Investing Thoughts and Wisdom (mostly from others) – Part 29
I have a file full of notes and excerpts from investors that I’ve collected over the years. I’ve been meaning to organize it for a while and so, via this newsletter, I’ll gradually do so (in several parts, some of which will be open to all, and many which will be for paid subscribers). [Previous posts: Part 1, Part 2, Part 3, Part 4, Part 5, Part 6, Part 7, Part 8, Part 9, Part 10, Part 11, Part 12, Part 13, Part 14, Part 15, Part 16, Part 17, Part 18, Part 19, Part 20, Part 21, Part 22, Part 23, Part 24, Part 25, Part 26, Part 27, Part 28.]
I used to read through this file a lot, but it got to be pretty long, which led me to summarize the key parts of my own philosophy (as of the present time) in a blog post titled Final Decision Checklist.
Please note: Nothing here should be considered investment advice or the best way to invest. These are things I’ve saved as reminders and notes to myself that I’ve found helpful in the past, and think they are worth sharing in case any of you happen to get an insight from any of it.
General Reminders:
The goal is to win by not losing.
While you want to try to not ever lose money on an investment/trade, you will be wrong and make mistakes. That’s part of the game—so you need some diversification to account for being wrong.
“No matter how hard you work at having systems for avoiding error and practices of trying to stay within your circle of competency, et cetera, et cetera, you still make mistakes.” —Charlie Munger
Remember, it is about making good expected-return bets, even if they won’t all work out. But make sure you are making a good expected-return bet, and that you’ve done the necessary work, before putting capital to work.
Can this investment survive (and maybe even thrive) under high inflation?
Is the company or investment conservative with its balance sheet and leverage? Can its balance survive a major recession where revenues could drop 20% or more (depending on the industry) without having to raise outside capital?
Are management’s incentives aligned with shareholders?
Is the management team comprised of owner-operators that have the “capacity to suffer” adverse reported earnings’ impacts that may accompany opportunities to invest and reinvest in markets and other projects that will expand the company’s long-term sustainability and competitive advantages?
But remember that the capacity to suffer isn't enough…it also has to be right. (e.g. Barnes and Noble was a closely-controlled company and invested in its Nook product, but why would you decide to compete with Amazon, Apple, and Google, who were all larger and already had big lead in the market?)
Is the stock undervalued? [General rule-of-thumb: FCF yield at least 2x the AAA-rated bond yield…..or a minimum absolute level of about a 10-12% pre-tax yield (8.34x – 10x pre-tax), or about 6-9% after tax. But flexibility may be required for earlier-stage businesses if you pursue investing in them.]
Munger, 10% comment: “Though not an iron rule, we hope to make, say, 10% pretax long term when buying with equity.”
Bruce Greenwald on the return Warren Buffett expects [also included in Part 7]: “His idea of a fair price, by the way, is a price that gets him a return going forward on that investment without any improvement in the multiple of somewhere between 13 and 15%. By normal standards, when the average market return is 7-8%, that’s a really good price, he’s looking for a very good price. They call it a fair price because the multiple may be fairly rich, it may be 13, 14 times earnings. But the value of the growth may bring his return up to 13-15%. So when he says a fair price he’s talking in terms of normal value metrics, and there the reason that you prefer that to a poor company at a really good price is that because the good company can grow through reinvestment and things like same-store sales growth, your return will come in the form of capital [gain], not distributive income, and that, after tax, is much more valuable.”
Is the probability very high that the earnings you are using is a normal level of earnings? (i.e. Don’t underestimate competitive forces…. even from competitors that don’t yet exist.)
“We have found in a long life that one competitor is frequently enough to ruin a business.” —Charlie Munger
Are the next 10 years extremely likely to have the company earning more FCF? (i.e. How predictable is it that the future path is positive?)
Is there plenty of margin for error?
Is this investment antifragile? (i.e. Would this company benefit from volatility and tougher times because, for example, it has cash for acquisitions and a history of making them at the right times, a history of smart buybacks, etc.?)
Is this a good addition to a portfolio goal of having 6-12 uncorrelated positions if you know them deeply, have limited downside, and much more upside potential than downside risk? Or 15-30 uncorrelated positions if you know them well and are confident about the upside potential versus the downside risk, but maybe aren’t things you know extremely deeply and/or maybe aren’t quite 1-foot hurdles? [For more on position sizing, see Part 3.].
Is this a business I’d want to own in its entirety, if it was the only one I could own (and run by the people running it, and by buying it at the current price)? (i.e. Am I taking a businesslike approach to investing?)
