Category: Wealth Management

The 7 Habits

Published on:
May 16, 2020
Reading time: 3 Minutes.
Last Update:
May 18, 2018

Habit 1: Be humble.

Two unwritten laws of investing should lead your decisions. One, you will make mistakes that will result in the loss of money. Two, businesses and consumer preferences change. So, you will need to adapt and develop new mental models. In a recent CNBC interview, Warren Buffett discussed how our consumer habits hit Coke and Ketchup are changing and how it affects their valuation.   

If you admit to the two unwritten laws of investing, you will become a better investor - one that thinks carefully before buying a stock. And if business knowledge is continually evolving, then growing your knowledge base is fundamental to stock investing.

Habit 2: Have a checklist. 

In The Education of a Value Investor, Guy Spier describes a simple tool: the checklist. A few of his checklist items include: Are any of the key members of the company's management team going through a painful personal experience? Is this company providing a win-win for its entire ecosystem? Is this stock cheap enough (not just in relative terms)? And is the price for the business reflects the value today - not for an excessively rosy expectation of where it might be in the future?       

__________
A NOTE FROM NOAM

If you are looking for a second opinion, especially when considering big changes to your portfolio or strategy. Unbiased, professional insights can help you reexamine your assumptions and reduce emotional decisions.

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Habit 3: Don't follow the crowd.  

My brother and I sat down for lunch with a savvy real estate investor a few days ago. The real estate investor's dad used to make horrible, costly investing decisions, he told us. In the middle of 2007, his dad purchased homes as investments. And in the late 90s, his dad bought stocks of tech companies. Concluding that any business his dad would invest in was bound to fail, he jokingly said, "If my dad entered the morgue business, people would stop dying."

So if you hear or read about an investment idea that was thought of or written by someone else, it's probably too late to invest.

Habit 4: Keep it simple. 

You know the difference between a healthy relationship and a complicated one. In the former, you meet someone. You immediately have exciting topics to talk about, share common interests, and shortly after the first date, and both sides are genuinely interested in the well being of one another. Anything outside of that can be defined as a complicated relationship.

What is true in relationships is also applicable to stock investing: you need to feel comfortable about the business you invest in, and you need to feel somewhat assured that you can understand where the company will be over the next five years. Surprises and hidden truths, in both business and in real life, work against you. 

Habit 5: Rationality is key.

Reason rests where study, observation, and knowledge live. If you buy businesses, you need rationale reasons. When asked his secret to success, Munger once answered "I'm rational." 

Reason rests where study, observation, and knowledge live. 

Habit 6: Have a goal in mind. 

Unless you think carefully of your goals, you will likely find yourself attempting to achieve someone else's goals. You hear a neighbor earning a fortune by buying Bitcoin, and you will try to beat them at their own game. Another example of the dire consequences of not having clear goals is that you will not know when to stop and make bets that you cannot afford to lose. 

I have two goals in stock investing. First, my goal is to beat the S&P 500 index over five years. Second, to grow my knowledge of finance by studying businesses, industries, and management. 

Habit 7: Develop habits. 

Since I started to write about businesses about a year ago, I developed the following new habits: 

1. Sift through the operating financials of 15 companies each week.

2. Read two to three annual reports each week. 

3. Study and refresh my memory on investment concepts every quarter.

4. Research a new industry every month. 

The Voyage

Published on:
March 7, 2020
Reading time: 3 Minutes.
Last Update:

In The Cherry Orchard, Anton Chekov writes that "if there's any illness for which people offer many remedies, you may be sure that a particular illness is incurable." In this essay, I apply Chekov's principle to business research.

My point is that there are many ways to approach financial analysis. Yet, no single approach is perfect and that for investors, the right mindset is more important than any other particular technique.

The balance sheet

Investors should have a clear understanding of what the business they are buying is worth. Because only when investors understand what the company is worth can they decide whether or not the current price of the stock is over- or under-priced. I offer three approaches to evaluate the value of a business.

First, begin with the balance sheet where assets are reported at cost or market value. And the assets are classified as either short-term assets [1] or long-term assets.

But it is your job to determine what the assets are worth. For example, real estate assets are classified as long-term assets. But in a reasonable economy, any office or apartment building can be quickly sold, at market price, in less than three- to five months. 


The income statement

The second approach to determine value is by looking at the earnings. Value is closely associated with how much cash flow the business generates. If company A generates a million dollars in net earnings while company B makes half-million dollars in net profits, the former will be more valuable than the latter.

