The Poor Investor

Investigatory Value Investing

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Forecasting for Dummies

I recently attended the New Orleans Investment Conference and although I do not invest in mining companies and I’m not a “gold bug,” or a gold investor at all for that matter, I did take away a lot of useful information.

Though, perhaps the most useful piece of information was this:

Never forecast.

Now, admittedly, this was something I always knew, but the conference did help to solidify this thought some more in my mind. Watching people make big assertions about the price of gold going up, predicting stock valuations and movements in commodities only to see them be dead wrong two years later just made people look foolish. The people who made these forecasts and the people who followed them. All foolish. Imagine the hard-earned capital that was probably lost as well.

I worked at an investing research company for a short while and watched a seasoned analyst, who had been working there since the company’s inception, miss one of the most important calls in his industry.  One of the dozen or so companies he was following was bought out and he missed it completely.  It totally side-swiped him.  He even went as far as to say the company would never be bought out when another analyst brought up the prospect of the company being sold.  Talk about egg on the face.

Still not convinced? Well, think about this, do you even know what’s going to happen to you tomorrow? You know your life, your schedule, how many hours are in a day, etc. and I’ll bet you can’t accurately predict most of what happens to you tomorrow. You don’t know what your boss is going to say to you. You don’t know if you’ll get in a car wreck on the way to work. You don’t know if you’ll even wake up tomorrow. Test yourself. Try to predict a dozen or so things and see how many work out as planned.

So, if you can’t predict what’s going to happen to you, the person, or thing, you probably know the most about, how can you accurately predict what millions of investors are going to do? The bottom line is that you can’t. The best we can do as investors is look at the trees and forget about the forest. Will the market crash this week? I don’t know. Will it be down next year? No clue. However, I do have confidence that solid, well-managed companies trading for less than they are worth will most likely be trading at values higher than they are now. That’s the best we can do as investors. We take bets on stocks where the odds are in our favor and don’t when they’re not. And then we spread these bets out so we don’t bet the farm on one company because if there’s anything about this “not being able to forecast” thing it’s the whole “not being able to forecast” part.  You don’t know if “company X” will go to zero tomorrow. If “X” does go to zero, you want to have companies A, B, C, D, etc. to fall back on. Maybe it’s 20 companies, maybe it’s 100. That’s for you to decide. The point is to build your portfolio structure so that it won’t fall over if one brick crumbles. Keep the odds in your favor.

Examples of the “odds being in our favor” are things like companies trading at a discount to book value, or even cash value. Maybe it’s a company like BDCA Venture, Inc. trading below its NAV of $6.89 per share at $5.00 per share. Or maybe it’s a company like Electronic Systems Technology, Inc. trading at or near cash. Maybe it’s a management team that lowers the risk; management that’s honest about the direction of their company and can back up what they say with an excellent track record. People like Apple’s Tim Cook or Tibco Software’s Vivek Ranadivé. Perhaps it’s a catalyst on the horizon like a patent approval or a drug approval. Whatever it is, you put the odds in your favor in some way. If there’s nothing putting the odds in your favor, you’re no longer investing. You’re speculating; you’re gambling; you’re forecasting.

Never forecast.

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Who You Know or What You Know?

I’ve recently finished my MBA and am now searching for employment opportunities. In this search I’m reminded, quite starkly, of the oft-quoted phrase, “It’s not what you know, it’s who you know.” The great thing about the stock market is that it works in exactly the opposite way. In the stock market, it’s not who you know that matters but what you know. The market, as Ken Fisher puts it, is “The Great Humiliator” and does not care who you are or who you know, “it wants to humiliate everyone.” In fact, who you know often works against you and may even entice investors towards illegal activities, as exemplified recently by a few well-known individuals.

