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.
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?
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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.
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.
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."
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.
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.
Investment checklist is a set of questions you go over before making an investing decision. The checklist lessens the emotional aspect of investing by forcing you to think before you act. It results in a better decision making process.
Strangely, academia doesn't talk about the value of checklists. It is also strange that in investment circles, hardly anyone mentions the checklist. Google the term' investment checklist,' and you will only find vague, general, abstract thoughts.
I never heard of the investment checklist while in business school. I even studied for the Chartered Financial Analyst (CFA) designation for five years, and not once did I come across the phrase.
So this essay attempts to correct this missing information. My goal is that you will understand why the investment checklist is essential and that you will have a list of over 50 checklist items to use in your research.
As I wrote in The Hats The Investor Must Wear, knowing which stocks to avoid is the first step in investment research. And checklists help to achieve that first step.
In Chapter 11 of The Education of Value Investor, Guy Spier writes:
"Even with a well-constructed environment and a robust set of investment rules, we are still going to mess up. The brain is simply not designed to work with meticulous logic thorough all of the possible outcomes of our investment decisions. The complexity of the business world, combined with our irrationality in the face of money-related issues, guarantees that we'll make plenty of dumb mistakes...there is one other investment tool that is invaluable that it merits a chapter it is own: a checklist."
Spier mentions that it was Mohnsih Pabrai that explained to him how valuable was the checklist. And that revelation came to Pabrai after reading Atul Gawande's description of how pilots use checklists. He writes:
"…they came up with an ingeniously simple approach: they created a pilot's checklist, with step-by-step checks for takeoff, flight, landing, and taxiing. Its mere existence indicated how far aeronautics had advanced. In the early years of flight, getting an aircraft into the air might have been nerve-racking, but it was hardly complex. Using a checklist for takeoff would no more have occurred to a pilot than to a driver backing a car out of the garage."
Pabrai  followed the technique. And by the second edition of The Checklist Manifesto, Gawande mentioned how Pabrai was using checklists in investment decisions.
I keep a checklist in a CODA document . My checklist evolves around items such as balance sheet, income statement, risks, management, product, capital allocation, credit, product, competitive landscape, investment thesis, valuation, and corporate governance.
For example, on liabilities, the following checklist items appear:
-What are the major debt covenants, and is the company meeting those minimum debt requirements?
-What is the company's management experience with capital markets?
-Is the company placing debt at market terms, or are they forced to raise debt at unfavorable conditions?
-Is there balloon payment over the next five years?
-Does the company have the ability to issue debt, if needed?
-What assets will be used as collateral?
-Is the debt payment floating- or fixed-payments?
-Has the company's credit ratios improved?
-Does cash flow from operations service the debt payments?
-What is the fair value of the debt?
-What is the peer group's leverage ratios?
-What are the liquidity and capital resources over the years five years?
-What are the debt rating agencies saying?
"If you want to improve the quality of the decision," said Daniel Kahneman in an interview to Farnam Street, "Use algorithms, whenever you can. If you can replace judgments by rules and algorithms, they'll do better. Indeed, when we write an investment checklist, we reduce the emotional aspect of investing.
Another benefit to the investment checklist is it serves as a starting point. You don't need to invent the wheel each time you research a stock, just follow the lessons of the past. (More on that in the section below.)
The checklist also grounds you. Many times in the past, I felt a high conviction about a company. And just as I was about to buy the stock, I went over the checklist, only to realize that either (1) I missed out on crucial points, or (2) the position didn't meet the criteria I had set for myself.
But there are two drawbacks to the investment checklist, too. First, the checklist gives a false sense of security. As if buying a stock is akin to boarding a plane; that all we need is a checklist, and we will safely reach our destination.
But the truth is that there are risks that we cannot prepare for. Investing is placing a bet on human psychology just as it is on the fundamentals of the business. And we can't predict human behavior, let alone all the factors that will influence the price of a stock.
