"There is a difference between solitude and loneliness," explains Mihaly Csikszentmihalyi in Flow. While both experiences result is the same, solitude is a desired state of mind while loneliness is not. In his words:
"How one copes with solitude makes all the difference. If being alone is seen as a chance to accomplish goals that cannot be reached in the company of others, then instead of feeling lonely, a person will enjoy solitude and might be able to learn new skills in the process."
"On the other hand, if solitude is seen as a condition to be avoided at all costs instead of as a challenge, the person will panic and resort to distractions that cannot lead to higher levels of complexity."
This wordy prelude to the difference between solitude and loneliness is my way of introducing a day in my work life. The typical day consists of many hours where I sit, read, and think. And this is done from the quiet of my home office.
As a value investor, I spend most of the time reading. Usually, at 7:00 am, I sift through general business journals such as The Economist, Financial Times, and The Wall Street Journal. I also subscribe to Barrons, Fortune, and Forbes magazine to keep up with financial news. And about once a week, I'll read about industry-specific publications such as American Banker.
After reading a bit of financial news, I move to read reports by individual businesses from their public filings. I find that when annual reports are written for investors, and not to please regulators, they reveal a great deal about an industry, business strategy, and competitive landscape .
Next on my reading list are books. My reading list is not structured. The reading list includes anything from autobiographies of CEOs, to marketing and business lessons. While in the early years, I only read books about business and finance, I moved to psychology, philosophy, and history.
General reading, unrelated to business or investing, I believe, makes a difference. I am not sure how to define that difference, but I know that reading about history and human psychology has many benefits and application to capital markets. Reading a broad range of topics also affects my wellbeing. Reading a wide range of topics gives a sense of perspective, reduces the urge to act, and promotes a kinder self.
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I also like to spend an hour or two a day on my portfolio holdings. I own 19 stocks in different industries (from computer hardware chip manufacturer as Micron to the graphite electrode manufacturer Graftech to pharmaceutical companies such as Teva.) So I try to learn something new every day about their business or their industry.
So, about 4 to 5 hours of my day are used for reading. The remaining hours are for independent thinking. While financial press compresses information and business insights into sound bytes, it takes a long time to understand a business truly.
For example, I heard a reputable investor this week describe his lengthy conversation with Indian regulators. He was attempting to decipher how will regulators behave if (or, rather, when) Indian rating agencies will falter. In short, it takes a long time to understand a business.
But it takes even longer time to understand the value of a business. Consider Coke-Cola, for example. The big picture is obvious: here's a company selling a product that consumers are buying.
But why did Coca Cola survive where others have failed? How come competitors were unsuccessful in copying their business? The answer to these questions, perhaps, a topic for the future essay, requires deep thinking. To answer, we have to delve into branding, distribution, and biology .
"A happy life must be to a great extent a quiet life, for it is only in an atmosphere of quiet that true joy can live," writes Bertrand Russell in The Conquest of Happiness.
Because the typical lifestyle of a value investor is so different than that of a day trader, I thought it would be worthwhile to write about briefly.
To write about a day in the life of a value investor was inspired by a Youtube video I saw last week. Titled A Day in the Life of Day Trader, the Youtuber mentioned the word "markets" 13 times. She explained her trading methods when the markets open. When markets are volatile. When markets close. And how she scans markets for opportunities.
In a recent CNBC interview, Warren Buffett was asked how Todd Combs will manage a $13 billion portfolio, run Geico, oversee Haven, be on the board of JPMorgan. "Portfolio management is not something you do every day," he explains. "Portfolio management is something you learn over decades."
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.
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  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 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) 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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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 .
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.
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.
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.
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.
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.
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.
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?)
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% . 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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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.
By studying the stock market, you read and experience fear, greed, euphoria, , and times of immediate and unexpected duress .
Not only will you learn about the psychology of other investors, but you will also better understand your psyche.
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.
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.
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.
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 . 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."
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. 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.
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.'
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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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.
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."
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.)
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.
Jason Fung's book about what causes obesity has valuable lessons for students of financial markets. The first lesson is that investing requires a lattice work of mental models . The second lesson is that investors should be wary of the brokerage industry's agenda. The third lesson is that we tend to reduce our knowledge to sound bites, but we should carefully examine our choices. This article is about my favorite highlights from the Obesity Code.
