Specialists vs Generalists

February 4, 2011 § Leave a comment

One of the things that I find really fascinating and also hilarious (and, if thought about too much, super scary) is when 24-hour news stations have nothing to report on, so they try to find some interesting new story that in reality isn’t all that interesting and actually not really new. But they find it anyway and put it up with the crazy fast moving news graphic. And then they have that expert—-who has apparently dedicated his entire life to the study of this particular story—-flown in to put it all into perspective for us. (The one that made me realize that this was bonkers was when I was doing my MA in Theology and CNN had this week long news story on the fact that there are more than 4 gospels written and one was even about Judas being a good guy! And it was this big crazy deal! The end of the Bible! Except for the fact that any MA student in theology, antiquity, medieval history or religious studies has read all of these much later gnostic gospels and this is, in fact, not new or news. Oh well.)

Now, this isn’t to put down 24 hour news networks. I’m sure there is some benefit to them and we may figure out that benefit one day. But this all-too-common occurrence has significance for the value investor. That significance is that our society places an exorbitant amount of value on the specialist—-the dude who’s spent years of his life studying the significance of some minute cross-section of human understanding, in order to increase our collective understanding of that thing. And these specialists are super important: I come from a family of PhD’s and I’ve seen both the dedication needed and rewards for being the expert in a field. (In fact here is a cool lil cartoon about why PhD’s are totally necessary.) But in placing so much weight on the word of the specialist, we set up a value-drawing mechanism that is silly when you actually sit and think about it. Or to put it in another way, when we place so much weight on the authority of specialists, something else is smuggled in that I don’t think we actually want. And that thing is an attitude and a belief system that I think the true value investor needs to shy away from and be comfortable in dismissing.

So what is that thing? Well, it is the belief that the more detailed you can get in your data, the more precise you can be in your conclusions and therefore you’ll make better decisions.

On the outset the correlation between data and precision seems to be pretty linear. More data = better decisions. Only a fool would jump in his car with 30 min before his flight on a 20 min drive to the airport without looking at the traffic report. If you know one route is slower, you take the other one.

But this reasoning does not continue ad infinitum. There comes that point on the spectrum where the data begins to be irrelevant, a time-suck or so small in significance that it doesn’t affect the situation. Accumulating this data is meaningless and wont (or, perhaps, shouldn’t) alter your decision and may make you screw up the whole process. Just because you’ve spent 30 min figuring something out, it doesn’t make it any more right or wrong or authoritative than the thing you figured out in 30 seconds.

Now we generally act with common sense in our everyday lives. No one, upon seeing that route A to the airport is bumper to bumper, collects data about their car’s fuel efficiency ratios regarding route B. Route B may be longer or more hilly or the escarpment may cause a wind-tunnel effect drag on your vehicle, but route A will cause you to miss your flight. We filter out the little details with the big trump.

But for whatever reason, we don’t do this with the market. My guess is because when we were kids we were told a lot about chaos system and all watched the little cartoon of the butterfly flapping his wings in some exotic country and producing a hurricane in Saskatchewan or whatever. And a lot of ink has been spilled about how that same butterfly flapping will cause Exxon Mobil’s revenue to go up 2.6%, on average for the next 10 years (adjusted for inflation.) And people make market decisions based on this stuff. And it’s crazy.

And as people lose money by doing this and as technology gets better and faster, we reason that we haven’t been beating the market because we haven’t got detailed enough. So there is now a race-to-the-bottom-of-things in order to corner the market and be able to make the proper correlations between the flapping and the ticker symbols. And people pour lots of money into faster trading platforms, or will throw money at MIT math PhD grads in hopes that these people who have dedicated their life to cutting edge probability math will, by means of their special insight, unlock the hidden mysteries of the chaotic system and you are bathed in a money shower. So you got the guy who’s an expert on butterfly flapping in the commodities sector and one in energy stocks and an expert on this circumstance and that circumstance in hopes that their combined power will somehow give you an edge. And it doesn’t work because of the misplaced correlation. More data does not equal precise conclusions.