This reminds me of how the Oracle from Omaha was baffled by David Sokol's irrational behavior. In the 2011 Berkshire annual meeting, Buffett said that Sokol had given away to a junior partner four times the amount Sokol purchased Lubrizol. In Buffett's words:
"I witnessed Dave voluntarily, transfer over 12.5 million dollars - getting no fanfare, no credit whatsoever to his junior partner...what makes it extraordinary is that $3 million, you know, ten or so years later, would have led the kind of troubles that it's led to."
Sokol's forerunning Lubrizol was unpredictable and made no sense. Munger summed it best:
"I think it's generally a mistake to assume that rationality is going to be perfect, even in very able people."
The second drawback to the checklist is that the more you rely on it, the less likely you are to follow your conviction. It is almost like the paradox in game theory that shows that no matter how fast the wolf is, it will not catch up with the turtle if both objects are stationary .
Similarly, in my view, there is a point in time where the investment checklist causes more harm than good. It becomes an obstacle. Or an excuse to sit idly. And many investing mistakes are mistakes of omission.
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Trying to think like great investors is an excellent exercise. One of my favorite past time is to ask what great investors would ask me before I buy a stock.
Having this imaginary investment committee is one of the best ways to stretch investing skills. So I gathered a list of the top questions each great investor would ask:
1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when growth potentials of currently attractive product lines have largely been exploited?
3. How effective are the company's research and development efforts in relation to its size?
4. Does the company have an above-average sales organization?
5. What is the company doing to maintain or improve profit margins?
6. Does the company have the depth to its management?
7. Are other aspects of the business somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
8. Does the company have a short-range or long-range outlook regarding profits?
9. In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholder's benefit from this anticipated growth?
10. Does the company have management of unquestionable integrity?
1. What is the value of the company? You are buying shares in a business.
2. Is the value you get worth the price you pay?
3. Are you comfortable holding- and following the stock for five- to ten-years?
4. Is this company using debt to finance its operations? If so, why?
5. Why are you buying the stock?
6. What are the assets you are buying?
7. Are you willing to hold the conviction for a long time? More than two years?
8. What is the true book value of the company after adjustments?
9. Is the price low relative to a few years back?
10. Don't forget to look at the value of the stock before selling.
1. Do you understand the business?
2. What is the economic moat that protects the company so it can sell the same or similar product five or ten years from today?
3. Is this a fast-changing industry?
4. Does the company have a diversified customer base?
5. Is this an asset-light business?
6. Is it a cyclical business?
7. Does the company still have room to grow?
8. Has the company been consistently profitable over the past ten years, through good time and bad?
9. Does the company have a stable double-digit operating margin?
10. Does the company have a higher margin than competitors?
1. Do you want to spend a lot of time learning about this business?
2. Who is the core customer of the business?
3. Does the business have a sustainable competitive advantage?
4. What are the fundamentals of the business?
5. Are the accounting standards that management uses conservative or liberal?
6. What type of manager is leading the company?
7. Does the CEO manage the business to benefit all stakeholders?
8. Does the CEO love the money or the business?
9. Does the business grow through mergers and acquisitions, or does it grow organically?
10. Have past acquisitions been successful?
1. Is there a raider in the wings to help shareholders reel the benefits of the assets? (for asset plays)
2. Are costs being cut? (for turnover situations)
3. Did the company duplicate its success in more than one city or town, to prove that expansion will work (for fast-growers)
4. What is the company's long-term growth rate, and has it has kept up the same momentum in recent years? (for stalwarts)
5. What percentage of earnings are being paid out as dividends? (for slow -growers)
6. What is the institutional ownership? (the lower, the better)
7. Is the p/e ratio high or low for the company and for similar companies in the same industry?
8. Is the product that's supposed to enrich the company is a major part of the company's business?
10. How is the company supposed to turn around? (for turnaround situations)
Before I leave you to write down checklists of your own, I want to emphasize three points. First, checklist items are evolving in nature. What used to be important in the past may be outdated in today's markets.
Second, you may need a different set of checklist items for different scenarios. A specific checklist item may apply to a particular industry or company size, but irrelevant to another. Remember that checklists aren't there to remove the thinking from the investment process, the checklist is there to support it.
Third, make the checklist specific to your experience; to your criteria of investing.
