Category: Portfolio Management

Is robo advice enough?

Published on:
January 12, 2020
Reading time: 2 Minutes.
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"If you want to improve the quality of decision," said Daniel Kahneman in an interview to Farnam Street, "Sse algorithms, whenever you can. If you can replace judgments by rules and algorithms, they'll do better."

Robo advisors or automatic trading promises just that. It is a software that calculates your risk and return profile. It shows you the right mix between stocks and bonds. It is an algorithm that attempts to answer how much you need to save today to live in retirement comfortably. You can now build a financial roadmap in a few clicks. Have we discovered the one recipe for success in financial life?

Not so fast. The term 'auto trading' gives the impression that our financial destiny is an airplane ride. Where all we need is to sit down, buckle up, and let the pilot set the journey on auto. But life rarely works that way.

What happens in practice is that life is full of surprises. And what sets you apart from others is how you will manage these surprises. In my view, to prepare for life events, you need to ask questions repeatedly.

For example, should you use your 2019 bonus to upgrade your home or to add to your savings? Or you may read about loan-backed funds and wonder if you should invest in them. Or, perhaps you want to help out a relative and need guidance on how best to manage the process.

Robo advisors will have little to say about these questions.

While I believe auto advisors serve a great purpose [1], they cause harm if not used correctly. From conversations I had with readers, I often see that auto investing creates an illusion. For example, a married couple boasted to me that they were on track for college education for their child and had enough safety nets. But they were taking far too much risk to meet their return objective.

Auto advisors are akin to Fitbit watches [2]. But just as a heart monitoring device cannot create health ,to achieve your financial goals, you will need more support that what auto advisors offer.

The world is better for robo advisors. But to reach your financial goals, you will need more resources.

   
Feedback mechanisms are essential.

Here is what Charlie Munger says on Matt Ridley's The Rational Optimist "

In the course of the book Ridley missed a major factor as to why capitalist economies outperformed all other forms of economics organization."

He continues:

"It isn't just a division of labor that works so well. What communist Russia lacked was a feedback mechanism. The process of free capitalism drowns businesses in feedback. If you do things right, you win new customers, and if you do things wrongs, you start to lose the ones you've got."


We need feedback on our behavior - Just as thriving economies do .

Two illustrations

A reader reached out to me about a year ago. She lived outside of the United States but wanted to buy U.S. real estate, an office building. But she had difficulty in understanding the tax consequences [4], and she was getting mixed opinions whether the investment was a good idea.

She wanted me to decide for her. But instead, we had multiple conversations about why she had wanted to buy a U.S. based property in the first place. She had never asked herself that question. We discovered she had one goal in mind:  to help her grandchildren with college tuition. And once we understood that, we found a better investment vehicle.

Another story happened just a few weeks. A reader was working as an investment banker when we met. He said the hours were long and that his clients expected him to be available 24/7.

He was facing a dilemma. He was contacted by a large organization that offered him a secure job with additional intangible benefits [5]. But he was unsure whether to accept the offer. He feared he was giving up on his dream as a self-made entrepreneur, and that there was no 'upside' to working at the large firm.  

Instead of prescribing a solution, I said: "let's ignore the financial-side, and only consider the domestic-harmony-side between you and your wife and between you and your children. Which occupation would improve the latter side?

He took the offer.

FOOTNOTES: [1] Since robo advisors compete with traditional model of financial planning, the advisory fees dropped. [2] Fitbit measures things. Like the quality of sleep and heart rate. [3] Auto advisor uses a 12-question survey. An insufficient practice, in our opinion. [4] IRS taxes foreign investors at a higher tax bracket than U.S. citizens. [5] Intangible benefits such as work/life balance, an easy commute, and great culture to be part of.

2019 reads

Published on:
December 27, 2019
Reading Time: 3 Minutes.
Last Update:

Business

Security analysis (the classic 1934 edition) by Benjamin Graham, Value Investing by Bruce Greenwald, Dear Fellow Shareholders and Value Investing by Marty Whitman, The Manual of Ideas by John Mihaljevic, The Creature from Jekyll Island by G. Edward Griffin, The Investment Checklist by Michael Shearn, The Great Escape by Angus Deaton, One Up On Wall Street by Peter Lynch, and Damn Right! by Janet Lowe.