Just as there is no single factor that causes obesity, there is no single formula for identifying value. There are multifactorial reasons which, when put together, bring the analyst closer to the economic truth. Some of the common multifactorial reasons include: industry, competitive landscape, management, brand awareness, franchise value, the company's relative and absolute valuation  and financial information, such as valuation and leverage ratios.
"The multifactorial nature of obesity is the crucial missing link. There is no one single cause of obesity. Do calories cause obesity? yes, partially. Do carbohydrates cause obesity? Yes, partially. Does fiber protect us from obesity? Yes, partially. Does insulin resistance cause obesity? Yes, partially. Does sugar cause obesity? Yes, partially." [page 216]
Investing is more art than math. Investors should read about management; decipher its character and integrity as those qualities are more important than any price to earnings or price to book value ratios. While it is fairly easy to arrive at the return on invested capital ratios or trends in net profit margin, investors should use the bulk of their understanding on whether the company's product or service will be in demand a decade from today. And numbers won't always answer this question.
The relationship among the factors is important, too . Consider the following example of how various factors are related: home prices rise, lenders are loaded with capital to deploy, middleman (such as brokers) are hungry for deals and you get the 2007 real estate debacle.
How to market services and products is now studied as an academic degree. It is little surprise that with growing research into how our minds work, marketing's influence on us is growing each year. (Almost all MBA programs now require candidates to read Robert Cialdini’s Influence: The Psychology of Persuasion as part of their required reading list).
"In 1988, the American Heart Association decided that it would be a good idea to start accepting cash to put its Heart Check symbol on foods of otherwise dubious nutritional quality."[page 110]
Brokerage firms, not unlike health companies, may not have your wellbeing in mind. Brokerage firms earn more money the more you execute trades. They also earn money by lending the capital they hold (similar to the banking business model.) So, the industry welcomes frenzy stock trading activity.
The brokerage industry will also sell practically any investment product, be it an ETF, option or cryptocurrency, as long as there are investors willing to buy it.
Yet the brokerage industry often gets it wrong. For instance, it took over 30 years for the industry to embrace index-fund trading. In an interview with CNBC, the late John Bogle said he was accused of being "un-American." In short, the brokerage industry has an agenda. And it may not coincide with yours.
Nassim Taleb called the phenomenon of taking complex issues and simplifying them to the point they become meaningless as soundbite culture. He was describing Wall Street culture: where stock commentators are bullish on stocks because of rumors; because management is buying back the stock; or because of the industry's tailwinds. Stock commentators break apart a business into its individual parts. But to make a sensible investment, investors need to put the parts back together.
"An avocado, for instance, is not simply 88 percent fat, 16 percent carbohydrate and 5 percent protein with 4.9 grams of fiber. This sort of nutritional reductionism is how avocados became classified for decades as "bad" food due to their high fat content, only to be reclassified today as a "super food." [page 205]
Reductionism does not work in business analysis because business fundamentals change over time. When the price of crude oil was about $100 in 2014, investors valued gas and oil companies at 15 to 20 times the earnings multiple. As crude oil prices halved to $54 by 2018, valuations of gas and oil companies dropped to the single digits.
In The Obesity Code, Fung demystifies type two diabetes. When we eat food - be it carbs, fats or protein - insulin kicks in. Insulin, in return, regulates how much sugar is in our blood. If we eat all the time, insulin is constantly working and its effect on the body eventually wears off.
"The human body is characterized by the fundamental biological principle homeostasis. If things change in one direction, the body reacts by changing in the opposite direction to return closer to its original status. For instance, if we become very cold, the body adapts by increasing body-heat generation. If we become very hot, the body sweats to try to cool itself."
While reading about insulin resistance, I thought about my ill-habit of daily checking the price of stocks in my portfolio. Colleagues of mine even get notified when a stock price jumps or declines in value every hour; it is a subtle, subconscious trigger to act .
Fung's answer to reduce the probability of type two diabetes is intermittent fasting , which focuses on the time between meals. I am taking that advice to stock investing. To reduce fatigue, I intend to delete the five stock trading apps on my iPhone and to monitor business actions (8-k filings) from now on, and not price movements.