To determine future earnings, you must have (1) a general understanding of the industry dynamics[2], (2) in-depth knowledge of the business margins and business model, and (3) an understanding of the business capital structure and how it may affect operations.

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The intangibles

It is also essential to look at the intangibles of the business, the third part of business valuation. Intangibles include management turnover and board compensation structure, business culture, and human capital, the brand of the company, and its position in the market place [3].

So these are the business intangibles. But there are internal intangibles as well. Internal intangibles are about you, the investor.  You must find the business you invest in to be interesting. It would help if you were passionate about knowing more about the industry. And that you are excited to follow the business in upcoming years.

Stock research is more art than math.

I, for example, made a mistake last year when I bought Frontier Communications. Lured by a what-I-thought-to-be-a-bargain price, I soon learned that now I was a proud owner of a business about which I had no interest in understanding.  In short, stock research is about art, not math. 


Top-down versus bottom-up research

There are two approaches to research businesses. In top-down analysis, investors pick a specific industry and filter out business candidates using criteria such as price to earnings or leverage ratios. For example, the gas and oil industry is distressed. The Down Jones U.S. Oil & Gas Index was 807 five years ago, and today is 463, a drop of almost 11% annually.

But the depressed industry may provide a few opportunities. Continuing with the gas and oil example, I recently looked at Gulfport Energy and Noble Corporation.

In bottom-up research, the second approach to find ideas, investors begin their journey by analyzing an individual business and comparing its valuation metrics and operating metrics to peers. Writing for Nerdwallet, Diana Yochim advises to research stocks by narrowing the focus on specific metrics, such as revenue, earnings, and return on equity.  

In both the top-down approach and the bottom-up approach, investors attempt to understand the business and industry. The main difference between the methods is the road that leads to a specific stock.

***

The famed historian, David McCullough, laments of his editor's most common question: What will be the theme of his next book? Yet McCullough explains that when he approaches a topic, whether the story of the Wright Brothers or the life of John Adams, he lets the story unravel itself. 

In other words, McCullough takes the mindset of a discoverer. That, too, should be the mindset of investors. When you analyze a company, you should not focus on the potential profit or how smart you may appear to your peers, uncovering a hidden jam. You should not have an agenda at all. Instead, akin to McCullough, more important than anything else, is that you have the mindset of an explorer. 

FOOTNOTES: [1] That can be liquidated in less than one year. [2] For example, are low-cost providers stealing market share?

The Money Game

Published on:
January 4, 2020
Reading Time: 5 Minutes.
Last Update:

Last week I visited the headquarters of a local real estate company that owns, manages, and develops apartment buildings. The company, which shall remain anonymous, operates about 70 apartment buildings in the western part of the United States. It has over 400 employees, and in the past year, it bought over a billion dollars in real estate.

The founder's focus in the early days was to buy distressed properties from banks. And from that humble beginning in the 1990s, with grit and tenacity, he grew the company to be one of the most respected apartment operators in California. 

This essay is inspired by my conversation with him. Where I learned how much business has to teach us.

Price matters

A good business does not make for a good investment necessarily. Last week, I attended a webinar where one of the speakers explained that Coca Cola is a "compounder stock." By that, he meant that whether you bought the stock in the 1980s, the 1990s, or in the current decade, you would get a good return. 

Really? As a careful student of finance, I looked at what Coca Cola was trading for between 1997 and 1999. It was easy to see that you would have to wait for about a decade until you saw the price of the stock return to your cost basis. I don't know many investors who have that kind of patience.


Career advice

Consider Salesforce.com (CRM on Nyse). At $163 per share, this cloud-based software company is trading at over 90 times the earnings. And a quick review of their website tells you why investors willing to pay the hefty multiple. Salesforce focuses on software design, big data analysis, and artificial intelligence. Choose any path for a career, and you likely do well. 

The inverse logic works just as well. You should probably avoid low p/e industries. For example, both Noble Energy (NBL on Nasdaq) and Murphy Oil Corporation (MUR on Nyse) are trading at less than five times the trailing earnings. (So, why bother with a profession when you know you will compete on positions with experienced candidates?) 


The nonlinearity of life

Consider Nvidia Corporation (NVDA on Nasdaq) as an illustration of the nonlinearity concept. Between 1999 and 2016, investors in Nvidia saw a rate of return of about 8% [1]. But investors who bought Nvidia in 2016 saw a rate of return of 52%, a fourfold increase. (Nvidia now trades at $238.)  