Biographies

Working by Robert Cato, Natural Born Heroes by Christopher McDougall, Leonardo da Vinci by Walter Isaacson, The American Spirit and Brave Companions by David McCullough, Ogilvy on Advertising by David Ogilvy, The Rise and Fall...and Rise Again by Gerald Ratner,

Spiritual

To Heal a Fractured World, The Dignity of Difference, Genesis, Exodus, Leviticus, Numbers, and Deuteronomy by Jonathan Sacks, and Here All Along by Sarah Hurwitz.

Philosophy

Freedom and Its Betrayal by Isaiah Berlin, We Hold These Truths by Mortimor Adler, and 21 Lessons for the 21st Century by Yuval Noah Harari.

Fiction

Kitchen Confidential by Anthony Bourdain, Triple by Ken Follett, Don't Let Go and Home by Harlan Coben, Dark Matter by Blake Crouch, and Papillon by Henri Charriere.

Self-help

What Doesn't Kill Us by Scott Carney, Willpower by Roy Baumeister, Flow by Mihaly Csikszentmihalyi, Company of One by Paul Jarvis, The Laws of Human Nature by Robert Green, Atomic Habits by James Clear, Words That Hurt, Words That Heal by Joseph Telushkin, and Indistractable by Nir Eyal.

Science

I Contain Multitudes by Ed Yong, How to Change Your Mind by Michael Pollan, and The Body by Bill Bryson.

Wellness

The Oxygen Advantage by Patrick McKeown, The Obesity Code by Jason Fung, The Big Book of Endurance Training and Racing by Philip Maffetone, and Why We Sleep by Matthew Walker.

History

The Botany of Desire by Michael Pollan, and Marriage, a History by Stephanie Coontz.

Writing

On Writing Well by William Zinsser, and Draft No. 4 by John McPhee, and The Sense of Style by Steven Pinker.

Additional favorites

I  enjoyed a Special Report on South Africa that appeared in The Economist earlier January.

Is Amazon Unstoppable is one of my favorite articles this year. Written by Charles Duhigg, it appeared in the New Yorker on October. I also enjoyed . I enjoyed fall 2019 edition of the Graham and Doddsville newsletter, published by Columbia Business School. You can access Graham and Doddsville Newsletter Archives here.

I enjoyed The Anatomy of a Great Decision, which appeared in Farnam Street this April. Guy Spier published a white paper on Zero Management Fees which I thought was excellent.

The 2019 Annual Review

Published on:
December 14, 2019
Reading Time: 4 Minutes.
Last Update:

The best-performing stocks

Carriage Services (CSV on Nyse), Stericycle (SRCL on Nasdaq), WW International (WW on Nasdaq), and Hyster-Yale (HY on Nyse) are the winner stocks this year.

CSV is up 55%;  SRCL is up 51%; WW is up 33%; and HY is up 41%; Together, they contributed third quarters of this year's return.

The high returns on Carriage and Stericycle are because of the low prices I paid for both companies in the first quarter of this year, and not because of a material change in business fundamentals.

I wrote about Carriage Services in January and about Stericycle in February, during those two months the market  bottomed in 2019.

I can't remember where I got the Carriage idea. But I do remember reading about Stericycle from Laura O'Dell, CFA  of Diamond-Hill.

Download O'Dell's report titled Stericycle: Waste Not, Want Not.

Buying Hyster-Yal was a bet that the geopolitical and trade wars will wane away at some point. And that Mr. Market confused risk with uncertainty.

Buying Hyster-Yal was a bet that the geopolitical and trade wars will wane away at some point. And that Mr. Market confused risk with uncertainty.

When I bought HY in May, the stock traded at what is now the 52-week low, about $45 per share. I published an essay on Hyster-Yale in September. (If you are interested in getting live updates on my stock activities, write to me.)

Oprah Winfrey's Weight Watchers traded $30 a share when I wrote about it. And in less than 48 hours after I bought the stock, because of a gloomy earnings call, WW dropped by a third in price.

But in August, WW bounced back to $30 a share and now trades at $39. Weight Watchers has a recognized brand with sophisticated, deep-pocket investors. But WW is not a compounder stock or a long-term hold - I hope to sell the position soon.

The worst-performing stocks

The three worst-performing stocks, which I define as stocks that experienced a price dropped over a third, were Superior Industries (SUP on Nyse), Gulfport Energy (GPOR on Nasdaq), and Beasley Broadcast Group (BBGI on Nasdaq).