"My number one priority in life, above my happiness, above my family, above my work, is my own health," said Naval Ravikant, AngelList founder, on a Farnam Street Podcast. "Because my physical health became my number one priority, then I could never say I don't have time...I do not start my day, and I don't care if the world is imploding and melting down, it can wait another 30 minutes until I'm done working out."
Both physical exercise and nutrition are important for us. The two constitute a large part of our wellbeing. Visit Doctor Fung's website for details.
"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.
Stock research is less glamorous than you think. Most of us do not get to travel around the world. We never meet executive management. And the only calls we get are from sell-side analysts .
The truth is that in investment research, you spend most of the time sitting in a room alone. And it is often difficult to focus on what matters. Just take a look at my last week's "to-do" list:
(1) Read one, random chapter from CFA Institute curriculum. (2) Find 10 to 15 companies that are trading below the 10-year average earnings per share. (3) read the 10-k reports of Vivint Solar, United Natural Foods and Interactive Brokers Group. (4) finish reading Howard Market's Mastering the Market Cycle for next week's book club (5) write about the 2018 rate of return.
In one of the best self-help books I read this year, the author asks, "How long would it take (in months) to train a smart, recent college graduate with no specialized training in the field to complete the task?"
It is a simple-but-sophisticated tool to manage our time - or at least to sort out our schedule. Reflecting on the question, I saw that I did not dedicate a single hour to the one project that mattered the most: writing a guide about the REIT industry .
There is plenty of incorrect information on how to value REIT stocks. I wanted to correct that. And this is exactly that type of work, Cal Newport argues, that is very valuable in our economy and is also extremely difficult to pursue due to distractions.
In Deep Work, he defines this type of activity as "a professional activity in a state of distraction-free concentration that pushes your cognitive capability to its limit. This effort creates new value, improves your skills, and is hard to replicate."
"The ability to perform deep work is becoming increasingly rare at the same time it is becoming increasingly valuable in our economy. Consequently, the few who cultivate this skill, and then make it the core of their working life, will thrive."
For stock research, in short, Deep Work is a powerful tool that sorts our time by order of importance, and that demands us to focus on what matters most.
Invigorated by this concept, I set out to complete, over the next 45 days, a guide about REIT investing. I carefully blocked out four hours per day to focus solely on the project; specifically, between 6:30 AM and 8:30 AM, I will write the chapters of the guide, and between 7:00 PM and 9:00 PM, I will research REIT companies to write about.
I will be devoting 30 hours of Deep Work sessions per week over several weeks. In terms of output, I plan to write 30,000 to 35,000 words and will determine the guide successful if it serves as a starting point for an investor who is looking to buy REIT stocks.
The strict schedule requires me to write a guide outline. So, in the first chapter, I will write about the origin and history of REITs in America. The second chapter will be devoted to the types of REITs, such as equity and mortgage REITs.
In the third chapter, I will describe how to value REIT stocks using the income approach, the private valuation approach, and the comparable approach. The fourth chapter will include metrics about the industry, such as the leverage ratios, risk, price multiples, and red flags. And why invest in REITs will be the topic of the fifth chapter.
You can read now read the Guide to REIT investing.
To make dreams real, Cal Newport found inspiration in the Four Disciples of Execution. The four disciplines of performance are:
(1) Focus on the wildly important - The idea here is to channel concentration into a single thing that is paramount. As example would be my goal of publishing five high-quality investing guides in 2019.
(2) Act on the lead measures - Lag measures describe the thing you're ultimately trying to achieve (in my case, write an eBook guide on how to invest in REIT stocks). The lead measures the new behaviors that will drive success on the lag measures. Which, in my case, was scheduling 10 Deep Work sessions over the weekdays.
(3) Keep a compelling scorecard - An example of a scorecard would be to track the amount of weekly Deep Work hours. If you met the hours planned, then try to add an hour or two of Deep Work the next week.
(4) Create a cadence of accountability - The idea here is a weekly reflection where you will review what was achieved and look for ways to improve.
Deep work, I learned, is a skill - not a habit. It requires more than the ability to focus on a subject. For the stock researcher, Deep Work is a technique that forces you to concentrate on the value you bring.