Similarly, life is not linear. There are times when we feel stuck and lack  vision for the future. And at such times, going over the historical record of companies such as Nvidia, which shows an overnight success (that took the company to achieve over a long period)  I find to be to alleviate the mood. 

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The impact of few events

In Brave Companions, the historian David McCullough tells that the time former president Teddy Roosevelt spent in Medora, a little town in the Badlands of North Dakota, had a profound effect on the former president's life. Similarly, I believe that just one or two stocks will have a profound effect on your life. 

Take Amazon, for example. If you bought $10,000 worth of shares a decade ago, the value of the position would today be 33 times higher, $330,000.  If you had placed the same amount of money 20 years ago, you would earn 100 times your money. The value of your Amazon position would be a million dollars. 


A gate to human pyschology

By studying the stock market, you read and experience fear, greed, euphoria, , and times of immediate and unexpected duress [2]. 

Not only will you learn about the psychology of other investors, but you will also better understand your psyche.

Not only will you learn about the psychology of other investors, but you will also better understand your psyche.


Inspiration

My parents visit Paris each year and marvel at the ingenuity of the Impressionist era. And how can we not marvel at the wonders of business. 

Want to study the art of business? Just read about the annual report by MasterCard, Maotai, Markel Insurance, and Moody's.  

Many find inspiration in the words of Shakespeare and Henry James. And to me, annual reports can be a form of literature. I love reading annual reports by  Carriage Services (which I bought last year), Jamie Dimon at JP Morgan, and Warren Buffett at Berkshire Hathaway. 


Global exploration

Stock research is also an opportunity to explore the world. A friend of mine looks for companies outside the United States that share a similar business model to successful, U.S-based companies. So, for example, she will look for Indian-equivalent Moody's. Or the South-Korean equivalent of a stock exchange such as the New York Stock exchange. 

Last month I bought a few shares in Micron (I will publish the investment idea in the upcoming weeks (write to me if you would like to be notified when I post the investment idea). And I quickly realized that geopolitical tensions resulted in a 10% loss in revenue. 

It is one thing to read about geopolitical tensions, from the sidelines. But the effect is different when a business you own is hurt.


The long term outlook

Where the business will be in ten years is one of the first questions I ask before buying a business. For example, it is reasonable to assume that in ten years, we will keep chewing gum (say, Wrigley's) and that we will drink soup in the winter (say, Campbell's). So it is reasonable to project ten-year cash flow and to compare the net present value to the current price. But who can predict where our payment system will be in ten years? 

So when you buy a stock with a long term outlook, you tend to ignore daily market movements. And thinking over the long term requires you to focus on the business fundamentals, whether management is capable and invested in the business. And whether the industry is growing. In short, the stock market also teaches us to focus on what matters. 

FOOTNOTES [1] Nvidia became public in 1999, at $12, and the shares traded at about $45 in 2016. [2] For example, the 2008 recession, valuation of tech companies in the late 1990s, the Great Recession of the 1930s, and the interest rate environment in the 1980s. [3] If the Mexican government built a needle coke plant, and I estimate that only public funds can raise that amount, Graftech's business will suffer.

On Relationships, Marketing, Processes, and Habits

Published on:
December 21, 2019
Reading Time: 4 Minutes.
Last Update:

Life in equity research is about asking questions. It is about wondering what exactly did Fiserv, a financial services company, do over the past decade that drove the stock price tenfold [1]. It is thinking about how, after 105 years, General Electric was part Down Jones Industrial Average, it lost its place.

"If he [Charlie Munger] were teaching finance, he would use the histories of 100 or so companies that did something right or something," writes Jennifer Lowe in Damn Right! Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger. 
"Finance properly taught should be studied from cases where the investment decisions are easy."

Life in equity research is about understanding businesses. Not academic theories.  

That studying business is at the heart of equity research was not clear to me when I started this journey. When I studied for Chartered Financial Analyst (CFA) exam[2]. During that period, I read investment topics such as the risk management application of option strategies and reviewed foreign exchange concepts such as forward markets and sport markets. While these topics, perhaps, are of interest to the student of finance, they serve little in the hunt for the next Amazon.      