I bought Superior at almost $6 a share in May, and SUP now trades at $3 a share. I first hear about SUP from the legendary investor, Mario Gabelli, of GAM Investments. Even the price halved, I like Superior's business model and believe that SUP offers a dollar of value for 50 cents.

I will write a full-length report on Superior in the upcoming months (Write to me if you would like to know when the article is published.)  

Gulfport is another stock that halved in price. After reading the company's recent public filings, which will leave you in state of gloominess, I decided to buy a few GPOR shares only because I thought Firefly Value Investors, an active investor and hedge fund that specializes in a turnaround situation, may revive operations. Read more about Firefly on the SEC's website.

A contrarian position I took was buying BBGI. At $4 a share, I thought it was a Benjamin-Graham-bargain-stock. The Beasley family owns BBGI for the most part. And the family had done a reasonable job in capital allocation decisions over the past years.

A strategy that focused on tailwinds companies is superior to a strategy that looks at companies facing headwinds.

But I don't see a heroic future for the stock and will likely sell the position in 2020. I have little interest in following the economy of radio stations - especially as the industry continues to experience headwinds.

I should have followed Charlie Munger's who said that "one of the lessons management has learned - and unfortunately, sometimes relearns - is the importance of being in businesses where tailwinds prevail rather than headwinds."   

In short, the three companies, which in total represent 10% of my portfolio, fit in the contrarian, cheap buckets. While I don't expect a particular wondrous future for these positions, the stocks were cheap, and so I bought a few shares. In total, the three companies detracted 35% percent from the annual return.

Two stocks I am most proud of

The first company is GrafTech (EAF on Nyse.), which I bought a month ago. The second company is Mednax (MD on Nyse.), which I purchased in April 2019. I believe that over the next three- to five years, these two companies will have a more meaningful role in the portfolio than all the of all other stocks combined.

Both Mednax and GrafTech had little effect on the portfolio results this year. But they have more value of all portfolio companies.

In April, I published an introductory article on Mednax, and last week I wrote a summary about GrafTech. In my view, Mednax has a CEO that is a great capital allocator, and GrafTech has a unique position in the market place; It is a low-cost producer of needle coke, which I estimate will increase in price - and in demand - over the upcoming years.  

Both Mednax and GrafTech had little effect on the portfolio results this year. But they have more value of all portfolio companies.

A review of the performance

I was more active in the stock market this year than  I would have liked. On Average, I placed small bets (less than 2% of the portfolio size) each month and traded 16 times. GrafTech was an exception. This position now represents about 15% of my portfolio.

To fund the purchases, I exited from 8 companies, for a slight gain[2].

In two cases, I bought and sold the position within a few months [3]. The two companies were Signet Jewelry (SIG on Nyse)  and Flexsteel Industries (FLXS on Nasdaq). The net realized gain from activity was negligible.

I overpaid in both circumstances. And there were too many abrupt changes in the industries. In jewelry industry: the lure of diamonds is waning down. And who knows how will we shop for furniture in the future.

To further summarize the performance in numbers, in 2019, my total return was 8%, which included 5% in capital appreciation and a 4% in dividend and interest received. My portfolio now has 16 names, with the largest position being GrafTech.

Finally, let the digital record show that my goal in 2020 is to own a much more concentrated portfolio: with no more than ten companies by year-end.

FOOTNOTES
[1] My focus here is the 2019 performance. I exclude stocks bought in prior years.
[2] Since I didn't buy these positions in 2019, I excluded them from this article.
[3] A practice I am not fond of.

The Guessing Game

Published on:
September 14, 2019
Last Update:

Mathematicians give names to numbers that cannot be expressed as common fractions. Consider the constant Pi [1] or the square root of two as examples. In this week's essay, I make the case that stock investors should copy how mathematicians dealt with uncertainty [2].

A sense of unease

A few weeks ago I bought shares in Gulfport Energy. At about $4 a share, GPOR traded at  four times the trailing 10-year average earnings per share of $1.84 and at less than a third of its reported tangible book value.

Peer companies traded at much higher valuation. Southwestern Energy (SWN on Nyse) traded at four times the 2018 earnings per share but the 10-year average earnings per share we negative[3]. Southwestern traded at roughly the reported tangible book value.

Another peer company, SM Energy (SM on Nyse), with reported book value per share of $2 and 10-year average earnings per share of $0.26, was trading at 60 times the earnings per share and at about two-thirds of book value.

