The Free Capital Blog Digest

The following is a digest of posts from Guy Thomas’s Free Capital blog from Feb 2011 through Jan 2012.  Each post provides a link to the parent article with bullet-pointed lists of key-takeaways from each. For the complete discussion by the original author, please click the link to the parent article.

How important is analytical intelligence in investing?

  • Equity trading is not as reliant on raw mental strength (IQ, analytical ability) as fixed-income trading; instead, equity trading is more dependent upon mental characteristics such as:
    • Actively seeking information from dis-confirming sources
    • Adjusting for one’s biases
    • Accepting uncertainty for long periods
    • Deferring decisions for as long as possible
    • Calibrating your certainty to the weight of evidence
    • Responding unemotionally to new information
    • Indifference to group affiliation
  • The mental characteristics which are helpful in investing are not universal positives and may be useless or negative characteristics in other endeavors

Max, min and average payoffs

  • Most activities can be categorized as max payoff, min payoff or average payoff
  • Max payoff means the activity is “positive scoring”, your payoff is your highest or best result and failure carries no lasting consequences
  • Optimal traits for max payoff are:
    • high energy
    • irrational optimism
    • persistence
  • Examples of max payoff activities include:
    • selling
    • leadership
    • most sports
  • Min payoff means the activity is negative scoring, your payoff is your lowest result and even a single failure may have lasting consequences
  • Optimal traits for min payoff are:
    • meticulous care
    • good judgment
    • respecting your limitations
  • Examples of min payoff activities include:
    • flying a plane
    • driving a car
    • performing brain surgery
  • Average payoff activities combine elements of both max and min; investing is an average payoff activity, with particular emphasis on the min aspects
  • A lot of success in investing comes from simply avoiding mistakes (min payoff)

Discussion of diversification (posts 1, 2, 3 & 4)

  • Diamonds and flower bulbs
    • Diamonds are companies with exceptional economics and long-term competitive advantages that you’d be happy to hold if the stock exchange closed tomorrow for the next five years
    • Flower bulbs are companies which are cheap at the moment but which have no exceptional business qualities (they often make a good quantitative showing but not a strong qualitative one); they can usually be counted on to bloom but should be bought in modest size because they require liquidity to get back out of the position and realize the value
    • Which should you buy? Diamonds are exceptionally rare and require outstanding foresight of long-term durability; flower bulbs are more common, simpler to spot and merely require patience and a strong stomach
    • “Investing is a field where knowing your limitations is more important than stretching to surpass them”
  • How many shares should an investor hold? Some theory…
    • The optimal number of stocks to hold, N, is a function of…
      • quality of knowledge about return dispersions (decreasing)
      • $ size of portfolio (increasing)
      • volatility of shares (increasing)
      • capital gains tax rate (decreasing)
    • Exceptional investors with exceptional quality of knowledge should hold a concentrated portfolio; Buffett from 1977-2000 appears to have held approx. 1/3 of his portfolio in his best idea and changed it annually
    • With a small portfolio, liquidity is not a concern but as your portfolio scales a large number of holdings becomes optimal to maintain your liquidity which enhances your optionality by giving you the opportunity to change your mind without being trapped in a position
    • If the companies you target have highly volatile share prices, it becomes attractive to switch frequently so that you can “buy low and sell high”, thus you want to restrict your position sizing (higher number of positions) and maintain liquidity
    • If the capital gains rate is high you are penalized for turnover so you want to keep your total number of positions low and hold them for longer
  • How many shares should an investor hold? Some practicalities
    • There is clearly a trade-off between the number of positions you have and your quality of knowledge
    • A portfolio which is higher in diversification may hold many lower quality businesses (flower bulbs) but the certainty of the analysis of each might be significantly higher than a concentrated portfolio of several high quality businesses (diamonds) whose analysis is extremely sensitive to long-term forecasting accuracy
  • Concentrated investors often “come a cropper”
    • Many investors eventually disappoint because they have concentrated their bets on companies the world turns against
    • This has happened even to great investors like Warren Buffett (ex., WaPo, which now looks like a horse-and-buggy investment)
    • The danger of concentration is that nothing grows forever, and concentration + illiquidity often make it hard to escape mistakes