Cultivating relationships

Another subject absent of finance programs is the value of relationships. I believe that none of the legendary investors would achieve success if they didn't have a supporting spouse, a loving family, a community to belong to, and outside interest beyond the passive ownership of equity interests. In other words, developing soft skills is as vital as understanding GAAP accounting.  

One example of a life skill is creating goodwill. It is so much easier to ask someone for help when already you have assisted them in the past. In our time of just-because-what-can-I-lose Linkedin requests, you will gain an advantage over your peers if you carefully develop an ecosystem of friends that genuinely care for one another.

And developing and maintaining relationships requires work. It is about spending time each week thinking about how to bring value to others. It is about small acts of kindness and putting the focus on others. It is about remembering what Viktor Frankl used to say in the name of Kierkegaard. That the 'The door to happiness opens outward.'

The door to happiness opens outward.

Understand: Whether the stock portfolio increases in price over 12 months is mostly dependent on factors beyond your control. But whether you build genuine life-long relationships is entirely up to you.  

_____
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Look for a second opinion, especially when considering big changes to your portfolio or strategy. Unbiased, professional insights can help you reexamine your assumptions and reduce emotional decisions.

Join the waitlist to learn more.

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Bringing business development efforts to nil

There is tension between investment research and the business of investment management. I estimate money managers use between half to three-quarters of their time in the latter. They travel to meet prospects, they speak at conferences, they interview at any opportunity.

From conversations I had with money managers, I learned that many of them would much prefer to replace the ratio of business development to investment research.

I don't have an answer on how to do that. My personal story is that I saw this inherent tension between the research and business side of things. And I decided to avoid managing other people's money so that I won't have to spend time explaining to them my investment decisions.

Business development becomes crucial when fund managers hire a team of professionals. As I wrote in January of this year,

Hiring a team of analysts will distract the asset manager with tiresome managerial duties. And instead of carefully reading about investments, the manager will eventually sift through the analyst's cliffs notes.

Read more in Mohnish Pabrai's Ten Commandments of Value Investing.

In short, I keep business development efforts to nil and decided to be a team of one. Read Paul Jarvis' Company of One, to learn about this model of work.


The lifestyle of an equity analyst

There is no single formula for life in equity research analysts. Your lifestyle is different when you have young children compared to your lifestyle when they are in college. Not unlike life, the investment life is much different when markets are fully priced compared to market everybody is selling.

While there is no fixed, daily time structure, I find it useful to have a few key performance indicators (KPIs). These KPIs allow us to keep track of progress.

For example, in a particular one month, I will write in my Bujo calendar: "This [Month] I will read [Number] 10-k reports. I will read about the business model of [Number] companies from [Number] investment newsletters; and track the stock activities, via 13-F filings, of [Number] fund managers."

Your lifestyle should drive investing decisions. These decisions should not drive your lifestyle.

Some investment ideas take months to understand. For example, I bought GrafTech (read the GrafTech article) after researching the industry and the competitive landscape for weeks. Others are much faster. I recently bought Micron in less of six hours of research (Write to me if you would like to know why.)

How to measure success

In The Big Book of Endurance Training and Racing, Doctor Philip Maffetone ridicules the 'no pain no gain' fitness concept. He explains that "this is an emotional reaction - one that is based on current trends, often started by advertisements and other marketing - and one that can be irrational."

The 'no pain no gain' attitude is irrational because you should listen to your body's intuition. And the same can be said about the myth of "no risk no reward." (Read more about this myth and other investing myths in The five myths of stock investing.)

Success in the stock market should be about processes. Not about a percentage point more or less compared to the performance benchmark. In the long run, your financial success is the knowledge and wisdom you accumulate about business, the relationships you cultivate, the investing principals you follow, and how you chose to live your life.

You will never hear investors in their later years regret making that they didn't earn a extra percentage points to their investors. More likely that they will lament that they didn't spend enough time with the people they loved and didn't make an effort to make the world a better place.

When asked by William Green, about the key to a fulfilling life, the legendary Irving Kahn remarked:

"For me, the family has been very important. Having a family, healthy children, seeing what we've achieve at the firm. These have all given me great pleasures."

We know that we should explore and travel the world. We should inspire others to lead. And we should remember and recite what former President Theodore Roosevelt said, "I have never in my life envied a human being who led an easy life. I have envied a great many people who led difficult lives and led them well."

And that is life in equity research.

FOOTNOTES
[1] Fiserv stock went up from $12 in 2010 to $117 in 2019
[2] I passed the CFA exam in five years of work.