Yet I felt discomfort after buying Gulfport. I attribute the unease to my inability to understand where Gulfport operations will be in five years. There are three factors that drive Gulfport's business. And all three factors are practically impossible to predict over a five-year time frame.


Three factors that affect natural gas price

First are the macroeconomic issues. These macro factors are heterogeneous and myriad in scope: from consumer spending and confidence levels to employment statistics such as Mass Layoff Statistics (MLS). From prices, productivity and wages variables as indicated by the Consumer Price Index (CPI) to international economic indications such as the German Industrial Production.

Macro factors also include supply and demand variables. For U.S- based natural gas investors, that means a visit to the U.S. Energy Information Administration website, and a review of the domestic production [4].

Then gas investors are expected to determine the trends in each of the demand drivers - those being industrial use, electric power, consumption and exports - a Sisyphean  task. Read Forbes' article about Oklahoma gas and oil industry as example.

The second factor relates to natural gas reserves. The natural gas company will determine how long the company's revenue can continue without incurring additional debt or equity issuance. Uri Geller, a psychic known for his trademark television performances of spoon bending, was once employed to predict how much natural gas reserves could be found. This antidote serves as example that it is, at the end of it all, somewhat of a guessing game.

In a May 2019 presentation to investors, Gulfport Energy's management reported on 92,000 in net reservoir acres in SCOOP (read about SCOOP on Enversus blog) and 210,000 net acres in Utica Shale. Management also reported that as of fiscal year end 2018, it had reserves of 1.3 net Tcfe in SCOOP and 3.4 net Tcfe in Utica Shale. But who can tell how much is still buried in the ground?  

Uri Geller was once employed to predict how much natural gas reserves can be found; estimating future gas reserves is, indeed, a guessing game.

The third issue is the regulatory and political environment which greatly affects the price of natural gas. A recent example from the state of Israel demonstrates how. The exploration for the Tamar gas field began in 1999, then a decade after, in January 2009, "Tamar was the largest find of gas or oil in the Levan bain of the Eastern Mediterranean Sea and the largest discovery," reported the Jerusalem Post. Noble Energy joined the drilling activity in 2006 and was the primary benefactor of the discovery.

Nobel's energy investors were thrilled but the Israelis threw a fit. The Israelis blamed their government of dire misuse of natural resources, which belonged to citizens and not in the hands of foreign, private interest groups, and that forfeiting such a national treasure was, in effect, a security threat. This political debacle began five years ago and continues to this day. In short, political and regulatory concerns are real.

GPOR's margin of safety

Merriam-Webster dictionary explains gambling as "to bet on an uncertain outcome." And if we were to use their narrow definition of the word then indeed buying Gulfport was a gamble. But I will propose a wider definition. Let us expand on Webster's definition with "without any margin of safety."

Buying Gulfport Energy was speculative; but at least there is somewhat of a margin of safety.

The wide margin of safety was the result of the low price to earnings ratio and low price to book value ratio. It was the result of today's investors receiving $24 billion of proved developed and undeveloped per share, while five years ago investors received $8.7 billion, and ten years ago they received $740 million. The margin of safety also results from management's buy back strategy and reduced planned capital expenditures for 2019.

***

"You've got to have models in your head," said the famed value investor, Charlie Munger. "And you've got to array your experience - both vicarious and direct - onto this latticework of mental models." My main point in this essay was to advocate that investors should observe how mathematicians had dealt with irrational numbers: they defined the phenomena and moved on with the analysis.    

While researching Gulfport, I understood how uncertain the future price of natural gas would be. So I looked for a wide margin of safety. I then moved on to read about the company.

FOOTNOTES 
[1] Pi is also known as Archimedes' constant.
[2] By giving uncertainty a name and then moving on.
[3] Southwestern Energy reported a 10-year average loss of $1 per share.
[4]  the domestic production is 80 billion cubic feet per day while comparing to the demand is about 90 billion cubic feet per day.

Are we there yet?

Published on:
July 21, 2019
Last Update:

Corporate America cannot stand still. Executive management reports to shareholders on growth expectations and on future strategy. Middle management reports to executive management on upcoming changes to processes and to efficiency measures. And each employee, as anyone who has worked in an office knows, is permanently busy.

This phenomenon, the need to act, can be seen in balance sheets. Consider the balance sheet of Signet Jewelers (SIG on Nyse), a company whose common stock I bought this week, is a prime example.

