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.
My favorite tables shows the power of compounding. Taken from the Aquamarine 2017 annual report, the table has just three columns and four rows. The table shows what happens to an investment after 20, 40 and 60 years of operations assuming 7%, 12% and 18% rates of return.
How can we not marvel that a 12% rate of return will multiply the original investment by 10 times in 20 years?
Glancing at the table every once in a while, I am reminded that (1) stock investing is a long term game, (2) not losing money is more important than maximizing return and (3) a reasonable rate of return, say 7% to 10%, will result in a wonderful investment outcome over a long period of time.
Yet it is unbelievably difficult to focus on year 2039 and beyond. The anticipation of whether a company will report higher sales numbers or net earnings is just too exciting to pass on and it results in both wide mood swings and in swinging market prices.
It is a self-fulling prophecy: if investors expect stock prices to move as a result of quarterly projections then -whether the business fundamental changed what so ever - the stock price indeed moves.
According to Warren Buffett and Jamie Dimon, the quarterly projection of earnings per share is bad both to shareholders and to the economy as a whole. In an Op-Ed to the Wall Street Journal, they write:
Companies frequently hold back on technology spending, hiring and research and development to meet quarterly earnings forecasts that may be affected by factors outside of the company's control.
A few examples from my own portfolio: When Weight Watchers', which I bought in March, management reported to investors in April 2019 of expected softening in sales, the stock dropped to $17 from $27 in less than 24 hours. Yet when the same management reported last week of an expected uptick in sales, the stock immediately jumped to $30. Another example is Hyster-Yale which I bought a few months ago. Here too when management reported on an uptick in sales, the stock climbed to $63 from $55. In short, when management projects earnings, capital markets do what they do best - they react.
Yet between stimulus and response there is space. And I argue that the price movement after a quarterly announcement is the wrong response. Can we reasonably expect a company such as Mednax for example, which I wrote about last week, with over 16,000 employees and a fresh senior executive leadership, to make meaning changes in 90 days?
Wall Street certainly expects more reporting today. In The Art of Speculation, written in 1930 ,the legendary investor Phillip Carrett, writes that "many companies publish annual statements that confine themselves to balance sheets and even those publishing income statements omit many details."
More remarkable than the little amount of information companies reported back then is that investors were drawn to the stock market just as much as they are today.
But today's companies report much more. Consider Hawaiian Airline’s management, which provides guidance on expected gallons of jet fuel consumed (expected to be 1.0 to 2.0% less); that available seat miles will be up between 1.5% and 2.5%. It further breaks down the quarterly earnings report by available operating revenue per ASM of 13.81 cents, compared to 14.25 cents a year ago.
This level of reporting takes much energy. I can only imagine how much time senior management spends in preparing for analysts’ questions and how both legal counsel and public relations people advise them. Legal counsel may ask them to use words such as "we believe" or "it is likely that" while public relations people will tell them to emphasize words such as "we exceeded" and "we are positive" and "we see growth."
Research shows that daily meditation or religious practice assists in developing more tolerant, kind behavior. People who have such daily practices are less prone to get upset while driving and are more kind to random strangers.
And just as spiritual meditation on why we are here, how did we get here and how we should live our lives is helpful, I believe that a quarterly- let alone daily - outlook on stock movements is harmful.
To that I suggest three remedies: First, to develop meta-rules, such as "will not sell a stock for at least two years." This will reinforce the attitude that a quarter is just one piece of the puzzle.
Second, to garden. There is no better reminder that change takes time than nature. That There are simply no shortcuts.
Third, cut, paste, print and regularly view and meditate on the Aquamarine table.
"We face danger whenever information growth outpaces our understanding of how to process it," wrote Nate Silver in The Signal and the Noise. "The last forty years of human history demonstrate that it can still take a long time to translate information into useful knowledge and that if we are not careful, we may take a step back in the meantime."
Indeed, I had taken a step back this week and wanted to bury my head in the sand. This was the result of the movements in my stock portfolio.
