What infrastructure has to do with investing

When was the last time you thought about infrastructure?  Your mind probably drifts to roads, bridges, subways.  But when was the last time you thought of the infrastructure that is so boring that it's thoughtless?  Things like your water, electricity or plumbing?

The scale of these projects is breath taking.  In the US and Canada everyone who wants to be wired with electricity is wired with electricity.  And it just works.  You never flip a light switch and think "I hope the lights come on this time."  The same is true for plumbing, or water if you're in an urban area.  These things work and they're enormous.

Step back and consider electricity.  How many miles of electric wires are there in the US?  Google tells me that the US electric grid is the largest interconnected machine on the face of the earth at 200,000 miles.  And right now everything is working.  I mean there are probably a few localized outages, but it all just works, and will work tomorrow, and the next day, and the day after that.

This giant machine marches forward every day regardless of what's happening.  But what's even more unique about the system is that any outage is quickly localized.  If you plug in too many items into an outlet you'll blow a fuse.  If a tree falls on a line and overloads a circuit a fuse blows at a distribution hub.  There have been a few rare instances where a portion of the country goes offline, but the entire grid hasn't gone down.

The reason for this is by design.  Issues are isolated to the smallest area possible.  If a lamp is bad it's just a fuse.  If a house goes bad then maybe a neighborhood.  But plugging in a counterfeit iPhone charger into a wall socket doesn't have the ability to down my city.  This is by design.

So what does this have to do with portfolio construction?  Most portfolios are constructed where the errant iPhone charger can take a country offline.  Investors concentrate their portfolios into similar companies, or companies that rely on each other, or on specific conditions in a given country continuing.

The challenge is to design a portfolio that's like the electrical grid.  If you make a mistake and buy a dud (and we all do) that the damage will be limited to that dud.

The natural answer is to state "buy an index and you'll get a bit of everything and be safe."  Unfortunately it isn't that easy.  The largest companies in the S&P have underfunded pensions that are invested in....the other largest companies in the S&P!  Smaller companies are reliant on suppliers that have financial difficulties of their own.

If you start to follow this train of though you'll end up in some tangled web of interconnected liabilities that looks like something out of a CSI show.  But just because something is connected doesn't mean that an issue can bring the entire company down.  What you want a resilient companies with strong balance sheets and a growth mindset to overcome setbacks.  A balance sheet gives a company time.  And time is necessary in any situation where the future becomes unclear.

It's always a good time to look through your portfolio and make sure you aren't concentrated in any sector, or that companies don't rely on each other.  Sometimes you can load up on companies in the same sector and avoid contagion effects.  Whereas contagion exists across sectors, especially with manufacturers who have specialized suppliers.

Call me old fashioned, but I always want a solid balance sheet.  A company with a shaky balance sheet and growth can outrun their liabilities, but it's never a guarantee.  A solid balance sheet gives the company and investor time to react to market realities.

In the end I want my portfolio to be like the electrical grid.  I want it to be able to withstand a few trees falling and a hurricane in Florida without a blip in New York.

If only a company did... then things would be better

I have a family member who believes there is a deep liberal conspiracy to smuggle illegal aliens across the border and dump them with senior citizens.  At the same time I have another family member who believes that if it weren't for those pesky conservatives they'd have pristine bridges, commuter rail, free college and whatever else they can dream up.  Maybe you can relate to one of these, or maybe like most you are chuckling at the absurdity.  The devil is in the details you say.  But what's interesting is that often investors will tout equally outlandish theories about companies, and no one bats an eye.

How often have you heard someone say "X company just needs to initiate a buyback" or "Management is a bunch of idiots, anyone could run that failing division" or "we need an activist to unlock value" or "they should sell" or maybe "they should acquire."  The list goes on forever.  And just like the wild political takes a simple capital markets act will magically make everything better.

Maybe it's just Mr Market that's like this, and you aren't.  But I doubt it, every investor does this, myself included.  We think that a few simple acts can just change the trajectory of a stock.

But let's step back.  Why is a division, company or a stock in a slump in the first place?  I look at slumps in stocks/companies (anything?) through a sports analogy.  We always love to make fun of last place teams.  But those teams with the worst records are made with players who are some of the best in the world.  Sure, a few duds might have snuck through, but there are others who have hall of fame fabric.  So why does a team do poorly? Do they wake up and say "we want to lose."  They all go out and play four quarters like everyone else.  How are they so bad?

Companies are the same.  Why does a division underperform?  Why is a company sub-par?  Do employees show up at work and proclaim "I love underperforming today!"  Of course not.  In many cases employees might be thinking they're doing a great job.  They might be exceeding expectations.  So what is it?