Meeting management

  • Opportunity cost of time: is it better spent speaking to management or investigating other ideas?
  • Getting an edge: sometimes speaking with management helps to understand the picture in a way that gives you an edge
  • Buffett: if you need to talk to management, you shouldn’t own the stock
  • Don’t be schmoozed

Analytics versus heuristics; why I don’t use DCF models

  • Time is precious and DCF models take too long
  • A good buying opportunity shouts at you from the market; if you need a calculator, let alone a spreadsheet, it’s probably too close
  • Robustness is more important than refinement; it’s easy to find apparent discrepancies in valuation, but most are false– it’s more important to seek out independent insights which confirm or deny the discrepancy than to calculate its size; when info quality is good, focus on quantifying and ranking options, but when it is poor, focus on raising it
  • Non-financial heuristics are often quicker and sufficiently accurate to lead to correct decisions; you may make more errors than the rigorous analyst but you can work much faster and evaluate many more opportunities which is usually a good trade-off
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Notes – A Compilation Of Ideas On Investing

How to Screen for Hidden Champions

  • If I could recommend only one book for value investors to read it would be Hidden Champions of the Twenty-First Century
  • Reading about Exxon Mobil (XOM) and Apple (AAPL) and Starbucks (SBUX) and thinking you are becoming a business expert is like reading about blue whales and elephants and thinking you are becoming an animal expert. Tiny insects are a lot more common than giant mammals
  • Screening for Hidden Champions:
    • 10 years consistent >= 15% op margin and market cap < $1B
    • 10 years consistent >= 15% ROE and market cap < $1B
    • 10 years consistent >= 8% ROA and market cap <$1B
    • 10 years consistent EPS increase and market cap < $1B
  • If an ultra-conservatively managed family company earns 10% on equity it would probably earn closer to 20% on equity if it was sold to a professionally managed multinational
  • Some companies have negative equity, to correct for this, screen for >= 8% ROA regardless of ROE
  • The best place to screen for hidden champions in the UK is SharelockHolmes

Backtesting Net-Nets: Does It Matter?

  • Net-nets are a symptom of the overall stock market’s health
  • You should ignore a net-net for two years after you buy it, at minimum
  • The key to a successful NCAV portfolio is to not sell your winners too fast
  • If a stock has low institutional ownership, low short interest, no analyst coverage, and a small number of shares outstanding – nobody is looking at the company; buy net-nets where institutions own the fewest shares
  • Inactivity is necessary to really judge your net-net selection skills
  • If you are just taking a profit (or loss) in a net-net within 1 to 2 years of buying it – I think you’ve basically just traded a stock on a different basis than you analyzed it
  • A good net-net is really just a decent business. Why would insiders still control 10% to 50% of a company that has been public for 10 to 30 years?
  • Try to buy the “best” net-net available each month with an emphasis on “safe” rather than “cheap”
  • Attractive net-net criteria:
    • Long history of consistent profitability
    • Long tenured CEO
    • High insider ownership
    • Low leverage
    • High cash relative to share price
    • Good capital allocation decisions
    • Simple business
    • Good business
    • Lasting business
  • Ideally, you don’t want to pay more than the company’s own cash for the stock
  • High insider ownership in a newly public company doesn’t have the same meaning as it does at an old company
  • Dividends are nice, not because they’re important but because of what dividends are a symptom of
  • Retailers are tough net-nets; a retailer that loses some of its competitiveness is a retailer that could be out of business in a matter of years
  • How to sabotage a NCAV portfolio: sell too soon; if you sell your winners when they go up, you destroy the performance of a net-net; the big winners are needed to outweigh the big losers and the mediocre performers
  • The holding of net-nets is critical
  • Slowly assemble a net-net portfolio over a period of a couple years, and don’t sell anything for those first two years

Should You Wait for a Crash – Or Buy Today’s Best Bargain?