I was overwhelmed with information. Companies reported annual earnings this week - which set an immediate price reaction by Mr. Market. Frontier Communication, my largest position, and one that represents almost 10% of my stock portfolio, reported higher-than-expected revenue which translated to a $4,000 increase in unrecognized market gain. Mr. Market also welcomed news from management of Stericyle, a position I began in January, which described began its business transformation. The reported goods news resulted in an increase of $1,500 in recognized market gain.
But the stock of Oprah Winfrey's Weight Watchers (which I bought in January) tumbled by 27%. The 2018 earnings per share of over $3 per share were abnormally high noted management. Management also lowered the 2019 earnings per share forecast to be about a dollar per share. Management reported on a gloomy outlook (some would say realistic) given "competitive pressures." and the market was infuriated. The dreary news resulted in $4,000 unrecognized market loss.
Management of Victoria’s Secret, a position I started last year, reported to shareholders that it will close 53 Victoria's Secret stores this year. L Brands stock fell by 10% shortly after, to $25 from $28, a $2,000 unrecognized market loss for me.
The unrealized market gains were offset by unrealized market losses. But I was not dispassionate about the whole thing. On days my portfolio value was elevated by 30% gains, I felt great. I happily talked to everyone and even showed a somewhat, jovial stride.
Yet on days my portfolio was is down 30%, I shut the my offie's door. And instead of walking outside, admiring the beauty of San Diego weather, I made repeated trips to the break room to fill with coffee my empty cup. The emotional toll from market fluctuations was real and unpleasant.
The emotional toll has a real emotional toll but hardly anyone in finance or in business talks about it. In The Psychological Price of Entrepreneurship, Jessica Bruder writes of "entrepreneurs who have begun speaking out about their internal struggles in an attempt to combat the stigma of depression and anxiety that makes it hard for sufferers to seek help."
Yet Wall Street has not caught up with Silicon Valley. On Wall Street, you don't talk about emotions. "And if you do," said a Wall Street veteran who asked to remain anonymous, "It's a sign of weakness."
Over the weekend, after markets had closed, I realized how idiotic my behavior was. To track daily or even weekly the market value of my stock portfolio was sill. I had no plans to sell stocks so what investors were willing to buy the stocks for was meaningless. I manage my own money and no investors I need to report to on the portfolio value. And I never buy stocks on margin so there was no risk of a margin call.
A few years ago I read in a book by Nassim Taleb that if I was to daily check the price movement of the stock portfolio, by the nature of statistics, the amount of losses would be greater than the gains.
In Fooled by Randomness, he wrote:
"A minute by minute examination of a portfolio means that each day you will have 21 pleasurable minutes against 239 unpleasurable minutes, amounting to 60,688 and 60,271, respectively, per year."
Yet knowing that something is harmful and doing something about it is not the same. Hence, my solution going forward is to call Charles Schwab for market orders.
The problem with trading over the Internet is that it forces you to log into your brokerage account. That in turn forces you to see the price movement of your stock portfolio. And if that's not enough, all brokerage platforms add a visual cue. Just in case you don't remember what was your cost basis, they color the gains in shiny green and losses in bright red.
In Jewish philosophy it is said that where penitents stand, even the wholly righteous do not stand. I bring this sentence of wisdom as a means of an excuse. I knew that watching price movements was wrong. Great investors, from Warren Buffett and Guy Spier to Nassim Taleb, commented on this issue in the past. But I had to feel for myself the emotional distress in the present to finally do something about it. Sometimes, lessons are learned only by experience.
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.
Page 3 of Sequoia Fund's annual report to shareholders demonstrates the power of compounding interest. Say it's now July 1970, you are 25 years of age and you place $10,000 in Sequoia. Fast forward to today, and your investment would now be worth $4.3 million at the end of last year.
Since its inception, Sequoia Fund achieved an annual rate of return of 13.65% compared to 11.00% for the SP 500 index - and this 13.65% yearly return compounded for almost 50 years would have turned a moderate amount of savings into a comfortable retirement.