So what is a value investor to do? Well, one thing is to get real comfortable with mystery. And what I mean by mystery is that grey zone between the seeming randomness of the incredibly tiny and the general order that we have around us. If you keep going smaller and smaller, down past the atom and all the way into the quarks and tiny half particles, physics tells us that when we get that low, everything is random movement and we can’t really figure out how all this random movement of particles holds an atom together and brings order to the world around us. Have you ever tried to have a conversation with a die-hard materialist? He’s talking about the randomness of particles and how because of this randomness we can’t really know anything for certain, except you know for certain that he’s a crappy lunch companion. There’s a gap that is too big for us to compute between the random/small and the big and predictable. There may be a correlation, but we can’t figure it out and it probably wont be a factor in the real/macro world until it is no longer small, but big and more easily discernible. In other words, don’t worry about a butterfly flapping in New Jersey. But if 65 million butterflies are flapping in New Jersey at once, I’m not taking a plane out of LaGuardia. Or, as Buffet said, look for one foot hurdles to step over, not seven foot hurdles to try to beat.

And the best way to do this is to try to increase your general knowledge of all things. Be a specialist, but don’t think that going super deep into one aspect is going to magically shed light on other things. It’s like putting a cardboard tube on the end of your flashlight. No, I think the true value investor has to be comfortable with the whole range of human experience. The best value investor is not a craftsman, perfectly sculpting a portfolio, but a great editor, cutting out the things that don’t need to be there and boiling decisions down to the essential (and statistically higher probable) elements. And don’t sweat the fact that you can’t know everything about everything. You will be far better off knowing a bit about tons of stuff rather than a lot about a small section. If anything, being a generalist will keep you safe from the man-with-a-hammer syndrome. The MWAH syndrome is that to a man with a hammer (ie: the thing he is a specialist about) every problem begins to look like a nail. (I’m looking at you Paul Krugman.) But if to you every problem is a nail, when you meet a screw you are, well, screwed. But if you can call a nail a nail and a screw a screw, you wont panic when something new and unforeseen enters into your investment life. No panic and steadiness is good. Strive for that.

So value investors should learn about as much as they can. And not just in the business world either. They should learn how metaphors illuminate aspects of human experience; they should learn about math and probability. They should learn about psychology and how people act differently in groups vs how they act on their own. They should definitely read history and primary sources from antiquity. (Basically, they should read Art of Manliness.) That well rounded, wide range of insight to draw from should be the thing we as value investors really strive to develop. Not just for making wise choices in the market, but for building up character in general and being a better man.

But as long as there are people putting all of their eggs into the specialist basket, there will be market discrepancies that should provide lots of one-foot hurdles. Happy jumping!

I am long XOM

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Methodology: Part 3. Don’t Be Stupid

January 18, 2011 § Leave a comment

This is my series on how I decide to buy what I buy
Part 1. Part 2.

Ok, so we got the “is it selling cheap” down and the “what is the intrinsic value” down and we have talked about margin of safety and all those good things. But it’s still not time to buy. Being wise about your investments is more to do with keeping your emotions in check and making sure that you aren’t doing really stupid things because of any kind of psychological reasons then it is making sure everything fits into a numbers box.

This is probably why I am more inherently attracted to Charlie Munger than I am Warren Buffett. Sure Buffett is the granddaddy can-do-crazy-math-in-his-head super investor, but Charlie Munger is good ol fashioned don’t-be-a-one-legged-man-at-an-ass-kicking-contest common sense kinda guy. In fact the best thing I have yet to read on investment has come from a lecture he gave at Harvard in 1995 called The Psychology of Human Misjudgment.

So I think the most important thing you can do once you think something may be a good investment is to have this emotional check list that you go through. Give the investment some time. Think it over. Ask questions. Plot out the best case, good/likely case and worst case scenario and see if you could live with the worst. Be really honest about whether you are doing this because it would be risky not to as opposed to any number of outside factors, like herd mentality or whether you say things like “man I’ve put so much time into this. It’s gotta pay off. I’ve worked so hard.” No. Be zealous about staying as objective and conscientious to the context as possible.