Most of this stems from our inability as outside investors to appreciate the nuance of a situation.  Maybe a division is underperforming because management fails to motivate employees.  Different managers who are motivational might be able to turn something underperforming into something outperforming.  But we just don't know.  Likewise it might seem foolish for a company to be hoarding cash.  Why would a company without investment opportunities save money?  What we might not know is that management had experience with a nasty downturn and wanted to make sure the company survived going forward.

My point is as outside investors we really don't know or understand the reasons for what's happening.  But insiders do.  They know why something is dysfunctional, and they know why the problem can't be fixed either.

These simple fixes we toss around as investors aren't new to management.  I sometimes laugh when I see activist proposals.  I think "I'm sure management has never considered buying back stock, they'll probably be so happy with such a great suggestion."  In a few rare cases there are managers who have their heads firmly in the sand.  But just like everything else, there is some underlying, and almost guaranteed unspoken reason why the action hasn't happened to date.

Does this mean all hope is lost?  Not at all, but we shouldn't hope for simple things either.  I could fill an afternoon sharing stories of activists who had a simple fix for a company that turned into a quagmire once they won and became involved.  As outsiders we don't know why a situation is what it is, but we should know that fixes aren't simple.

Does this mean we should avoid companies that are a mess?  If they aren't trading at a discount for the mess then I'd stay steer clear.  Why invest in a mess when you can invest in something pristine for the same price?

What this means is there are no simple fixes for companies, just like lower/higher taxes won't magically fix the nation.  The fixes required to unlock value are difficult, time consuming, and costly.  But if the discount is deep enough then they're worth it.

Success is only obvious in hindsight

My close friends and family will usually claim I'm "crazy" or "march to a different drum".  What they're saying, or so I hope, is that the challenges that excite me are far from normal.  And that's how I found myself attempting to backpack 100 miles through the mountains in less than 50 hours.

I've always been fascinated with endurance events.  Riding a bike across the state, ultramarathons, canoeing the Ohio river.  I've always been active, running, skiing, hiking, backpacking.  I started to dip my toe in the endurance waters in 2012 when a friend and I biked the State of Maryland in 60 hours.  It was a good intro, some of the trip was incredible, some monotonous, some a challenge, but enjoyable overall.  It was a good accomplishment, 200 miles in 60 hours.

Biking was one thing, but distance walking was another.  The event I walked in was in the Allegheny National Forest, an area of close to a million acres an hour and a half north of Pittsburgh.  The goal of the event was to walk the length of the North Country Trail segment that went from the north border of the forest to the south border.  The trail, a 4,000 mile monstrosity, has 100 winding and hilly miles in the forest.  You start at 1,200 feet, hike up 12,000 feet of hills and down 12,000 feet of hills to end at 1,200 feet in elevation at the end.  The challenge was to complete this hike self-supported.  There were no aid stations, no volunteers, nothing, just you, you're gear on your back, and a lot of miles.

About 20% of the people who attempt this finish.  Maybe one reason friends consider me crazy is I looked at this and said "oh, 100 miles in 50 hours? That's just 2mph at a constant pace, seems easily doable"  Uh huh... but what about sleep and eating! Well, there wasn't much sleep, and I ate as I walked.

What I worked out was that for every minute I was stopped I had to increase my average speed slightly.  That might not be bad in the beginning, but after walking 60 miles?  I determined to not stop except when completely necessary.  I slept about five hours total during the event and was moving the other 99% of the time.  Was it worth it?  It definitely was, I finished with two minutes to spare.

Over 50 hours my margin of safety was 120 seconds.  I have thought about that two minutes considerably since I finished.  What if I had dawdled at a road crossing an extra minute?  What if I took a little longer to filter my water?  What if I had sat on a rock for a few seconds a half dozen times.  There are so many variables of things that could have happened to eat that margin that it's crazy.

I trained for months for the event.  I ran considerable distances.  I woke up at 2am and would hike 30 miles in the middle of the night so I knew the feel of being in the woods at night.  Sometimes before bed I'd put on my backpack and walk a quick two miles in the dark in the neighborhood, just to get more miles in.

All of this training helped, but I was never assured completion until I crossed the finish line.  I had doubts I could complete the event up until I crossed the finish.  As a participant it was never clear I'd complete it.

To outsiders it seemed abundantly clear I'd complete this.  Afterwards my wife, kids, parents, friends all said "oh yeah, we expected you finish."  This expectation was based on my stubborn drive, and training.  But they weren't out there walking with me!

I don't know if that hike will become a lifetime achievement or not.  Maybe I'll do something wild and crazier in the future.  But what I do know is that for now it has taught me a lot of life lessons.

When I look at companies that the market has labeled "successful" I think back to my hike.  To outsiders it appears that all of the preparation will guarantee success.  When success happens everyone nods in agreement because it was expected.  But when failure occurs people are shocked.  How it this happen?  It happened because success is only assured in hindsight.  To the players involved there are a million variables, a lot of tiny stops eating up seconds that are digging into that two minute margin.

