Five year summary of PDCO stock price. From 2012 to 2018

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Noam Ganel is the Managing Director of Pen & Paper, a value-oriented stock research publication. Subscriptions are now available. He also serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Financial Analyst (CFA) credential.

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Don't follow the herd

A Few Ways to Find Stock Ideas

July 20, 2018

In The Conquest of Happiness, before Bertrand Russell discusses happiness, he explains in nine chapters what makes us unhappy. Using the same structure of thought in this meditation, I write about stock ideas best to be avoided. I then write about a few examples of better methods to find stock ideas.

Four mediums that should be avoided

First, the herd. If a friend, a brother in-law or a a colleague advises you which company or industry you should invest in, it is likely a sign for you to avoid it. Company names that ended with ".com" epitomized the late 90s, resulting in irrational valuations based on newly invested valuation criteria such as eyeballs per page or organic traffic to website. The story ended poorly. Companies such as pets.com or toys.com declared bankruptcy and thirty years after, the word “.com” can be replaced with “cyrpto.” 

There is a wide gap between how useful technology is and how successful it will be for the investor. Consider the airlines industry in the early part of the last century as an example. This miraculous human invention, wonderfully portrayed by the historian David McCullough in The Wright Brothers, fundamentally changed how we travel and trade.

But to an early or even a late investor, the airline industry resulted in subpar results. The explanation for the industry’s poor performance was best summed by Warren Buffett in 1990: 

"In a business selling a commodity-type product, it's impossible to be a lot smarter than your dumbest competitor."  

Second, brokerage reports written by Wall Street analysts. Did you know that Wall Street rarely issues advice to sell stocks? At fault is the nature of the firms that employ analysts and the companies they write about. If GE would like to raise common equity to the general public and hires Morgan Stanley to market and to underwrite the stock offering, it would be practically impossible for a Morgan Stanley analyst to write a "sell" report on GE bonds at the same time. (This is because the common equity is in an inferior position compared to that of the bond holder. In other words, if the purchase of the bonds is a bad idea than to purchase the common stock is even worse).   

Third, TV shows with characters such as Mad Money's Jim Cramer. Every first year student in Psychology learns that people often regret in life what they did not do as opposed to what they tried - even if they failed. Stock media takes advantage of this knowledge. For example, Cramer may show us how the stock price of Amazon or Apple increased over the past decade and how much money we could have made. He then may explain to us that company ABC stock is likely to result in a similar outcome.  

Fourth, advice from anyone who has little capital invested in the investing idea. Whether a real estate partnership, mutual fund or hedge fund, unless the manager of the fund has a substantial amount of their own net worth in fund - which I define as over 80% of their entire net worth - the investor's financial destiny and that of the fund manager are not the same. 

If a manager loses money, he or she is likely to move to manage other funds in the future. Daniel Kahneman once said, "I've always felt ideas were a dime a dozen. If you had one that didn't work out, you should not fight too hard to save it - just go find another.” And fund managers listened.  

Four useful mediums

The first useful medium is the 52-week low list. Every week, we can read a new list of stocks that are trading at their lowest price over the past year (I use Gurufocus free stock screener). Often the devaluation is related to fear of an expected bankruptcy, litigation or a change in the economics of the business. But, on rare occasions, you may find a sensible stock idea from this list. In Capital Markets Have Reason, which Reason Does Not Know, I wrote why I bought the stock of Orchids Paper Products, a company I found while sifting through the 52-week low list.

Another useful source is to read what others are suggesting to sell. When Wall Street analysts recommend selling a stock, it may be a great time to buy it because of a cheap price. I use this technique by subscribing to the Motley Fool Stock Advisor, where authors suggest selling stocks they previously recommended. In May 18 of this year for example, the newsletter suggested selling Caesarstone. The message said that "this quartz countertop maker is struggling at a time we thought it would be grabbing an exciting new opportunity. We think it's time to let go." I did the opposite and you can read why in My Romantic, Love Story with Caesarstone.

The third medium are letters to shareholders written by value investors. I often read letters written by honest managers, such as Guy Spier of Aquamarine, Bruce Berkowitz of Fairholme, Bill Ackman of Pershing Square and the folks behind Ruane, Cunniff & Goldfarb.

I learned about Seritage Growth Properties from Bruce Berkowitz. Here is what he had to say on Seritage in 2017:

Seritage is a simple redevelopment story clouded by a complex tenant relationship with Sears. Seritage owns 40 million square feet of retail space and surrounding parking lots; Sears occupies 75% of its retail space. When Sears closes stores at Seritage locations, the real estate is re-rented at market rates three times higher to tenants such as Whole Foods and Nordstrom Rack. Proportionally higher cash distributions to owners then follow. I believe this opportunity to recapture valuable real estate is why Warren Buffett personally became one of the largest shareholders of Seritage.

Finally, look for companies that recently cut or eliminated their dividend distribution. Just as a business school’s administration office refrains from accepting candidates with low GMAT scores because it lowers average scores, institutional investors shy away from companies that cut dividend rates. It is perceived as a signal for poor future results.

This often results in a precipitous decline in the stock price. While the devaluation may be justified because the fundamentals of the business had changd, at times, it is simply a natural course of business where management is prudent and responsible.

In Where the Financial Statement Reveals Little Economic Reality, I wrote about my purchase of Frontier Communication. In early 2017, management reduced the dividend rate per share to 4 cents per share from 11 cents per share. Management eliminated its dividends going forward and the company now trades at a much lower price compared to the past decade.