The “what you know” I’m referring to here is your own analysis of individual companies and the markets in general. In fact, if you would have listened to common wisdom (the “who”) you might have sold in May, went away and missed out on a 2.1% gain in the S&P 500. You might have missed the boat on Apple at around $427 a share when everyone was claiming the sky was falling only to watch it rise to $633 a share, a lost opportunity of $206 per share. Once, when I was new to investing, I told a friend not to invest in Sirius XM when it was trading around $0.30 per share and he missed out on a potential 10-bagger. Or, you might have listened to friends who told you to buy Facebook when it first went public at $38 per share only to watch it drop to $18 in the first three months.

Nothing works better in investing than coming up with your own conclusions. For one, you won’t have the conviction in the company you are buying if you go based off of someone else’s recommendation. Even if someone is spot on about a company’s valuation and tells you that company X will go from $5 a share to $15 a share—even if this person is absolutely right and has a compelling enough reason— are you going to be able to hold the company’s stock when it goes from $5 a share to $1 a share before it goes up to $15 a share? Will you really have that level of discipline and, more importantly, trust in someone else’s judgment? Only by doing your own analysis, coming up with your own valuation and buying a company that you have strong conviction in because you put in the hard work will you be able to hold through the downs (or buy more) and not sell too early during the ups. This person’s recommendation may be 100% accurate but you might be enticed to sell at $7 for a $2 gain because you just won’t have the commitment you would have had if you came up with the idea in the first place.

Secondly, if your investment is in a company someone else recommends, you probably won’t have any idea of what to look for when things are going south. Are insiders selling? Did a member of management leave? Is this good or bad? How do you know if you didn’t investigate the company thoroughly? Now, say, the company has to raise funds by issuing stock— is this good? Was this part of the company’s plan all along? If you weren’t following the company, if you didn’t do your homework, you wouldn’t have any idea on these questions or any others. There won’t be any tip-offs to tell you when things are going well or if the management is running the company into the ground when you don’t put in the long hours of work it takes to investigate a company thoroughly enough to have conviction in it.

These are just a few of the reasons why you need to think for yourself when it comes to investing. This is why I don’t like recommending companies, it takes away from a core part of what will make someone a successful investor. I like to use companies as examples to illustrate ideas and how to think about companies, not as advice for what to buy. And with that, I will leave you with a quote from the Oracle of Omaha himself:

“You have to think for yourself. It always amazes me how high-IQ people mindlessly imitate. I never get good ideas talking to other people.”  -Warren Buffett

Investing: Life Lessons

From the last issue of The Marathon Perspective, written by Jim Kennedy of Marathon Capital Management.

LESSONS FOR LIFE:

1. At the heart of every investment is a value proposition. Sometimes it’s disguised as a good balance sheet, other times as a prospective stream of future earnings or cash flow, and other times as the seed of an idea by a competent management team. Regardless of the proposition, with some conviction you need to identify both the future investment return and the anticipated time frame for that return. The key words here are “conviction, return and time frame.” Strive to have all three before you enter into an investment. None of us will be right 100% of the time, but having these three partners at your side will increase your odds of success.

2. Stay away from “story” stocks and water cooler tips. As investors, we are bombarded by ideas 24/7: the Internet, friends, talking heads on network shows, publications, etc. Use the simple rules noted above (conviction, return, time frame) and you will be able to cut through the clutter and avoid the less than honorable promotions. Just remember that every “story” or idea can be made to sound terrific by the right promoter. Take the time to look behind the curtain and do a little homework. Walk away from things that don’t smell right. A simple perusal of SEC filings and other research materials can save you lots of heartache and money.

3. Learn from your mistakes. To paraphrase Einstein: the definition of insanity is to do the same thing over and over and expect a different outcome. We all make investment mistakes. The sad truth is that we don’t always learn from them. As painful as it sometimes is, revisit your bad investment decisions and try to figure out why they went south. Not only will this exercise reveal weakness in your investment process, but it will make you a better investor in the long run. No one gets it right every time, but by understanding your mistakes, you increase the odds of success going forward.