As outsiders we never see these challenges or struggles.  Even worse, as outsiders we tend to minimize these struggles.  It's not a single struggle that brings down the endurance athlete, it's a culmination of events.  Your feet hurt, your legs hurt, you get tired, you don't eat enough, your brain tells you to stop.  What was the specific event that killed the race?  You can't identify one, it's a number of things working together.  And failure in the business world is the same.  It's a culmination of many decisions working together.  Sometimes there is a single reason for failure, a big giant mistake.  But usually it's dozens of small decisions that at the time looked like the right decision that when assembled in hindsight result in failure.

Success is just like failure, a combination of multiple variables put together in a very specific way.  You can increase your odds of success by doing things correctly, but it never assures anything.  And you can increase your odds of failure by doing everything wrong, but you might succeed!

This is why I think success narratives are nothing more than false hope.  Getting up early, or drinking coffee with butter, or reading 500 pages a day assures nothing.  Even worse, if you adopt a task some successful person has deemed important, and your journey isn't the same as theirs the task might be harmful instead of helpful.

If you ask any successful person what it felt like on their journey they'd echo what I wrote above.  They were never quite sure they'd make it until they made it.  At times on the journey it feels like success is assured, but at other moments it feels like failure lurks around the corner.  It's a constant battle you fight, and if you stop fighting you fail.

I don't have any great wisdom on what it takes to be successful.  My only parting words are this, find the destination you have in mind and determine what variables will make a difference.  Then focus on those variables as you move forward.  Good luck might find you and give you a boost.  But it's always a possibility that misfortune finds you as well and derails your plans.  Either way, you won't know until you set a path, work to execute it and see what happens.

Act Now! Bargins disappearing quickly...or maybe not?

When the market starts to slide financial news starts to read like heated fans in a close sporting match.  Suddenly every little flinch and flick is of utter importance and vital to the final outcome.  As an investor it's really easy to get drawn into that mentality.  If we're honest with ourselves we'd admit that it's fun, there activity, there's news, there are big gains and big losses.  I think humans crave activity verses boredom.  There is also a mentality that if you don't buy quickly then you'll miss out on opportunities until the next bear market.  And given how quick bear markets seem to be these days you definitely don't want to miss out.  Or do you?

Before I go any further I want to dangle out a little maxim that is useful in investing as well as in real life: If someone is pressuring you to buy something quickly it is not a deal for you, but a deal for them.

I want to break down this argument that you must buy now to find deals with a few simple scenarios:

1) Stocks climb from here (you missed the dip) -  Let's imagine there are deals laying around everywhere, and people who want you to buy stocks would agree with that.  You need to be buying with both hands they say so you don't miss opportunities.

If you are just buying and selling the index then this line of thinking could apply.  If you mis-time the bottom you'll never have another opportunity as stocks rise to infinity (I jest, but just slightly).

But most investors aren't purchasing the index.  When a consumer loses confidence in an appliance, or a person they don't earn all of that confidence back immediately.  It takes time, the same is true with stocks.  If the market worries that a company won't make earnings and the stock drops 30% it won't rise a corresponding 43% instantly, it will be spread over time, the time it takes to rebuild confidence.  You will have this period of time to take advantage of individual opportunities.

Let's image that stocks do rise quickly with no confidence rebuilding period.  What do you do now?  Maybe it doesn't matter, if stocks do grow to the sky, and the market is always up and to the right then any time is the best time to buy.  This is the lesson of the US, that markets always recover and always go up.  If you like it at $50 buy at $60 because it'll be at $70 tomorrow.  There is never a bad time to buy, and dips just boost your gains.

As they say in financial advertising, the past is no prediction of the future, and we don't know if the US market experience will hold forever.  But investors also invest based on financial advertising and past results, even though we know they are meaningless for the future.  I selfishly hope that US stocks just go up forever as well, I live in the US and I have a family here, I don't want to spend 10/20/30/50 years treading water.

2) Stocks continue to fall -  If you loved it at $80 you'll love it even more at $60, or imagine $30, or when you sell at $15...

Investors either view a downturn as an opportunity to "buy on sale", or as a reason to panic and dump holdings they previously liked.

The longer markets fall the more confidence is lost in specific businesses.  I don't know why this is true, a stock price doesn't reflect the economic reality of the underlying company.  It's supposed to be a rough proxy, but it's susceptible to swings, over valuation and under-valuation.  But people act as if when a stock falls, even if the business is doing alright that the business has suffered harm.  What's even crazier is that company management eventually acts like this as well.  It's a self-fulfilling prophecy.