This Too Shall Past

Published on:
November 13, 2019
Reading Time: 3 Minutes
Last Update:

Timing the markets is hard; perhaps, impossible. But it is easy to see that market prices widely swing.

In this essay, I describe the investing performance of past and current value investors. As you will shortly read, all legendary investors reported poor results at times. The active investor should know that even great investors failed to correctly time markets. 

For the passive investor, I bring the historical record of indices such as the S&P 500 and the Dow Jones. Here, my goal is to show you that if history is any evidence of the future, then markets swing in price. 

So if you invest in an active mutual fund or an exchange-traded fund (ETF), unless you can calmly withstand market swings,  you are best to buy assets that do not have a daily market quotes.

The active record

Even great investors reported paper losses [1]. The legendary Walter Scholls wrote to investors of a 5% loss in 1957, followed by a 9% loss in 1969 and an 8% loss in 1970. 

During 1973 and 1974, Scholls reported a loss of 15% during each of those two years; Sequoia fund, another legendary fund,  reported a loss of 38% during those years. Even Charlie Munger lost over 53% [2].

Let's fast forward to current examples. Between July 2007 and June 2008, Mohnish Pabri lost 32%, and in the following year, he suffered an additional 25% paper loss. In other words, in two years, the market value of a $100,000 investment was halved. 

Pabrai, whom I admire and who much influences my thinking, also reported a loss of 22% in June 2012. So let the record show that even great minds experience bad years.

Another investor whom I consider to be one of the greatest is Guy Spier.  In 2008, he reported on a 47% loss and a 16% loss in 2015. He writes in The Education of Value Investor 

"2008 was something else. I'd never experienced an avalanche like this within my portfolio. The serious damage began in June when the fund fell by 11.8%. The following month, I was down another 3.5%. And then things started to get ugly. In September, it tumbled by another 12.5%. For the year as a whole, I was down 46.7%. On paper, almost half of my shareholders' money and my family's money had gone up in smoke."

(To clarify: by no means is this an attempt to embarrass Pabrai or Spier. The goal here is to show you that it is a certainty that you will see paper loss if you invest in the stock market. Whether you invest on your own or let others manage your money.) 

The next section is for readers who are disinterested in neither investing on their own nor in a fund. This section is for those who choose to invest in the stock market using ETFs. 

The passive record

If you were bullish [3] on the United Stated economy and, say, a decade ago placed a $100,000 bet in an ETF that tracks the performance of the S&P 500 index, the value of your position would now be $271,000.

And compounded growth of about 12% over ten years may now affect your expectation levels. Yet it is unlikely you will get double digits return from a single-digit growth economy. 

In Bull!, Maggie Bahahr shows why. She provides three examples of market cycles. First, between 1882 and 1897, 15 years, the S&P 500 total return was 3.4%. Between 1903 and 1921, 18 years, the total return was 0.6%. More recently, the S&P 500 annual return between 1967 and 1982, 15 years, was 0.2%. And between 2000 and 2004, the annual total return was negative 5%.

Can you imagine the frustration of parting with cash for 15 to 18 years only to realize that you are no better off than when you started?

Not only do market cycles affect return, but the annual return also affects the investor's psyche. For example, between 2000 and 2003, the S&P 500 lost value. If you had $100,000 in the stock market, the value of your portfolio would be $60,000 three years after. In 2008, the market lost that same amount of value in a single year - the S&P 500 lost 38% in 2008.

Both the Dow Jones Industrial Average and the Russell 2000 show similar results. Between 2000 and 2003, the Dow lost 28% in total, and in 2008 it lost 34%. The Russell 2000 dropped 21% in 2012 alone and 35% in 2008.

***

There is little we can do to stop, delay, or change the natural swings of markets. But two things are in our control. First is an awareness. Knowing that you will have a significant paper loss at some point should leave you less troubled when the day arrives. You will know that this too shall pass [ 4] .

Secondly, keep cash handy. It is one thing to see the market price of your portfolio drop - yet it is terrific when price declines allow you to buy great businesses at excellent prices.

FOOTNOTES
[1] Paper loss is the unrecognized loss in a stock's market value. 
[2] Performance results taken from The Superinvestors of Graham and Doddsville as written by Warren Buffett in 1984.
[3] Bullish in a sense you believed the economy would become stronger.
[4] This adage was notably employed in a speech by Abraham Lincoln before he became the sixteenth President of the United States.