Signet's main balance sheet changes

First, between 2015 and 2014, the goodwill and intangible accounts increased to $966.3 million from $26.8 million. On the right side of the balance sheet, Signet’s long-term debt increased to $1.3 billion from practically nil. These changes occurred because Signet had bought Zales, an online jewelry store. Forbes magazine described the acquisition in February 2014.

Second, 2016 and 2017, Signet reported on a preferred stock of $611.9 million. It also reported that it would be selling the receivables portfolio (read: the loans Signet provides, partly through third parties, when customers purchase jewelry). And indeed a year after the receivables dropped to $779 million from $1.9 billion. The cash flow from the receivable sale was used to pay down the long term - it dropped to $688 million from $1.3 billion.

Third, between 2018 and the first quarter of 2019, Signet continued to sell the receivables portfolio. As of its recent public filing it reported on $96.2 million in receivables, down from $779.7 million the year prior. Another major balance sheet change was that that goodwill and intangible accounts, dropped to $561 million from $1.3 billion. The drop in the goodwill account was due to an impairment loss related to the Ret2Net purchase. Read about the acquisition here.

These are my notes: taken while sifting through Signet's reported financial results. Bolded with exclamation marks are three milestones in Signet's life over the past five years

Signet over the past five years

How should we understand this pace of activity? One group of investors cheers for Signet's Animal Spirits while the other prefers if the company would operate in a conservative fashion. What is worrisome to both groups is probably the company’s long-term trend.  

Five years ago when Signet traded as low as $75 and as high as $151 (at an average earnings multiple greater than 15 times the trailing earnings per share), investors argued that Signet's market share of the bridal segment was increasing alongside the consumer’s demand for jewelry. The conventional wisdom was that, in the long-term, shareholders would be awarded.

But in the long term we are all dead*. Signet is not the same company it was five years ago. In numbers: the pre-tax return on tangible assets ratio was 15% in 2014. It has steadily declined to a minuscule ratio of 3% in 2019. The pre-tax profit margin, defined as pre-tax net income divided by revenue, was 10% five years ago. It is now less than 2% (even after removing the non-cash impairment charge related to Ret2Net acquisition).

The balance sheet tells a similar tale: in 2014 for every dollar of common equity, Signet reported 57 cents of liabilities. Today the ratio increased by fivefold: for every dollar of common equity, Signet now reports $2.60 of liabilities. Another way to look the company's leverage is that Signet had zero long-term debt five years ago. It now has $650 million. For the long-term investor, in short, Signet in 2019 is not what Signet was in 2014.    

2019 leverage ratios compared to 2014

Active management

Three lessons present themselves. First, investors with an investment outlook of three- to five-years must allocate time, perhaps quarterly, to review management decisions. They should review and question management's capital expenditures decisions, find out what the business strategy is and closely monitor how management reports on operations in the each of the quarterly earnings calls.

Second, Investors should look for industry trends and for regulatory changes. For those who invest in jewelry companies, or more broadly, in consumer discretionary segments, the regulatory environment greatly matters (Signet's sales are largely driven by the consumer's ability to take personal loans).    

The third lesson is that whether to buy a stock should be based on present circumstances, using historical financial statements so that future estimates and pro forma projections should not sway the attention. And why I bought the common stock of SIG, based on the present conditions, will be the topic of s future essay.  

***

In our business environment, which reveres Andy Grove, former Intel CEO, chronicler of paranoia in the Only the Paranoid Survive, executive management will make poor decisions due to hasty decisions driven by a need to act.

In the case of Signet, by merely looking at the balance sheet, we see an executive management that has been wearing too many hats. They wore the financier hat when they replaced long-term debt with preferred equity. They wore the visionary hat when they acquired Zales in 2014. Too bad that they recently had to wear the accountant's hat, the least attractive of the three, when they took an impairment loss of $740 million this year.

In this article, my main argument was to highlight that investing for the long-term is no excuse to let stock investments idly sit in the the portfolio. Corporate America’s behavior is such that every few years a large transaction will occur**. That transaction will dramatically change the business fundamentals and the company’s outlook, be it a restructure, an acquisition or a change in capital structure. More so, it is the nature of capitalism, in which yours truly is ardent believer, that in a free market system, profitable enterprises will lose competitive advantage***. Often too quickly. And brutally often.

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