Can you imagine what a 26% compound rate of return could do? To illustrate the point, I will use $50,000 as a starting amount, which is what $10,000 was worth in the 1970s. And using the 72-rule, we calculate that every three years, the initial amount will double.
So in 2022 it will be worth $100,000; in 2025 it will be $200,000; in 2028 it will be $400,000; in 2031 in will be $800,000; in 2034 it will be $1.26 million; in 2037 it will be $3.2 million; and in 2040 it will be $6.4 million.
And that is the miracle of compound interest.
To look for investments with a 26% rate of return means that you expect that the stock you buy today will be worth at least twice as much in three years. And to inspire for that level of return, you must be an active investor.
I define an active investor as one who spends a large portion of the time reading and valuing companies, analyzing financial statements and corporate statements, and is not afraid to act completely different than the market. Active investing requires a lot of effort with an unknown expected outcome.
In pursuit of such high standards, the active investor will make a lot of errors. Both Mohnish Pabrai and Guy Spier bought Horsehead Holdings, a company that declared bankruptcy and wiped equity shareholders.
Warren Buffett and Charlie Munger bought Dexter Shoes Company and Cort furniture, which Munger referred to as "macroeconomic error." And Sequoia Fund had a significant position in Valeant, a stock that dropped in price by 70% in 30 days two years ago.
By focusing on such a high, abnormal rate of return, we also avoid the stock of companies that cannot possibly demonstrate such a performance. For example, Nike Inc. earned $1.93 billion or $1.17 per share in 2018. For $69 per share, the implied earnings multiple is about 60 times. For the investor with a 26% required rate of return, the company would have to earn $3.86 billion or $2.34 earnings per share in three years, an unrealistic expectation .
Passive investing, defined as the purchase of ETFs, cannot return 26% either. The S&P 500 total return, which includes dividends reinvested, has returned an 11.66% over the past 40 years; the Dow Jones Industrial Average's with dividends reinvested annual return was 12.4% during that time. The Wilshire 5000 with dividend reinvested earned 8.7% during that time.
And since the return of the stock market is dependent, in the long run, on corporate earnings, which have never shown to grow in the double digits, at 26% compounded return is unrealistic.
I learned about the rule of compound-at-26% from Mohnish Pabrai. In his talk at Boston College, he illustrates this point. The purpose of this meditation is by no means to convince you that a 26% rate of return is reasonable. The first point of this essay is to encourage you to think about an adequate rate of return for you and the second point is to reflect how you plan to achieve it.
When a story describes a picture of two separate groups with a gap between them, the reality is often not polarized at all. Usually the majority is right there in the middle, where the gap is supposed to be.
Many investors define themselves as either value-oriented or growth- oriented, where in the former definition, the investor focuses on accounting fundamentals, and in the latter, the investor focuses on the product or service and whether it will become popular in time. But I think the two definitions are complementary - a great investor looks at both the numbers and the product behind them.
“Information about bad events is much more likely to reach us. When things are getting better, we often don’t hear about them,” notes Hans Hasling, author of Factfulness. As an example, I purchased the stock of Patterson Companies amidst negative news about the company and its future. Wall Street analysts commented that management had eliminated the dividend payout policy, that the CFO had resigned and that the earnings guidance decreased. But as I wrote in The one advantage of short term thinking: A cheap stock price, one a 15-year comparison, the company's did fairly well.
Let us now summarize 15 years of operations: revenue increased to $5.6 billion from $1.7 billion, an increase of 229%. Earnings increased to $171 million, or $1.79 per share, compared to $119 million, or $1.75, an increase of 43%. And the number of outstanding shares only grew by 10%, to $92.6 million from $86 million. And a few more praiseworthy notes: the company did not report a single year of loss in earnings; since 2010, it had returned $615 million in dividends (at purchase price of $23 per share, the dividend yield is over 4%), and PDCO operates in an industry where time is your friend. Read: the need for dental and veterinary products is likely to increase with time.
A line will not necessarily continue to be straight. Straight lines, in reality, are rare. Think of a person’s weight or height as an example - when there is a gradual increase each year but eventually the growth stops. Capital markets often behave as if the price direction of a stock will either go down or up for perpetuity.