Are there good reinvestment opportunities? (i.e. Is the runway long and wide?)
The ideal buy to earn the highest returns is probably a low p/e (high earnings yield) and low ROIC business, where diligence leads you believe that the low ROIC is going to become a high ROIC.
This way you may get the combination of re-rating to a higher p/e and also increased earnings.
These ideas are likely to be found by thinking conceptually and not just quantitatively (i.e. where are the tailwinds? Where may higher returns be coming in the future as a result of economic, political, technological, or other changes?).
Don't confuse the economy with the stock market.
The stock market is a discounting mechanism. The direction of the economy does not necessarily mean that the direction is the same for the stock market.
Remember that economies can have a lot of problems that don't impact shareholders.
“Using U.S. market data going back to 1926, Vanguard analyzed the predictive powers of a whole range of metrics. The rather depressing conclusion – at least from an economist’s point of view – is that we are pretty much wasting our time by assigning any value at all to what goes on in the real economy. Of all the metrics tested by Vanguard, only P/E ratios seem to explain some reasonable proportion of future (real) stock market returns, and that is only if you are prepared to take a very long term view (10 years in the Vanguard study).” (Absolute Return Letter – December 2012)
Some of Peter Lynch’s Rules of Investing (from Beating the Street):
Investing is fun, exciting, and dangerous if you don't do any work.
Your investor's edge is not something you get from Wall Street experts. It's something you already have. You can outperform the experts if you use your edge by investing in companies or industries you already understand.
Behind every stock is a company, find out what it's doing.
Often, there is no correlation between the success of a company's operations and the success of its stock over a few months or even a few years. In the long term, there is a 100 percent correlation between the success of the company and the success of its stock. This disparity is the key to making money; it pays to be patient, and to own successful companies.
You have to know what you own, and why you own it. “This baby is a cinch to go up!” doesn't count.
Long shots almost always miss the mark.
Owning stocks is like having children - don't get involved with more than you can handle. The part-time stockpicker probably has time to follow 8-12 companies, and to buy and sell shares as conditions warrant. There don't have to be more than 5 companies in the portfolio at any time. [Note: Lynch was much more diversified himself.]
If you can't find any companies that you think are attractive, put your money into the bank until you discover some.
Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets. Always look at the balance sheet to see if a company is solvent before you risk your money on it.
If you're thinking about investing in a troubled industry, buy the companies with staying power. Also, wait for the industry to show signs of revival. Buggy whips and radio tubes were troubled industries that never came back.
If you invest $1,000 in a stock, all you can lose is $1,000, but you stand to gain $10,000 or even $50,000 over time if you're patient. The average person can concentrate on a few good companies, while the fund manager is forced to diversify. By owning too many stocks, you lose this advantage of concentration. It only takes a handful of big winners to make a lifetime of investing worthwhile.
In every industry and every region of the country, the observant amateur can find great growth companies long before the professionals have discovered them.
A stock-market decline is as routine as a January blizzard in Colorado. If you're prepared, it can't hurt you. A decline is a great opportunity to pick up the bargains left behind by investors who are fleeing the storm in panic.
Everyone has the brainpower to make money in stocks. Not everyone has the stomach. If you are susceptible to selling everything in a panic, you ought to avoid stocks and stock mutual funds altogether.
There is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of the newscasters. Sell a stock because the company's fundamentals deteriorate, not because the sky is falling.
Nobody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what's actually happening to the companies in which you've invested.
If you study 10 companies, you'll find 1 for which the story is better than expected. If you study 50, you'll find 5. There are always pleasant surprises to be found in the stock market - companies whose achievements are being overlooked on Wall Street.
If you don't study any companies, you'll have the same success buying stocks as you do in a poker game if you bet without looking at your cards.
Time is on your side when you own shares of superior companies. You can afford to be patient - even if you missed Wal-Mart in the first five years, it was a great stock to own in the next five years. Time is against you when you own options.
“The key in investing is to know what you know and know what you don’t know. You can know about management teams without meeting with them. Every situation is slightly different. So I come back to the point that if you know enough on other things that there is enough margin of safety. Even if you meet with management, you may not learn something. Obviously, actions speak louder. You want to see what they have done. Everything being equal, the more you know about management, the more honest and upfront they are, the more motive they have, the better the situation is and the deeper the discount. You have to analyze it all. The key to analyzing it is you have to ask: Do I really know what I think I know? Do I really know what I don’t know? If you can’t answer that question, chances are you are gambling.” —Li Lu