If you are interested in reading more about checklists, the following resources are a good starting point. Written by Atul Gawande, The Checklist Manifesto provides an excellent overview of industries such as the medical profession use checklists.
More specific to investing, I suggest The Investment Checklist by Michael Shearn. In that book, he provides over 50 checklist items. The Manual of Ideas, written by John Mihaljevic, breaks down the questions you want to ask, depending on your acquisition criteria. Specifically: when you buy Graham-style bargains when you look for hidden assets in a balance sheet, when you look at management, and so so forth.
It's a no secret formula that great investors have. Investors such Warren Buffett and Charlie Munger rarely calculate net present value of future cash flow and they don't follow a grand finance theory that only they understand.
The opposite is true. Great investors read about the operating performance of publicly traded firms from resources that are available to us all. Their business understanding is within everyone's reach.
The qualities that make a great investors are the topic of this meditation. As finance theory and finance engineering evolve and as more convoluted ways to determine value are taught in academia, the more I look for simple, common-sense tools that Benjamin Franklin could have easily understood and are likely to be used a century from today.
Serious investors are avid readers, because reading provides perspective. Understanding the past, reflecting on the present and thinking of the future are crucial. This is because they allow to stay calm when market are shaky. Consider the passionate Bitcoin traders of our days. They buy the currency so that they can sell it at a higher price. For them, reading Charles Mackay's Extraordinary Popular Delusion and The Madness of Crowds would serve well. The kindle version only costs $0.56 as a side note.
For entrepreneurs who subscribe to Fortune or Forbes Magazine, that dream of amassing wealth in Silicon Valley, reading The Age of Gold: The California Gold Rush and the New American Dream link will force them to ask better questions about life. For example, are there truly shortcuts to building wealth?
One of Buffett's most known principles is that he will not purchase the stock of a business that he does not understand. Readers of the The Education of Value Investor know that one of Guy Spier's principles is to never buy a stock on margin. And if you visit the Magical Formula website, you will see that Joel Greenblatt looks for companies with high earnings on tangible equity.
What one investor may look for in a stock is not what other investor will. But it is clear that each great investors have a keen understanding of who they are. This is what drives their stock investing decisions, not the market. In the words of the Third Avenue's legendary founder, Marty Whitman:
"Short-run market considerations, the life blood of the Efficient Market Theory, are unimportant in value investing. It is not that the value analyst has access to superior information vis-a-vis the OPMI market but rather that the value analyst uses the available information in a superior manner."
The more you know yourself, the more your stock purchases will be independent of market sentiment. When I buy a stock, I imagine the purchase to be as similar as if I had bought a house in a community that I know well and who’s members I cherish; where I know that the property is adjacent to great schools and offers a convenient commute to work. In such a scenario, it is unlikely that I will sell the home – even if the real estate market drops by a third in value.
Observe the great investors and you will see that all have enough money. They don't have to work. Yet they choose to wake up each morning, commute to their offices, read financial reports in the morning and make capital allocation decisions by the afternoon.
The great investors buy stocks for other reasons than profit. In my opinion, either (1) they have something to prove, (2) they regard stock investing as joyful activity, (3) they are interested in understanding how businesses work (Buffet called once himself a "business hobbyist") or (4) they look at stock investing as an extension of their personality.
You will do poorly if you place your wealth with a money manager who never admits to mistakes. Great investors always describe, both verbally and in written format, their investing errors.
In The Education of Value Investor mentioned above, Spier describes why he bought the stock of Tupperware and analyzes what went wrong. Mohnish Pabrai disclosed to investors, in plain English, that he made a mistake when he had bought the stock of Horsehead. More recently, Buffett said that he had overpaid for Heintz Kraft. In short, honesty matters.
What all great investors share is contentment in life. They don't seek more capital to manage or to change their personalities. They stick to their investing philosophy even if there are trendier investment areas. Great investors follow the maxim: "Be yourself," which I believe results in an almost mystical aura surrounding them. This quality, which cannot be achieved by having an ample number of followers on Instagram, makes you want to be around them and hear what they have to say.
