, also runs his own mutual fund.

Besides being a television personality, Kevin O’Leary is a Canadian entrepreneur and investor.  He started a software company called Softkey with $10,000 from his mother and grew the company to ~$3.8 billion when it was purchased by Mattel (at that time it was known as The Learning Company).  He also had several other successes that you can read all about in his book.

O’Leary Funds was started in 2008 when Kevin O’Learly was looking for someone to manage his money but couldn’t find the right person.   The company was co-founded by Connor O’Brien.  The company’s philosophy is simple, to “provide investors with value and yield.”  It does that through three core principles, “income, capital appreciation, and capital preservation,” according to the company’s website.   The company also describes its funds as being long-term oriented and disciplined.

So what is Kevin O’Leary’s investing philosophy/approach?

  • He never buys a stock that doesn’t pay a dividend.  This is something his mother taught him long ago and he firmly believes in it.
  • He buys companies that are growing free-cash flow and calls earnings “mumbo-jumbo,” saying, “you can’t lie about cash.”
  • Believes commodities aren’t attractive but the service providers are, saying, “I’d rather own the pipeline than the oil that flows through it.”  He believes if you own commodities you are speculating, not investing as commodities don’t produce a yield.
  • Thinks diversification is the only “free lunch” in investing and that you should not dedicate more than 5% of your portfolio to one investment.  He also owns multiple currencies as a way of diversifying.
  • Uses gold as a “buffer,” or “stabilizer,” and leaves it at 5% of his portfolio.  Gold, to him, is not an investment, merely a hedge that he sells when it becomes more than 5% of his portfolio and buys when it becomes less than 5%.
  • Likes to invest in countries where GDP is growing at >3%.  Some examples he gives are Brazil, India, and China.
  • Believes China will overtake US global economic leader and invests accordingly.
  • 5% of his net worth goes to venture deals.
  • Believes people should invest 20% of your earnings the day you start working for the rest of your life.
  • Believes people should always “spend the interest, never the principal.”

Here is an example from his “Global Equity Yield Fund” of what he is buying:

While a lot can be learned from these two individuals about investing specifics, the most important lesson lies between the lines.  What makes Rick Harrison and Kevin O’Learly so successful at what they do is their passion and discipline.  They believe in what they do and they hardly ever deviate from their rules.  The times they do, you can watch with your own eyes the lessons they learn and exactly how they get burnt by not being disciplined.  You can even hear in their own words why they don’t do this or that because they have learned from their mistakes.  Above all, they’re nice and honest guys (despite the fact that Kevin is seen as cold-blooded on the show).  So turn off Mad Money with Jim Cramer, because it will only drive you mad as you watch all your money fly out the window, and turn on Pawn Stars and Shark Tank and actually learn how to be a successful investor.

Apple’s Stock and the Voting Machine

Peter Lynch put it quite simply by saying, “Buy what you know.”  Now, I’d be remiss if I didn’t mention that there was a study showing this often does not work.  Here, however, it does.

The other day I walked into an Apple store to check out the iPad mini.  It was like walking into a swarm of bees in a beehive.  People were everywhere.  Everyone I know loves Apple’s products and owns at least 1 apple device.  Those I know who don’t own an Apple device plan on buying one in the near future.  I’ve used other products, talked to others who use other products, and everyone admits these devices aren’t as good as Apple devices, this includes: phones, computers, MP3 players, portable tablets, etc.  Apple products are vastly superior in every category, there’s really no debate.  The only reason you wouldn’t buy an Apple product is because you were interested in saving money, with plans to purchase one in the future when the price goes down.

As for the current state of Apple’s stock, Peter Lynch has something else to say about that:

“When even the analysts are bored, it’s time to start buying.”

There’s no question that analysts are bored with Apple, but, really, who cares?  Apple’s stock is a no-brainer at $431.72 as I type right now, March 10, 2013.  The company has $137b in cash.  With that amount of cash Apple could buy Ford and Honda and almost have enough money left over to buy Tata Motors at the companies’ current market valuations.  This is an insane amount of cash for one company.  If Apple has any problem, it’s having too much cash, not the worst problem a company could have.  Personally, I think Apple should follow in the footsteps of IBM and buy a massive amount of its own shares.  Its current share buyback program only allots $10b for this endeavor.  With $137b in cash, that is chump change.

Apple, according to a recent press release, plans on returning a lot of that cash to its shareholders:

“Apple’s management team and Board of Directors have been in active discussions about returning additional cash to shareholders. As part of our review, we will thoroughly evaluate Greenlight Capital’s current proposal to issue some form of preferred stock. We welcome Greenlight’s views and the views of all of our shareholders.”