I separate my questions into two chunks. Chunk one is more technical stuff:
-is there stable market share? As in, is there enough ways that they can get money and do what they do
-are they dominant or secondary in their industry
-do they have a strong brand? Is the brand being factored in to the price. Are you ok with that? (think Apple. Or Netflix. Or Coke.)
-do they use the power of the network/social media. Can they fit into a world dominated by google/twitter/facebook. Or does it not matter to their industry.
-Do they change fast. If yes, that’s bad. Don’t give yourself big hurdles to clear.
-Can they change their price, or are they in a dead heat with competition
-Do they have a moat beyond a brand identity?
-Do they have high inside ownership (I love inside ownership. Nice for them to have skin in the game. This is why I love Nordstrom as a company. Too bad they are always so freaking fairly priced. Man I should have bough in 08. Huge regret. Good lesson to learn. Trust your checklist.)

The second grouping of questions is…um…slightly less technical.
-Are you being stupid?
-Are you overconfident?
-Dividend? If not, justify your buy
-Is your margin of safety high enough?
-Are you buying for your own reasons, or because of someone else?
-Are you relying too much on past performance? (Just because they have a ROE of 20% for 5 years or have grown x amount of time in no way means they are a good buy.)
-Have you daydreamed about what living with the worst case scenario would be like?
-Is the stock falling or fallen. Remember the National Bank of Greece
-is this a concept stock or are they actually doing something. Don’t fall for the TSLA foil. (hey-o! see what I did there?)
-can you hold this for 3 years? Cuz you should. Now obviously, true value could be realized in 3 days, at which point you would sell. But it usually takes about 3 years for all the shoes to drop. Their hitherto unseen awesomeness is either revealed or you are revealed for not doing your homework.

The psychology of human misjudgement is something I am going to dedicate my investing life to. The emotional side of things is that important. Right now what I’m fighting against is the “omigosh the market is crazy rising! Buy buy buy!” Mix that with my youthful exuberance and my bias feelings of “hey, I’m the protagonist of this story. Of COURSE my portfolio is going to be awesome!” and you’ve got a recipe for crappy returns and buying things too expensive. So that explains why all is quiet on the CAPS front for me these days.

And I hope to update my emotional/common sense checklist every once and a while. I’ll let you know as I do.

*I don’t own anything I mentioned. Especially TSLA. Sell some cars, then we’ll talk.

Methodology: Part 2. Intrinsic Value

January 5, 2011 § Leave a comment

This is my series on how I decide to buy what I buy.
Part 1. Part 3.

Ok, so in the first part of this methodology survey we looked at some of my favourite metrics and the tests that businesses need to pass in order for me to consider them a good business qua business and also at a potentially a good value.

The second part of my methodology is to now really home in on that intrinsic value and see if I want to buy it at the price that is being offered.

Now, intrinsic value is not math. I mean, there is a lot of math involved, but there is no exact number you can reach. You can reach a ballpark figure, and if you have a big enough margin of safety, you don’t have to be perfect, just close. If you’ve calculated the intrinsic value of Graemecorp to be $25.50 a share and it is trading at $21 you don’t want to buy because you–like me–are probably wrong. Accept it. Respect the complexity.

Now, if Graemecorp is trading at $8 you may want to start thinking about buying. But the calculation of $25.50 that you reach is not infallible, no matter how much work you put into it.

But how do I determine intrinsic value? Well, its tricky, because the methodology is going to vary for different companies in different circumstances. Getting a good idea for fair value of a shipping company (which generally trades close to book value and low P/E) is going to be way different than for a venerable company like Johnson and Johnson, who has such a consistent history that you can feel comfortable if they are quite over book or have a higher P/E. So, sorry, you can’t just plug in a bunch of numbers into some sort of divine formula and get the perfect intrinsic value number. It’s an art!

So what I try to look for are floors and ceilings. A good floor to look for is what is called the liquidation value of a business, or in other words, what the business would be worth if you sold ever last paperclip, pencil and cleared out the inventory. (What this doesn’t take into effect is the value of the future profitability of the business.)