And by doing so, you give up on questionable uses of your time . Deep Work, in short, forces you to begin with the end in mind.
A question: If the beginning equity balance was $494 million and the company earned $382 million in a period of five years, should the ending equity balance be higher or lower than the beginning balance of $494 million?
The equity should increase in time. But what is clearly logical in theory is often murky in real life. Traded on the New York Stock Exchange under the ticker symbol PIR, Pier One is the company in question. And to begin the essay with its end: management of publicly traded companies acts materially different than that of private ones.
Based in Fort Worth, TX, Pier One is in the business of selling decorative accessories and furniture. It operates from over a thousand leased stores, of which 90% are located within the U.S.
Over the past decade the stock traded hands as low as $4 (in 2017) and as high as $39 (in 2015). And as I type these words, the stock price is less than $2 per share.
The recent decline in the stock price is attributed to trade wars. According to Pier One's most recent public filing, 59% of its products are purchased from China; 17% of the goods are purchased from India; and 16% of the goods are purchased from Vietnam. These three countries are affected by the new trade initiatives. And without getting into the specifics, because the cost to import goods is expected to materially rise, Mr. Market was upset.
Yet correlation is not causation. Just because trade wars is now a popular news item more people googled the term "trade wars" this month than ever before. was not the reason, in my opinion, for the abrupt decline in the stock price.
I argue that the fall in the stock price of Pier One is related to its corporate governance over the past few years. To cut the politically correct language, I will say it bluntly: At the expense of its shareholders, management has made some terrible decisions over the past few years.
In April of 2014, Pier One's management decided that purchasing its own shares in the public market would be an intelligent course of action. The Board of Directors authorized a budget of $200 million for management to purchase its own shares. So, between 2014 and 2017, management purchased over 16 million shares at a weight cost of $10.58.
In March of this year, I wrote about the peculiar way FASB accounting rules treats treasury stock, which can be summarized as follows: As the company purchases its own stock, the equity balance decreases.
Pier One stock now trades hands for $1.85 a share; the stockholders lost, on paper, about $130 millions. I used the expression “on paper” because the loss is theoretical in nature. But you should understand that the $130 million could have been distributed as dividends (management distributed only $90 million in dividends during that time).
We are beginning to unveil how a company that generates revenue and profits showed a declining equity balance. Let us now focus the discussion on Pier One's right side of the balance sheet.
For the five years preceding 2015, the average balance of long-term stock stood at $9.5 million. But in the third quarter of 2016, management decided (without giving any detailed explanation to shareholders) that additional debt was needed. And the company ended the year with a whopping $205 million in long-term debt. Since that time, the average long-term debt has been over $200 million.
Since the asset size of the company did not materially change in total during those years, the equity balance shrunk. In numbers: In 2014, for every dollar of asset, the company had 44 cents of liabilities. In 2017, for every dollar of assets, the company had 64 cents of liabilities. Another way to look at the company's increased level of leverage is to focus on total assets to total equity ratio. We observe deteriorating financials. In 2013 for every dollar of equity the company had 1.6 times the assets. In 2017 for every dollar of equity the company had 2.8 times the assets.
Because the nature of accounting rules is that management can reduce the equity book value by purchasing its own shares, management can artificially inflate the return on equity ratio, an earnings ratio highly guarded by Wall Street analysts. Also, evidently, with a lower equity balance, the earnings per share increases, another Wall Street favorite.
Pier One’s 2017 return on equity was 15% - at first glance, a noble achievement for a company selling a product with a 55% mark up (read: the company sells products that cost $100 at $160). But if management had not purchased its own shares, the return on equity would have been a subpar 5%.
The same calculation can be applied to the earnings per share ratio. The 2017 castles in the sky earnings ratio of $0.12 earnings per share would have been $0.003 if management had not purchased its own shares. In the world of earning multiples, it appeared that the stock was traded at 16 times the earnings per share. But as I argued in the preceding paragraph, the earnings multiple was 660 times.
According to a CFA Institute survey of fund managers, net present value calculation is one of the most popular investment tools. Net present value calculations estimate the exit price, which often is dependent on book value. My purpose in writing this meditation was to show that to find the book value, even for a profitable company, requires more effort than simply using what the accounting convention dictates.