Cash considerations aside, Apple trades at a current P/E of 9.79.  This is well below the 5-yr. average P/E of 15.6.  Furthermore, Apple’s P/E has never been so far removed from the S&P 500′s P/E as it is now, trading at ~40% below the S&P 500′s (~43% below the Nasdaq’s), with Apple’s average P/E being 64% above the S&P 500′s since 2003.

If the P/E is any indication of investors’ expectation, they don’t seem to believe that Apple will grow much faster than ~10% per year.  However, over the last 5 years Apple has increased earnings by an average of 63% per year.  If Apple continues growing at even half that rate, you’d be looking at EPS of ~$174 by 2017.  This would equate to a share price of $1703.46 at the current P/E.  Now, I must reiterate, this is the half-growth scenario.  Staying at the average current growth rate would mean a share price of $4973.32.  Now, my hypothesis is that we land somewhere towards the lower end near $1703, taking into consideration that the market discounts the future and that the company is not going to realistically grow into being 20% of our economy— but this would still amount to almost a 4-fold gain in under 4 years.  Furthermore, either way growth pans out, you’re looking at what could be over a trillion dollar company sometime in the 2014-2015 range.

With growth and P/E considerations in mind, read these quotes by famous P/E investor John Neff:

“Low p/e multiples usually languished 40 percent to 60 percent below prevailing market multiples.”

“Low p/e companies growing faster than 7 percent a year tipped us off to underappreciated signs of life, particularly accompanied by an attention getting dividend yield.”

As shown earlier, the p/e multiple does languish more than 40% below prevailing market multiples.  Also, Apple is growing much faster than 7 percent with a pretty astonishing dividend, for what I still deem a “growth company,” of 2.46%.

Peter Lynch would love this stock, especially when looking at the P/E in terms of the growth.  While Yahoo gives a PEG of 0.5, Peter Lynch looks at it a slightly different way.  He takes the long-term growth rate, which I estimate on the low side to be 30% (Yahoo’s estimate is 20%), adds the dividend yield, 2.46%, and divides by the P/E ratio, 9.79.  This gives 3.3 for my estimate vs. 2.3 for Yahoo’s.  In One Up on Wall Street Lynch describes the interpretation of these values as the following:

 “Less than a 1 is poor, and 1.5 is okay, but what you’re really looking for is a 2 or better.”

He goes on to give an example of a stock that scores a “3″ and deems it “fabulous.”  If we say that the number will most likely fall somewhere between these two estimates, 2.3-3.3, we’re looking at a stock Peter Lynch would undoubtedly rate as a “strong buy.”

Now, there are concerns that Apple’s moat may be drying up as companies like Google continue to steal market share.  However, in this analysis a margin of safety was added by considering Apple’s stock in light of growth drying up 50%, which isn’t likely to happen.  You have the new Macbook Air coming out, iPad 5, iPad mini 2, iPhone 5s, iMac, Mac mini, just to name a few.  And according to CEO Tim Cook, new products in new categories are on the horizon.  Some anticipate the iWatch as one.  The bottom line: it doesn’t matter what is on the horizon.  Apple could make a car and people would buy it just because it is an Apple product.  Even if Apple didn’t come out with any new products, looking at the company from a zero growth perspective, seen here (provided by Old School Value) for those interested in more advanced valuation methods, Apple’s stock has significant downside protection.

As was said by many great value investors, “Protect the downside and the upside will take care of itself.”

Let’s forget the growth concern altogether. A huge aspect not talked about very often is the strong IP position Apple has, illuminated below, from this article:

“…Apple is falling back on its IP portfolio to protect its market position. Generating revenue by suing other companies is not the ultimate goal of Apple’s recent lawsuits. Rather, each case that Apple wins confirms the validity and enforceability of its patents to its competitors. Apple can then license its patented technologies and designs and charge Google and other competitors for using them, piggybacking on their competitors’ success.

It would appear that Apple’s business model is evolving into two modes. First, use a closed model to develop innovative technologies for sophisticated user markets; patent the utilities and designs that the company engineers. Second, license those utilities and designs to businesses that wish to use them. So long as Apple continues to be the first of its competitors to patent new technologies, combining both modes would create serious revenue for Apple and help it maintain its leadership position.”

So… to reiterate the absolute absurdness of this price and to lighten things up a bit, watch this video of Bill Maher and his guests talking about Apple:

And although this video is older, I still find it extremely relevant to this post:

As Ben Graham famously said, “In the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine.”  Long-term shareholders that buy Apple at this price can take advantage of this phenomenon.

Disclosure: Long AAPL

The Investing Book You Haven’t Read

As a do-it-yourself investor, I love to read investing books. However, there are only a few books that have really had great educational value, the rest were merely entertainment.