Two good numbers to give you a potential liquidation value are the Net Current Asset Value (NCAV) which is simply the Current Assets – Total Liabilities. If the number is positive and if the per share price of the NCAV is higher than what is on the market, man you may have a good thing on your hands (note: often times the NCAV is positive is the company has a ton of cash on hand. Cash on hand is very good, but if it is just sitting there not doing much, not being reinvested nor being paid out in a dividend, you may question whether you want to pay for money to be sitting around.

The second good number you can find is the Net Net Working Capital. This was Benjamin Graham’s (go read him now) pet figure. It is perhaps the best detailed number you can find for a liquidation value.

NNWC = Cash + Short Term Investments + (0.75 * account receivables) + (0.5 * inventory) – liabilities

The logic of this formula is that if you are liquidating a company, you wont be paying full price for account receivables or inventory, so these are some pretty conservative haircuts Graham uses to measure the value. Again, if the per share price is below this, then the business is worth looking into. If you feel that they wont go bankrupt, then you may have a good pick on your hands.

Now, that being all said, these are floors for me. If prices are below these floors (rare) then they are falling into a “special interest” category and should be looked at further. It could be awesome, but it could be deadly and the company is in serious trouble.

But once you have a good ballpark on liquidation value, you can now start looking for a good ceiling. For me, a good ceiling is what the company is worth when skies are blue and all they need to worry about is not screwing up. They don’t need to be heroes; they just need to run a healthy business. If they still look cheap after passing this test, then we’re really sitting on something nice.

So what I run are two different valuation tests: the Discount Cash Flow (using a normalized CROIC as my growth rate) and the Ben Graham Intrinsic Value calculation. To get a great handle on the DCF, read about it here. (Fun fact: I didn’t know you could find really easy DCF calculation tools online, so I did a whole spreadsheet exactly like the one on Investopedia. It was a disaster. Total unmitigated disaster. I didn’t know a thing about Cash Flow. I think I valued Coke at like $17 a share. That was a grumpy evening.)

With a DCF there are two big numbers you need to make a decision about: the growth rate and the discount rate. For me the growth rate is pretty easy: you can either choose the 10 year average of revenue growth, EPS growth, FCF growth etc. But what I like to use is the 10 year average CROIC rate (with a bit of a haircut for safety). So I use a 80% of the 10 year CROIC average for my growth rate. My reasoning is that CROIC really tells you about the worth of a company and not just what the company says they’ve done.

Now the discount value is a bit tricky. Investment banks churn out crazy greek numerical values and something that is called a Weight Average Cost of Capital (or WACC) in order to find the number that you will discount future earnings by. But for me it’s simple (common theme eh?). I tend to use a discount value between 12% and 15% because it is insanely high. But seeing as I would be really happy with an annual 12-15% appreciation on my invested money, this is a further built in margin of safety. I also look at a DCF model using the average 30 year corporate bond rate (around 6%) just to see the ballpark range I’m playing with.

The second valuation I run is the Graham Intrinsic Value metric. Ben Graham talked about this a lot in his book and Jae Jun over at Oldschool Value has a great updated version of the formula that he uses (and that I stole!)

So let’s recap. I now have:

a NNWC value
a NCAV value
a DCF using CROIC and with a discount value
and
a Graham Intrinsic Value calculation.

So now I have a pretty good idea of my floor (NNWC, NCAV and a book value per share) and my ceiling (DCF) with my Graham value somewhere in the middle. All things being equal, my intrinsic value should be closer to my ceiling than my floor, so if I want to get good value I need to buy at a healthy discount of my ceiling. So I look for a 50% off of the DCF and I try to practice what Graham preaches with a 66% off of his intrinsic value calculation but it’s rare to find something like this.

So that’s my check list! You can see the breakdown here:

Yes, this is a screen shot of a spread sheet. Fancy eh?

Now, all this being said, each business and each circumstance around the business is unique and they are all treated differently. These are just my checklists, but there are instances where the company doesn’t pass the checklist, but still seem an attractive buy. And also there are companies that pass the checklist, but I don’t jump in because I’m not gung-ho about the business model. So in order to compensate for this, I have a bunch of questions/emotional checks and balances that I ask myself in order to see if I’m being a smarty-pants or actually being wise.