4. Sell your losers. Remember our premise from above: conviction, return, time frame? If one or more of these change and the equation becomes unacceptable based on your risk tolerance and investment goals, sell. Too many investors hang on to losing positions even as the red flags mount. Strike the phrase “I’ll sell when I get back to break-even” from your vocabulary. Your only thought should be “opportunity cost.” Think about it this way. Suppose you put $10,000 into XYZ stock and it went south on you. At the end of the year it was worth $5,000, but your conviction in the name has been cut in half because management did not deliver on its promise. At the same time, you research ABC stock and are enamored with its prospects. You wish you had funds to put into ABC, but you’re “stuck” in XYZ for now. The wise investor sells XYZ (remember that loss of conviction?) and redeploys that capital into ABC. The foolish investor will not admit a mistake and will “hope” that things turn out okay with XYZ. Fast forward 18 months: the foolish investor feels pretty good because XYZ is up 20% from its nadir, while the wise investor has made twice as much on ABC and is ready to redeploy capital again. Compound this type of behavior over a multi-decade investment time frame and the “opportunity cost” to the foolish investor is enormous.

As a side note: try to differentiate between a “mistake” and “steak on sale.” We are big proponents of averaging down on an investment, but only if your conviction is high and it satisfies your other investment criteria.

5. Check your emotions at the door. Woven throughout these discussions is an undercurrent of emotional investing. As difficult as it can be, you should approach every investment opportunity and decision rationally. Think about the past two years: when were you the most nervous about your investments? We’ll bet it was right near the bottom of the markets.

As Warren Buffett says: be greedy when others are fearful, and be fearful when others are greedy. Our phone rings off the hook when the markets are going through a rough patch. But history has shown time and time again, the best time to invest is when everyone else is scared. Were you taking money off the table in late 1999 and early 2000? Probably not, as most investors believed that trees do grow to the sky. Hindsight is always 20/20, but so is rational, fundamental investing.

6. Do your homework. One of the ways to remain rational while those around you are running for the hills is to understand what you own. If a stock is nothing more than a symbol and quote in the newspaper, then you will be subject to the foibles of investing. On the other hand, if you believe that by owning stock you actually own part of a business, you will become somewhat immune to the short-term fluctuations in share price. The foolish investor flits from idea to idea without doing any serious homework, while the wise investor digs into a story and either develops a reasonable level of conviction or moves on to the next idea. Most investors do more homework and research buying a new refrigerator than putting $10,000 to work in the stock market. There’s something wrong with that equation.

7. Read and think. If we had a nickel for every time someone asked “where do you get your ideas?,” we’d be long retired. Ideas come from every direction, but if you aren’t ready to assess them and make rational decisions, you may as well throw your money out the window. This is where reading and thinking enter the equation. The more you read, the more knowledge you will acquire on a wide variety of topics. This base foundation of knowledge is the bedrock of the investment process. It doesn’t mean you become an expert in any particular area, it just means that you are that less likely to make a mistake. Thinking is just as important. Many of us read, but how many of us think about what we’re reading? One of our favorite sayings is “research is to see what everyone else has seen, and to think what no one else has thought.” Turn off the Internet, T.V. and iPod and think for one hour a day. You’ll be amazed at what you find.

8. Management, management, management. We have an advantage over the average investor, in that management teams are more willing to meet with institutional money managers than with individual investors. It doesn’t mean they won’t talk to you on the phone or meet with you on occasion, but it’s a rare individual investor that has the time and perseverance to undertake such activities. With that said, there are ways for individuals to get to “know” management. Read the SEC filings that detail management’s background and pedigree; look at the top executives that a CEO has chosen to run the organization; listen to quarterly conference calls, particularly the unscripted Q & A session at the end of prepared remarks; ask friends, relatives and acquaintances if they know anyone in the industry; look at the board of directors – is it independent with the background and experience necessary to guide the organization? At the end of the day, a bad management team can run a good company into the ground. If you can not develop a reasonable level of confidence in management, move on to your next idea.