Another example, from my portfolio of stocks: when I bought the stock of Vitamin Shoppe in September 2017 for $5, it had declined in price since February 2013. And the price decline didn’t stop with my purchase. I saw the value of position decline by 30% before the stock price recently changed its course.
Frightening things get our attention, but they are not necessarily the most risky. “To control the fear instinct,” notes Hasling, “calculate the risk.”
Friends often ask whether it frightens me to see my net worth fluctuate with the movements of the capital market. But I don’t know of a better location to park savings than the U.S. stock market. The bed mattress is susceptible to theft; investing in fixed instruments, such as bonds and Treasuries is sensitive to the interest rate environment, and storing cash in a local’s bank savings account will expose you to inflation and will likely hurt your purchasing power in the long term.
And while Indian culture may think differently, even buying gold, historically at least, has provided less than an adequate return. In Why Stocks Beat Gold and Bonds, Warren Buffett writes comments on this issue.
A number by itself is often meaningless. What one often needs is a number to compare it to, or at least to divide it by some other relevant number. Take our perception of financial scams as an example: the Bernie Madoff Ponzi Scheme; the Theranos and Elizabeth Holmes debacle; the LIBOR manipulation scandal; the LTCM blow up.
Shouldn’t we ask the proportion of these episodes compared to the possibilities? If you believe that in effect every CEO of publicly traded companies can report false and misleading financial statements, then the proportion of scams is minuscule. Capital markets, at the end of the day, are a wonderful invention and a human achievement in both theory and in practice.
Categories can be misleading. Just as we would be wrong to say that blondes are stupid, or that Persians are cheap, or that British are snobs, we would be wrong to classify that small capitalization stocks are risky and that large capitalization stocks are safe.
Half of marriages end up in divorce. But should we give the same weight to a couple who married after a month of courtship compared to a couple that dated for five years?
Even small changes gradually add up to big changes. In stock investing, this instinct directly relates to the principal of compound interest. Guy Spier brilliantly explains this concept:
When it comes to investment results, many investors focus on what happened in the past month, quarter, or year. They might compare quarterly or annual results to an index or to the results of other funds. Financially sophisticated investors may talk about the search for alpha (a fancy way of referring to above-average returns) or the pursuit of superior risk-adjusted returns.
I pay as little attention as possible to these metrics because they distract me from the true task at hand. The only metric I find useful is thinking of long-term increases in net worth, or getting the miracle of compound interest to work in our favor.
The table below illustrates the point that seemingly modest differences in the annual rate of return can generate profound differences in the ultimate gain over long periods of time. My goal is to compound wealth at a high rate, while minimizing the risk of permanent losses of capital.
In order to keep my sights on the horizon, I frame the investing challenge as follows: I seek to double the Aquamarine Fund’s price per share as many times as possible over the course of my investing lifetime.
A single perspective can limit your imagination; it is better to look at problems from many angles. Before I present a loan transaction to our board of directors, I write the questions I expect to get asked.
Since our board encompasses individuals with different risk profiles and real estate experience, the way they view the world is different. And I learned that by imagining the varying questions, I grow my understanding of the risk and return of the transaction as well.
Blaming an individual often distracts from the big issue at hand. It is wiser to look for causes instead. In my day to day career, as a commercial real estate lender, I am often pushed by pushy brokers. Initially I had difficulty handling these conversations and blamed the brokers aggressiveness when a deal did not close.
Over time, I realized that brokers, by being aggressive, believe that the transaction will close. Whether I like it or not, it is just the dynamic of the brokerage industry and I learned to live with it.
A decision often feels urgent but rarely is. In Michael Lewsis' latest book, The Undoing Project - A Friendship that Changed our Minds, he writes that Amos Tversky, the Israeli professor, used to say that the nice thing about urgent matters is that if you wait long enough, they aren't urgent anymore. One way to handle this instinct, which in the stock market often prevails, is to simply trade after the markets have closed.