More of that in post 3

Methodology: Part 1. The Checklist

January 4, 2011 § 2 Comments

This is my series on how I decide to buy what I buy.
Part 2, Part 3

I gave myself a couple of investing challenges this past week. Not so much New Years resolutions, as more a guideline of good habits (and breaking bad ones) that I want to implement into my financial life. One of the bad habits to break was to stop playing around with leveraged commodity ETF’s, my favourites being HOU.to (which follows crude oil prices) and HKU.to (which follows copper.) They are definitely not value plays and therefore I shouldn’t be playing around with them. But having the type of disposition I have (being pretty calm when people go nuts about something) means that I do pretty well with tracking crude oil hysteria and price jumps.

But it’s not a science and I shouldn’t get into the habit of playing with it too much. And they fall way out of my investing worldview bubble, so I should just cut them out. You know…sometime. (Note: Yeah, so writing this out has made me rethink the whole short-term commodity trading and I realized I’m playing with fire. Sold all my positions in HOU.to (had none in HKU.to.) Made some money, but it’s guilt money! Lesson learned: do not stray from your worldview.)

But a good habit I’m implementing is to actually formalize my checklist and have the businesses I invest in pass my criteria. The checklist is designed to look for devaluation in price, gauge financial health, ballpark intrinsic value and have all the info at my fingertips so I can make a decision.

Now, there are plenty of awesome spreadsheets out there that can do all of this for you. The best one I’ve ever encountered is put together by Jae Jun at oldschoolvalue.com. He’s been tinkering with that sucker for a while now, and it is so worth the price he charges for it. If you want to save some time, go there and get it.

Now, there are two negative things that happens when you buy a ready made checklist. The first is that you are following what the author deems to be important (Jae sidesteps that problem by putting every freaking thing you could ever want in it!) The second, and more serious consequence is that you never learn how to do this stuff yourself. So that’s why I decided to clack out my own spreadsheet of the metrics that I use to gauge intrinsic value.

So lets talk about the process!

For me, investing is about one simple concept: each stock represents a business (this in itself can be a revelatory idea for some people) and that business is worth something. The money they generate, the monetary value that they can produce by means of their product, service and combined intelligence is worth something in a dollar sense (aside: magic happens when the value created is monetary and a social value to the world. But that’s another blogpost). I as an investor am trying to figure out what that money is worth, what it will be worth in the future, and how much of it in the future the business will generate.

Then when you have that all important figure, you go and see if the market is selling the stock at a greatly reduced price to what you deem the intrinsic value of the business to be. Basically, you are trying to buy a dollar for 50c. (Props to Joe Ponzio).

So I am trying to do 2 things:
1. See if the market is potentially undervaluing a business.
2. Find a fair value for that business and compare my price to the market.

Part 1 is below. Part 2 will be in post 2.

So what I do is give a company tests to pass trying to determine if the market is under-valuing them and to gauge financial health. If they pass the tests then I try to figure out a good price (pretending that I wanted to buy the whole company for myself.)

These tests they need to pass. And warning: we’re gonna get technical now, so if you are a new investor–a mere youngling in the world, you’re gonna have to look these puppies up on Investopedia.

Checklist:

ROE  >15% for the past ten years. I look at the average. This shows me what sort of return they are generating. It shows that they can at at the very worst manipulate their EPS every year, or, hey, at the best are actually adding value! But this number is not to be trusted. So that’s why he’s first. (Think of it this way: if you sold a TV with a year guarantee that if they hated the TV after a year they could return it for a refund, you as the TV salesman could report that sold TV as earnings this year. But if they return it and you have to pay them back, well, you can still call it earnings for your EPS, but just have the money flowing out in another section of your balance sheet. Sneaky eh!? So be careful with this one.)

P/E <10 A good indicator that the market is undervaluing the business. Again, be careful as different industries tend to trade at different P/E ballparks. But as far as I am concerned, once you start moving north of 10, 12, 14 you are getting into non-value zone.

FCF growth >10% for the past 10 years. You can’t argue with cash. Sure you can manipulate earnings, but not the movement of cash.