9. To concentrate or diversify. This one is a function of your willingness to embrace the investment process, being mindful of your risk tolerance and time frame. Think about your life – how many jobs, spouses, pets, houses, kids, cars, etc. do you have? Most of us are willing to concentrate our “investment” in just about everything else in life, except when it comes to the stock market. This is not an endorsement
of concentration in the stock market – that would be too risky for the vast majority of investors. But for those willing to do a lot of homework, concentration can be very rewarding. The average investor might own 5 – 10 mutual funds investing in a variety of equity classes (e.g., large companies, small companies, international, etc.). This is a prudent way to spread equity risk, but at the end of the day, you end up
owning hundreds and sometimes thousands of individual stocks within these funds. Most people become closet indexers without ever realizing it. Contrast that with owning 10 – 20 individual equities that you know well. Sure it takes a lot of work, and you will lose money on a number of your choices (remember, we all make mistakes), but if you’ve done your homework and develop conviction through your reading and research, we think this can be a very rewarding investment approach.

10. Don’t lose money. This one comes back to the Warren Buffett school of investing: Rule #1 is don’t lose money; Rule #2 is don’t forget Rule #1. This one is much easier said than done, and yet, even Warren Buffett has lost money on some of his investments. But the key message here is that permanent loss of capital is very difficult to come back from.

Here’s a very simple concept that is foreign to most investors. When you first look at an idea, focus on how you can lose money, not on how much you can make. We are all enamored with how much we can make in any given investment, but how many times has your judgment been clouded by the “upside.” It is human nature to dismiss the red flags when you are excited by the tremendous potential of something. Our recommendation is to catch your breath, step back from the “story”, and look at the situation rationally. It’s okay to take a flyer on something that has lots of upside, but you can’t build a portfolio around too many ideas that result in goose eggs. So weigh the risk vs. reward carefully before investing a dime, and make sure that you stay within your investment discipline and risk tolerance.

11. Last but not least, wait for your pitch. You can not be an expert at all facets of investing, but you can become very good at certain approaches and styles. Don’t be afraid to say this one’s “too hard” to figure out and assess; there’s another pitch coming your way soon. Wait for the one that’s in your sweet spot and swing away.

We’ll leave you with a final cautionary note on the proliferation of Exchange Traded Funds (ETF’s). For the uninitiated, ETF’s are similar to mutual funds in that they allow an investor to put money to work in a particular sector or focused approach. As opposed to open-ended mutual funds that set their Net Asset Value (NAV) and allow buys/sells at the closing price each day, ETF’s trade continuously throughout the day.
These “trading vehicles” have taken Wall Street by storm and have attracted billions in assets. Call it a hunch, a cool breeze at the end of summer, or maybe just the ramblings of an old buy-and-hold investor unwilling to pass the torch, but there’s something going on here that just doesn’t feel right. That doesn’t mean that all ETF’s are questionable, but we highly recommend that you understand the structure of what you are investing in, asking such common sense questions as: does the ETF hold the underlying assets (e.g., stocks, bonds, gold, commodities, etc.); does it use leverage; is it a financial derivative of some other financial investment; what guarantees sit behind the “fund”; do you as an investor “own” the underlying asset in the event of liquidation; who “manages” the fund and where does it reside?

The bottom line after the last couple of years in volatile markets: fool me once, shame on you; fool me twice, shame on me. If someone can not explain something to you in plain English, and you have trouble understanding what you are investing in, walk away.

Notes from The Poor Investor:

The Marathon Perspective is another casualty among what is quickly becoming a dying breed: quality newsletters and writings pertaining to investing (among other topics).  In Jim Kennedy’s own words, “Eventually, the strong will survive and the choices will narrow, but for now the online universe is a thousand miles wide but only an inch deep.”  In other words, it’s becoming increasingly hard to “separate the wheat from the chaff” when the internet offers so much more “chaff.”  For most of us the lessons of investing will be hard-learned, especially when many of us foolishly emulate advice from books and websites which offer little value and insight.  My hope is that this website will provide investors with an abundance of “wheat.” 

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