  • To get consistently good investment results, follow one of two programs:
    • Buy companies that are clearly selling for less than their conservatively calculated value to a private owner
    • Buy companies that will earn high returns on capital while growing quickly for many, many, many years to come
  • During periods of panic, look for obvious mispricings; for example, high quality companies trading at less than 10x FCF; 10x free cash flow is less than stocks are generally worth
  • To fill a portfolio in the midst of a market crash, have a shopping list of companies you like but are overpriced ahead of time
  • You are very unlikely to cause any sort of catastrophic problem for yourself just by overpaying for the right kind of company. Buying the wrong company is your biggest risk
  • Just wait for an obviously wonderful business selling for the kind of price a normal stock sells for in normal times

Warren Buffett Checklist to Invest in a Great Business: KO

  • Buffett had 9 criteria he examined when determining whether he was investing in a great business:
    • Does the business have an identifiable consumer monopoly?
    • Are the earnings of the company strong and showing an upward trend?
    • Is the company conservatively financed?
    • Does the business consistently earn a high rate of return on shareholders’ equity?
    • Does the business get to retain its earnings?
    • How much does the business have to spend on maintaining current operations?
    • Is the company free to reinvest retained earnings in new business opportunities, expansion of operations, or share repurchases? How good a job does the management do at this?
    • Is the company free to adjust prices to inflation?
    • Will the value added by retained earnings increase the market value of the company?

Free Cash Flow: Adjusting for Acquisitions, Capital Allocation and Corporate Character

  • Make your Ben Graham investments on an EV/EBIT basis
  • Make your Warren Buffett investments on a price-to-free-cash-flow (P/FCF or P/OE) basis

How to Read a 10-K: What is the Most Important Part?

  • The only 10-K I read from cover to cover is the most recent 10-K
  • Print out and mark up a hard copy of the latest 10-K, 10-Q, and 14A
  • Check all of the 8-Ks and 13Gs from the last year or so
  • If there was a scandal, a proxy battle, legal case, unconsummated merger, etc. – read the 8-Ks and other documents surrounding that time period even if it was many years ago
  • Read the oldest 10-K as well as the newest
  • Read any shareholder letters ever written that are still available
  • Enter Balance Sheet, Cash Flow and Income Statement data into an Excel spreadsheet for every year the company reported to EDGAR
  • Always have at least 10 years of data
  • Look at the notes to the financial statements most critically
  • Ask yourself the following questions:
    • What is customer behavior in the industry?
    • Why do customers choose what they choose?
    • What does management really think? What are they really like?
  • Gannon prefers investing in companies where he understands customer behavior the best

How Long Should You Hold a Net-Net?

  • All we need to do is make sure that the stocks we buy are clearly worth more than we pay for them
  • Forget about trading a net-net a full year after buying it and instead focus on the two things that matter most:
    • Picking the right stock (company)
    • Holding that stock regardless of what the market does
  • Never sell a net-net in less than one year unless:
    • You made a mistake
    • You need to buy something else (that’s better)
  • A one to five year holding period is the right length for net-nets
  • Never sell a net-net just because it reached NCAV; NCAV is still really, really cheap

How to Get a Job in Value Investing

  • Look for someone trying to build a research team from scratch
  • The best combination is often when the position is brand new and the right person was impressed ahead of time
  • Do lots of research for free and then let it get into the hands of someone who can hire an analyst
  • Talk to everybody whose work you respect by sending them an email; share your best ideas with them
  • Set aside time to writing and reading about value investing every single day
  • Don’t send your casual thoughts to those you’re trying to impress; you want them to think of you as a thorough, insightful researcher

What is the Buffett/Munger Bargains Newsletter?