On the surface, their life contentment seems accidental; almost as if these great investors stumbled upon the life that is most suited for them. I find that hard to believe. The great investors are in a constant self-improvement mode, hacking for better habits and challenging themselves to become better decision makers.
While it is hard to define what makes and what will make someone content, it is obvious to see when one is not content. Think about that the next time you talk to your an investment manager.
"Learning is the oldest excuse in the book for the failure of execution. It's what managers fall back on when they fail to achieve the results promised," writes Eric Ries in The Lean Startup. "Entrepreneurs, under pressure to succeed, are wildly creative when it comes to demonstrating what they learned. They can tell a good story when the job, career, or reputation depends on it."
Yet, what else are we to do as investors but reflect on what we learned this year  ? Since January 1 of this year, index fund investors witnessed a drop of 2% in value. And if you look back at the stocks I bought this year, you can now buy them at an average price that is 8% less than what I paid for them.
Over the past 11 months, I sifted through the financials of 170 publicly traded companies . Only when the price to earnings ratio was low enough, I downloaded the 10-k report and began to read about the business.
Reading public filings was a new process for me. In 2017 as a comparison, if I had seen a stock listed in the 52-week low list, I would have then carefully read about the company and determined whether it was an opportunity or not.
Spending a lot of research time on a company was a mistake. It was flawed because by the time I read about the firm, I felt compelled to invest in the company just because I already spent hours of my time.
Learning the hard way, I finally understood this year how important it is to understand the right side of the balance sheet. Buying the stock of Orchid Paper Company, for example, was an unforced error on my part.
It was not difficult to see that in a rising interest rate environment, Orchid's ability to cover its debt service would tarnish.
Another unfortunate example was forgetting to adjust for the market value of preferred stock. The company was Rait Financial Trust, and in What Buying Rait Financial Trust Taught Me, I explained what eventually happened because of my omission of thought.
Even with a dormant stock market in 2018, I now realize how emotional stock investing is. When I saw the price of stocks climb in price, I immediately sensed a call to action. And because of this urge, I overlooked important issues before buying these shares.
Reading for the second time, Guy Spier's The Education of Value Investor reminded me that checklists are crucial. So, throughout 2018 I developed a checklist as part of the investment process. It has standards that I now must follow before buying, while holding, and before selling a stock .
It is easy to see what other great investors are buying. Websites such as WhaleWisdom.com dig in the portfolio of some of the great investors of our time.
For example, Mohnish Pabrai owns Fiat Chrysler (FCAU); Bruce Berkowitz owns Vista Outdoor Inc. and St. Joe Corporation. Guy Spier holds MasterCard (MA).
And even better, they often write and explain why they bought the position. In Berkowitz' words why he bought St. Joe purchase:
"The St. Joe Company recently announced that it received final approval from state and local agencies for its 110,000-acre Bay-Walton Sector Plan, with 170,000 residential units and more than 22 million square feet of retail, commercial and industrial development."
There is a wealth of information out there, and most asset managers are not shy to share it.
Building a watch list is one of my goals for 2019. During the past year, I came across beautiful businesses that generated plenty of cash flow while showing little to no debt. But the valuation of these businesses was too rich for me. With earnings multiples higher than 20 times the trailing earnings per share, I paid a dollar and thirty cents for a company that is worth one dollar.
But market values change. And my mistake this year was that given the rich valuation, I dismissed and never wrote down the names of the businesses that, at a price, could be great buys. In short, next year, I plan to list all the companies that I would like to purchase.
I intend to buy more stocks next year than I plan to sell. At the time of this writing, 60% of my investment portfolio is still in cash. Not because I am fearful of the stock market, but because I have not found any companies of interest.
Over the past two months, I added to positions I took earlier this year. I bought more shares in Leeway (LWAY) and Frontier Communications (FTR). I wrote about my purchase of LWAY in Why I Am Long Probiotics. And I described my acquisition of Frontier Communications in March of this year.
Finally, I continue to be passionate about sharing my journey with you. If you learned a thing or two about the stock market, then my efforts, and the efforts of Lisa, who edits these meditations, were not in vain.