It always takes a while to rebuild confidence, and the more that confidence has been destroyed the longer it will take to rebuild.  It's during this rebuilding period that you can continue to find stocks to purchase at attractive valuations.  Sometimes a stock will drift and fall during the rebuilding phase giving even better opportunities.

The best part of investing during the rebuilding phase, verses the initial fall is that investors should have an indication as to how the business will continue going forward.

When the market fell in late 2008 and early 2009 the index had some initial quick gains.  But confidence was lost for a number of companies.  I was able to find companies trading for less than net current assets and half of book value in 2010, and in 2011, and again in 2012, then in 2013, and 2014, and even a few in 2015.  The benefit was that for most of those companies they'd published a few years of financial statements showing that trading for such a low valuation was absurd.

So what's an investor to do?  First off, don't be the consumer rushed into a sale because a salesperson says you have to buy right now.  In the markets the salesperson consists of brokers and managers whose year end bonuses are only paid if the market has a gain.  That's why it's imperative that they convince the world to buy, buy, buy.  If everything is a buy they earn a tidy commission.  If you're a broker or manager trying to earn that bonus I don't blame you at all, keep pounding the table!  For the rest of us it's worth taking a step back and making thoughtful purchases verses a snap purchase.

You have to be in the game..

Did you see the meteor shower recently?  Maybe you were aware of it, or had heard about it, but you just weren't outside in the middle of the night.  Meteor showers are tough, they're late, they don't work around our schedules, and they are hit or miss.  You might clear your schedule, stay up late and then the weather is cloudy.  And even after all of that there are no guarantees, meteors shoot by all night, but if you aren't looking in the right spot you miss them.  In many ways investing in small forgotten stocks is very similar to the meteor shower.

There's an expression used to talk about many of these forgotten stocks, they're called "one day" stocks.  The reason for that is the stock might lay dormant for months, years, decades, and then in a single day earn investors a satisfactory return for the entire holding period.

The perverse thing about one day stocks is if you sell the day before the "one day" you have terrible returns.  If you are lucky enough to invest a few days before "one day" you might have a 5x or 10x return on a very short holding period.

These sorts of stocks are radioactive to investors with performance metrics to hit.  The reason is there are no steady gains, and in many cases no movement at all quarter to quarter.  The stock purchased at $37 three years ago is still quoted at $37.  A little secret is a fund manager would prefer a stock that appreciates from $10 to $13 verses one that trades at $37 for years before jumping to $180.  Small and steady gains mean liquidity and numbers to show at quarter end.  Our one day stocks offer none of that.

The trouble with one day stocks is you have no idea when that one day might be.  Trust me, there are plenty of us who have tried to read the tea leaves, interpret signs and guess at the one day.  But guessing doesn't work.  Just like the meteor shower you have to be out and waiting otherwise you'll miss it.

In the past I tried to find the best cheap stocks.  I'd look over a set of stocks trading for a low multiple of earnings or book value and then throw out ones that seemed questionable.  Questionable not because of value, but questionable as to whether I'd ever see that value realized.

I might as well confess my value investing sins.  I've passed over stocks at 1-2x earnings because of bad management.  I've passed over stocks at 4x earnings because it was a boring business in a bad industry.  I've passed over so many stocks at screaming cheap multiples for so many reasons I'm surprised I even have returns!

What I've discovered is this, when a stock is obscenely cheap it will eventually have a "one day".  The thing is you don't know when that's going to happen.  In the past year two cheap stocks, Vulcan International and Randall Bearings both had their one days.  It seemed like Vulcan would be cheap forever.  This was a company with a CEO who required shareholders to pester him and then sign an NDA to receive financials.  How could this stock ever see value realized?

Or how about Randall Bearings?  I discovered them at $2 and they're selling out at $42, quite the win, except for all of the red flags.  The CEO took an excessively large salary.  The largest supplier owned a large block of stock to prevent a sale.  Shareholders had to take them to court before the company was forced to mail out financials.  But with all of that the "one day" still happened.  The CEO and largest shareholder decided they wanted to own 100% of the company and made a bid.  This things eventually happen.

I'm tired of trying to guess what the next one day stock is and have adopted the meteor shower attitude.  It isn't enough to be aware that these stocks exist.  You can't try to read the clouds, you have to stay up late, sit outside and hope and wait that the clouds lift and your patience is rewarded.  It might not work the first time, or the second, but eventually you'll reap those gains.

My new mantra is that whenever I stumble across a cheap "one day" stock I'm going to pick up a small position.  I know that eventually 5-10% of my portfolio might be in dead names that don't move year to year.  But I also know that over time that 5-10% will also provide me with some nice surprises on the upside.  You have to be in the game to score, and the only way to score with these sorts of stocks is to hold your nose, buy a few shares, and then forget about them for the next decade.  Once you do that you'll be pleasantly surprised by what happens next...