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.
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.
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.
“No pain, no gain,” said Jane Fonda in one of her workout exercise videos. Somehow, the investment world has followed Jane’s advice. Today, the “obvious” relationship between risk and reward is hardly even worth the mention.
But the focus should be on the relationship between effort and return. That is, the more effort you put into analyzing companies and understanding their financial statements, the more likely that your see a higher return.
Let me restate the above paragraph in its negative form. The less effort you put into understanding the stocks you invest in, the more likely it is that you will lose money. Unfortunately, I learned this lesson the hard way. As I wrote in The Lessons Learned in Investing in Bon Ton Storesand in How Rait Financial Taught Me A Lesson, there is a price to be paid when financial information is overlooked or when notes to the financial statement are not read carefully. (You should read management's notes and disclosurelike you would read a lover letter: where you never want to miss a word).
Myth correction: There is a relationship between how much effort you put into stock research and your investment results.
Ask any MBA graduate how they were taught to understand risk and they will tell you that risk is the change in the quoted market price of a stock. For example, if the market price of stock A ranged between $17 and $20 while the market value of stock B ranged between $20 to $10, then stock B is riskier than stock A. But I propose to view risk as simply the likelihood of losing money.
Here is a thought-game to illustrate the idea. Meet George, who recently purchased a home. George is likely to sell his home in two years due to a job relocation. Now meet Benjamin, the proud owner of a home nearby. But, as opposed to George’s situation, Benjamin owns a dentistry practice near his home. And Benjamin intends to live in that home for at least another decade. It should be obvious to you that George has taken a substantially greater risk and is exposed to changes in the real estate market.
Myth correction: The definition of risk is how likely it is that you will lose money.
Investment advisors (spoiler alert: the topic of the next myth) often reason a hefty premium on earnings, say, anything above 25 times last year’s earnings per share, with the rationale that future growth in earnings will justify the current premium paid. And the great investing gurus have often stuck to that logic which further supports the myth. But for many of us it is the short term that dictates our investing behavior.
Take Goodyear Tire & Rubber Company as an example. Let us say that you had bought the stock in 2007 and had paid as low as $21 or as high as $37. Prior to your purchase, the company had shown earnings in five of the seven prior years. But the largest U.S. manufacturer of tires reported losses in both 2008, 2009 and 2010. And if you were to sell your position in 2011, you would receive as low as $8 and as high as $18. Very few of us would be able to hold the position for another decade.
In the Intelligent Investor, Benjamin Graham described the investor and his “short-termism:”
“His frame of mind, his hopes and apprehensions, his satisfactions or discontent with what he has done, above all his decision what to do next, are all determined not in the retrospect of a lifetime of investment but rather by his experience from year to year."
Myth correction: current price is more important than future growth.
Walk down Main Street in any town in America and you will not find a single store that sells profitable business ideas. And if an entrepreneur reads this and decides to venture out and to establish such an enterprise, common sense would dictate that if the entrepreneur truly knows how to earn a profit, would he or she not attempt to profit for him or herself?
But this common sense convention - that truly profitable ideas are rarely shared - is hidden by the naiveté of investors who rely on investment advisors to help them choose stocks that will (hopefully) increase their fortunes.
(To be clear: this is not a rant against investment advisors. Many of them are professionals who assist clients in retirement planning and by preventing their clients from making dire mistakes in the stock market. That is a praiseworthy work).
Myth correction: the role of a financial adviser should be to supply information and offer suggestions.
I will make the argument that to ignore short term market movement is one of the best decisions you will make as an investor. As I wrote earlier this year in Why I am Doing This, my plan for 2018 is to allocate $20,000 to the U.S stock market (effectively all my expected savings). I plan to allocate $5,000 each quarter and to find one stock to invest in about once a month. For most of us, it is very difficult to be oblivious to a declining stock market, so forming habits and goals (such as investing in stocks, regardless of where the market is) is one way to handle our investing nature that often acts against us. In the words of an ancient poet, “Habit’s but long practice, and this becomes men’s nature in the end.”
Myth correction: make a yearly plan of stock investing and stick to it.