When Bertrand Russell wrote about how to find happiness, he first commented on what makes us unhappy. In The Conquest of Happiness, he provided us with a checklist of habits to avoid before he addressed what may make us happy. In that spirit, in this article, I will focus on what to avoid when purchasing stocks.
If a stock is fairly valued - that is, the value you get equals the cost of the stock -then the stock trades at the average earnings multiple and average earnings per share over the past decade. Let’s look at the following three examples: Campbell Soup Company (CPB), Kellogg Company (K) and Williams-Sonoma (WSM). For Campbell, the 10-year average earnings per share was $2.26 and the average multiple over that period ranged from 21 to 16 times the earnings. The fairly valued range is between $47 and $36. Because Campbell trades at about $48 per share, it followed the definition of a fairly valued stock.
Using the same technique, the fairly valued range for Kellogg was $72 to $58, and again, since the stock trades at $68, it trades at the fairly valued range. For Williams, the range was $50 to $30 and the stock now trades at $52.
While purchasing a stock at its fairly valued range can be reasonable, paying a sum greater than what is fairly valued is a mistake. If you pay $126 Cboe Global Markets (CBOE), or $63 for Activision Blizzard (ATVI), you would pay above the fairly valued price range. For Cboe, the average 10-year earnings per share was $1.74 and the earnings multiple ranged between 27 and 19. That means that the fairly-valued price range is $47 to $33. For activision, the fairly-valued price range was $14 to $12. But the stock traded at $126.
At times, companies issue stock to raise capital, or to compensate management for their time, effort, or recent success. Whatever the reason may be, this habit often repeats itself in the future. And, as with everything else in life, what in moderation may be an acceptable business practice, at the extreme, it is really an addiction.
HEICO Corp (HEI), an aerospace company, had about 98 million outstanding shares at the end of 2007. Compare that with the current outstanding shares of about 325 million. If management had not diluted shareholders, each share would earn much more than the recent $2.04 per share and a position in the company would be worth more than $92. The story is the same for Hercules Technology Growth Capital (HTGC), a capital market company. Hercules had a mere 28 million shares outstanding as of 2007 and a decade after had over 73 million.
Diluting shareholders is not a business necessity. Look at the multinational conglomerate company Berkshire Hathaway Class B shares (BRK.B). Berkshire had 2.318 billion shares outstanding in 2007. As of its most recent filing, outstanding shares were 2.467 billion, an increase of about 6%.
It is even more impressive when a company reduces the amount of shares outstanding over time, effectively increasing the stock holder’s share in the company. Brinker International (EAT), a restaurant company, had about 105 million shares outstanding in 2007. It now had has 51 million shares outstanding.
Because losses often trigger management to seek capital by issuing additional shares and the net worth of the company declines, I try to avoid companies that lose money, even if I miss out on opportunities. Hamilton Thorne (HTL), a provider of advanced laser systems, has great potential and showed positive earnings over the past three years. But, from 2007 to 2012, the company lost earnings. DDR Corp (DDR), a real estate investment trust, holds an impressive portfolio of real estate. But the company reported losses over the past decade, even if you add back deprecation (as expected - management diluted shareholders and increased by 2.5 times the outstanding shares).
But losses do not always deter me. That is, if I can reasonably estimate earnings in the future. Besides, loss in earnings over the past year or two has typically reduced the stock price, resulting in an attractive in price at the first place. I felt that to be case when I purchased Famous Dave's (DAVE) at about $3 this year. Between 2007 and 2014, Famous Dave’s earned an average of $0.54 per share. But in both 2016 and 2015, loss was reported at $0.49 (in 2017, expected loss will be greater than $0.75). But I felt the decline in stock price did not reflect the economic realty over the next few years.
I was planning to go over the entire what-to-avoid checklist, but I am not even close to its end. (It is also a work in progress, as I often add or broaden certain checklist items.)
I covered three checklist items in this article and I plan to write about 12 more checklist items over the next few weeks. If you would like to be notified when I post articles, leave your contact information in the footbar below.