Assets > 1 and a half liabilities. Nice to know the outhouse isn’t overflowing.

Debt to equity ratio under 1. Debt can kill a business just as fast as it can kill a grad student.

FCF to debt > 10%. Good to see that they can manage the debt they do have.

CROIC growth >13% over the past 10 yrs. You can read more about CROIC here and here. If a business can generate a cash return on their invested capital, well, you’re gonna want to play for that team!

If a business passes these tests, man they are worth a closer look to see what sort of price you’d like to pay for em.

I’ll show you how I try to find that intrinsic value in post 2.

What do you swing at?

November 24, 2010 § Leave a comment

First off, don’t worry folks, I wont be always using a baseball metaphor for every post. That would be neither fun for you or…uh..doable for me. Besides, I’m much more of a hockey guy myself, but hockey doesn’t lend ample metaphors for investing. I mean, you could maybe do something with defensive +/- stats and stock volatility, but that’s way less sexy. And it would probably be a horrible idea for a blog name.

Anyway. They wont all be sports analogies.

But for this post, it is. The famous baseball-investment analogy is that the market is like a pitcher pitching you prices–some are good, some are laughable bad while others are there–right there, floating down the alley with a big “swing batta” sign on them. And you know that good feeling you get in your soul when you connect right in the sweet spot. Well, if you get the right pitch you’ll be fist-pumping around the bases Joe Carter style (touch em all Joe!) in no time. And the investing lesson we are to learn is to wait patiently for your pitch. And the bonus is, you don’t strike out by waiting. (And if this baseball analogy is something you enjoyed, you can read more about why we are called Batting 450 here)

But this raises the obvious question: what is a good pitch?

Well, in baseball different hitters have different spots. Some like down-and-away, others like up-and-in but no one can hit it out of the park, anywhere, all the time. So the thing you need to learn about yourself as an investor is where your swing is and what pitches you are looking for. Where are you comfortable? What do you know? What part of the plate gives you the best percentage chance at connecting and putting runs on the board?

For myself, I tend to look for pitches that (roughly) meet three criteria.

1. Solid companies with a history of returning equity to their investors. I know. It sounds lame to say “I like to invest in good companies who make money” but its true. Don’t overlook the simple. Therefore I usually look for 5-10 years of +13% in ROE (Return on Equity)

2. Mispriced. For some reason or another the market has either read doom and gloom for a particular business, or they have ignored some good things, or the market as a whole has tanked, bringing this great company to a price that looks like a bargain. This is perhaps the biggest factor. If you can judge whether a company is worth the price being quoted, well my friend, you are gonna mash some taters.

Mashin Taters!

This can sometimes be easier to do, especially if there is some super crazy crisis that is driving the stock price down. I mean, when BP went to $26 a share, it was a pretty attractive buy. Except for the whole disaster thing. And if you bought some then while everyone else was dumping shares, well you’d have made about 50% return right now. I didn’t swing, and I learned my lesson. (Lesson: follow your rules and don’t let emotion or opinions of others get in your head. Trust your swing.)

But not every company is going to go through some major crisis, so it’s not always going to be glaringly obvious. But discrepancies will happen. Look for em.
3. Dividend. Call me crazy, but I like being paid for taking a risk. There are plenty of studies out there that show that dividend stocks fare better than non paying stocks, but that doesn’t mean it will always be that way. But if I’ve bought it at a great sale price the dividend is icing on the cake. If I misjudged the sale and the price doesn’t rise that much (or, er…at all) then the dividend is a great hedge against my own innate ability to be oh so wrong. And I love hedging against that. You should too.

But if you are in this market, thinking about being in this market, or are a brand new investor baby like me, you need to sit down and think to yourself what your sweet pitches are. Write em down. Study others. Learn. Read. Heck, that’s what this blog is all about: me trying to learn my swing by writing it out, learning from you and getting it out of my head and onto paper (pixels?) so that I can grow and be better.

Disclosure: I don’t own BP. I mean, they did have to sell a bunch of money making stuff to pay for the whole spill thing. Oh, and also I don’t have any money. Like I said: new investor baby.

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