Here are the books which have helped me the most:

  1. One Up on Wall Street, by Peter Lynch
  2. The Intelligent Investor, by Benjamin Graham
  3. Poor Charlie’s Almanack, by Charles Munger
  4. Common Stocks and Uncommon Profits, by Phil Fisher
  5. What Works on Wall Street, by James O’Shaughnessy
  6. See below.

Most of these books you’ve probably heard of or read yourself. If you haven’t read them, I suggest you do if you plan on investing on your own. However, there’s one more book (6) that also goes on this list that most people haven’t read. This book, in my opinion, is essential to the go-it-alone investor. The book is called “100 to 1 in the Stock Market,” by Thomas Phelps. The only problem is the book is out of print and hard to find. Your best bet is borrowing it from your local library.

Thomas Phelps offers some good advice as to what to look for when trying to find a 100- to-1 investment:

  1. Inventions that enable us to do things we have always wanted to do but could never do before. 
  2. New methods or new equipment that helps people do commonplace things easier, faster or at less cost than ever before.
  3. Processes or equipment to improve or maintain the quality of a service while reducing or eliminating the labor required.
  4. New and cheaper sources of energy.
  5. New methods of doing essential jobs with less or no ecological damage.
  6. Improved methods or equipment for recycling the materials used by civilized man instead of making mountains of waste and oceans of sewage.
  7. New methods for delivering the morning newspaper without carriers or waste.
  8. New methods or equipment for transporting people and goods on land without wheels.

He even gives 365 examples of 100-to-1 stocks (from 1932-1971) which could have turned $10,000 into $1,000,000 if bought right and held tight.  Some of  the more familiar of these include:

  • J.C. Penney Co.
  • Deere & Co.
  • Abbott Laboratories
  • Dr. Pepper
  • Lockheed
  • Greyhound Corp.
  • Philip Morris
  • Merck & Co.
  • Goodyear Tire & Rubber
  • Motorola
  • International Business Machines
  • Johnson & Johnson

These stocks all gained at least 100x their original value and some obviously much more.

Let’s say you decided to invest using Mr. Phelps’ method using $10,000 (+any additional money for fees).  Furthermore, say you decide to devote a year to trying to uncover 25 stocks which you thought fit the bill as 100-to-1 type companies.  After this, you divide your money equally into the 25, buying $400 of each company, and hold them for 20 years.  If you only identified 3 out of 25 stocks that went 100-to-1, and say the rest went to zero, even factoring in that year you were looking for the stock, you would have a compound annual growth rate of 12.56%, and $120,000.

Here is the CAGR for identifying 1 out of 25 to 10 out of 25:

  1. 6.82%
  2. 10.41%
  3. 12.56%
  4. 14.11%
  5. 15.33%
  6. 16.34%
  7. 17.20%
  8. 17.94%
  9. 18.61%
  10. 19.20%

Even identifying 2 out of 25 is nothing to scoff at, which beats the average S&P 500 return, including dividends, by ~1%.  Not to mention, this method does not include the dividends you might gain from the companies you invest in.

This method, just like any other, is not fool-proof—and although I don’t know the odds, common sense tells me that they are heavily stacked against you in trying to find 100-to-1 type companies.  Keeping that in mind, I leave you with a parable Mr. Phelps shares with us in the beginning of his book:

“Ask and It Shall Be Given to You”

Five poor Arabs slept on the sand. A bright light woke them. Out of it came an angel.
“Each of you can have one wish,” the angel said.
“Praise be to Allah,” exulted the first Arab to catch his breath. “Give me a donkey.”
Instantly a donkey stood at his side.
“Fool,” thought the second Arab. “He should have asked for more.”
“Give me 10 donkeys,” the second Arab begged.
No sooner said than done. He had ten donkeys.
The third Arab had heard and seen how the first two had fared.
“To Allah all things are possible,” he said. “Give me a caravan with a hundred camels, a hundred donkeys, tents, rugs, food, wine, and servants.”
They came so fast that the third Arab was ashamed to be seen in his rags before such an entourage. But his shame did not last long. Deftly his servants dressed him in robes befitting his new status.
The fourth Arab was more than ready when his turn came.
“Make me a king,” he commanded.
So quickly did the crown appear on his head that he bruised his knuckles from scratching where an instant before there had been nothing but an itch. The palace gardens stretched out before him almost as far as the eye could see, and the palace turrets reached so high their pennants were lost in the desert haze.
Having seen his companions in misery ask too little, the fifth Arab resolved to make no such mistake.
“Make me Allah!” he ordered.
In a flash he found himself in sand, covered with leprous sores.

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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