  • Investing in net-nets is the best way for a dedicated, “do-it-yourself” individual investor to beat the market
  • The newsletter’s strategy is to find companies with the following attributes:
    • Simple business
    • Favorable long-term prospects
    • Able and honest management
    • Consistent earnings
    • Good ROE
    • Little debt
    • Very attractive price
  • It is modeled on the Buffett/Munger of the 1970s
  • “Really good businesses usually don’t need to borrow… they make the most of an already strong business franchise or concentrate on a single winning business theme” -Buffett
  • Use the higher of today’s interest rates and long-term average interest rates when considering valuations

How I Pick Stocks for the Ben Graham Net-Net Newsletter

  • Traditionally, big net-nets have been poor performers
  • The ratio of insider ownership to institutional ownership is actually one of the best predictors of the future stock market performance of a net-net
  • What makes for a good net-net?
    • High insider ownership / Low institutional ownership
    • High F-Score
    • Consistent earnings
    • Simple business
    • Decent ROE
    • Decent long-term prospects
  • The idea is to get the best business for the lowest price

How Should You Divide Your Research Time?

  • I put my energy towards whatever is most clearly undervalued
  • I keep cash close to 0% when I have good ideas
  • The important thing is picking the exact right company and then picking the approximately right price
  • I spent probably half a year thinking about buying DWA before I put in my buy order
  • A typical net-net for me is a 10% position held for just over a year
  • I spend almost half my time looking at net-nets and almost half my time looking at high quality companies
  • I look longer at each high quality company I research
  • Required reading:
    • Warren Buffett’s Letter to Shareholders (1977-Present)
    • Warren Buffett’s Letter to Partners (1959-1969)
    • The Snowball: Warren Buffett and the Business of Life
    • Buffett: The Making of An American Capitalist
    • Poor Charlie’s Almanack
    • Common Stocks and Uncommon Profits (by Phil Fisher)
    • The Interpretation of Financial Statements (by Ben Graham)
    • The Intelligent Investor (1949 Edition)
    • Security Analysis (1940 Edition)
    • Benjamin Graham on Investing
    • Benjamin Graham: The Memoirs of the Dean of Wall Street
    • One Up on Wall Street (by Peter Lynch)
    • Beating the Street (by Peter Lynch)
    • You Can Be a Stock Market Genius (by Joel Greenblatt)
    • The Little Book That Beats the Market (by Joel Greenblatt)
    • There’s Always Something to Do (about Peter Cundill)
    • The Money Masters
    • Money Masters of Our Time
    • Hidden Champions of the Twenty-First Century
    • Jim Collins Books: Built to Last, Good to Great, How the Mighty Fall, and Great by Choice
    • Distant Force (about Henry Singleton)
    • Kuhn’s The Structure of Scientific Revolutions and The Essential Tension
  • Specific reading on extreme market conditions:
    • The Big Short
    • Too Big to Fail
    • This Time is Different
    • When Genius Failed
    • The Panic of 1907
  • Knowing about historical episodes is understanding what the paper looked like every morning to folks who were as blind to the future as you are now
  • Case studies of investments made by investors whose books, letters, etc., the student has read
  • Side-by-side comparisons of stocks with the names of the companies omitted, for example:
    • Buffett’s investment in GEICO, Wells Fargo, Coca-Cola, Gilette, etc.
    • Graham’s investment in Northern Pipeline, DuPont/GM (long/short), etc.
    • Phil Fisher’s examples in his book
    • Joel Greenblatt’s examples from his books
    • Peter Cundill’s investments in his biography
    • Peter Lynch’s investments in his books
    • MSFT at different points in its history, WMT versus Costco, present day modern US railroads, present day comparison of high-quality large versus high-quality small company, comparison of present-day hated companies and historical Warren Buffett equivalent
  • Value investing is mostly about doing original research alone
  • New value investors love reading books on theory and technique; they spend too lite time studying specific stocks
  1. Open Google Translate
  2. Find the stock on its home stock exchange
  3. Read the company’s annual reports
  4. Study comparable companies in your home country
  5. Enter the stock’s past financials in a Microsoft Excel spreadsheet
  6. Use the past financials and comparison companies to appraise the stock’s value to a private buyer
  7. Compare the stock’s appraised value to its market price
  8. If the market price is more than 75% of the appraised value, forget about the stock
  9. If the market price is less than 50% of the appraised value, focus on the stock
  10. Otherwise: use your best judgment