Why I don't use watch lists

I remember as a kid sitting in a chair near our kitchen with my grandfather two chairs away.  I was leafing through a toy catalog.  The catalog's pages were worn and I knew the items and their prices by heart.  Suddenly my grandfather looked at me and said "What are you doing?  Looking at all the things you can't buy but wish you could?"  I was stung by the criticism, but he was right.  I had almost no ability to purchase any of the items.  I was just envying items I couldn't have.  As I reflected on this story recently it reminded me of why I don't keep a stock watch list or research stocks that I wish I can buy someday.

This current moment is all we have.  What has already happened doesn't exist outside of our memory and what happens next isn't guaranteed and is unknown.  We need to focus on the now, because in the now we can take action.  We might regret action taken in the past, but it can't be changed.  We can imagine what action we might take in the future, but futures never work out like we imagine.

When I'm looking for an investment I survey every potential investment candidate available at the current time.  I do this because these are the opportunities that I can take action on now.  From that pool of opportunities I'll research until I find one I wish to add to my portfolio.  

It's happened that I've purchased a number of names from a given pool at once.  I've also passed on investing anything at all if the current opportunity set isn't desirable.  By regardless of the eventual action I take I'm only evaluating the current opportunity set.

This strategy differs from other investors.  Most investors keep a watch list of companies they'd like to invest in at a given price.  I know investors who spend most of their research time researching companies that they might never have the opportunity to purchase.  The idea behind this is that they put in the research hours before an opportunity occurs so when it does finally happen they can act quickly.  This is the theory at least.

Part of the reason the investing public believes that investors should endlessly research companies, even ones they will never purchase is because this is what "great investors" tell them.  In interviews professional investors who understand Marketing 101 utter things like: "we never stop researching" or "We're always hunting for new ideas."  This makes perfect sense when you look at things from their vantage point.  A professional is getting paid for results, and their clients want the assurance that their manager is always at work always ready to make money for them.

I know a number of professional investment managers, some with great records.  I don't know if they're always working, but what I do know is they're always able to meet for lunch or take a phone call, and they're never in a hurry to leave.  It's a very flexible job, and for those with talent and savvy it's possible to earn great returns with less than full time work.  Not that clients would ever know this..

There's a misnomer that hard work generates results.  Work is required, but hard work alone doesn't guarantee anything except for being tired.  The problem with this myth is that if you look at top athletes or the top of anything skilled activity the highest performers are set apart mentally, physically, or genetically.  Some endurance athletes don't generate as much lactic acid as everyone else enabling them to continue when the crowd quits.  Top musicians have an ear for songs and so on and so forth.

If someone doesn't have a musical ear no matter how much they work they will never be a world-renowned musician.  The same is true for any skill set.  Hard work can move you past the average Joe or Jane in the middle of the pack, but hard work won't land you in the top.  The top is reserved for those with an exceptional gifting from birth coupled with time, chance, and some work mixed in.

The same is true for the top investors as well.  Warren Buffett has a gifting that allows him to size up opportunity and act in ways that others can't.  No matter how many annual reports one reads, or how many Munger quotes they parrot, or how many Dempster Mills write-ups they read they'll never replicate him.  It'd be like someone thinking they can become Usain Bolt by wearing the right shoes, practicing in Jamacia and doing the famous bolt stance after each race.

Just because someone famous, or someone in the newspaper (or online) does something doesn't mean that everyone should do it.  In some cases the opposite is true.  Investment managers profiled consider their interviews to be marketing material, not instructional information anyone can use.  In fact the opposite might be true.  Some managers might purposefully leave out their secrets as to give themselves an advantage.  

How does all of this tie into investing watch lists?  I don't think investors need to be researching companies because guru investors proclaim they're constantly researching.  Most professionals are talking to clients, managing their employees, managing their back office systems, prospecting for new clients, and in their remaining time looking for new investments.

Another reason, and possibly a more pertinent reason to avoid watch lists is because the current doesn't mimic the future.  Companies and their results reflect the current and past environments, not the future environment.  This seems like common sense, and it is, but common sense isn't that common either.

Let's take the most common use of a watch list.  One researches a stock that's compounded capital at high rates for years or decades but the current price is too high.  In theory all of this research will enable the investor to act and purchase this quality company once the price is lower.  Here's the problem, no one ever knows what will cause the price to crater.  Maybe the economy hits a recession and this business that's compounded capital sits at the cross hairs of public policy as a result of the recession, will their out-performance continue in the future?  Or how about the situation where the company changes and adapts to the new economic situation, will their past results apply to the future now that they've changed?

When the economic or market situation changes such that watch list stocks are suddenly attractive it's often the case that prior research needs to be discarded.  This is because in the new environment the old research isn't applicable.

Another consideration is whether the prior researched name is still the best opportunity in a market dislocation.  Given two stocks worth a hypothetical $100 per share in a market dip is it better to buy the previously researched company at $80 or another company that isn't quite as high quality for $65?  Maybe the $15 differential in this case is easy to brush away and say "I'd pay $15 for quality and give up that return."  But what happens with the differential grows?  What if it's $80 for the quality company and $25 for a similar company with a few warts?  You'll need a lot of compounding to make up that differential.

When the market crashes dislocations happen quickly and to everyone's repeated surprise prices remain somewhat efficient.  Debt laden companies drop like rocks whereas debt free companies with earnings power don't drop as much.  These quality companies that investors have spent hundreds of hours researching don't drop enough to merit a buy.  Whereas there are companies that drop like rocks that are merely babies thrown out with the bathwater.

I always want to be evaluating the current opportunities, not ones I wish will happen.  Maybe watch lists should be renamed wish lists.  These lists are similar to the toy catalogs I'd browse as a kid.  Full of items that I wished I could purchase.  But now as an adult with the means to purchase any of those toys I don't have a desire to buy them anymore.  This is true for watch lists as well.

Is this bank a quadruple or a zero?

In the market risk equals reward, or so they say.  High risk equals a higher reward.  In the case of Enterprise Bank (EFSG) the bank's business model is low reward high risk, but for investors who are willing to wade through the muck this could be a high risk/extremely high reward stock.

I wrote about the bank a little over two and a half years ago.  They're located near where I live, and I've started to think about them again as one of my running routes takes me near their office.  I hesitate to use the term "branch" because they don't really have a branch, just an awkward office on a weird elbow bend next to pseudo-junkyard (heavy equipment graveyard rental), and an indoor playground for kids.

The bank is a niche lender, they specialize in lending to start-up businesses and small businesses with troubled business models in distress.  I know what you're thinking, this type of niche lending doesn't seem to fit well in a regulated industry especially when the firm is highly levered.  You're right, it doesn't, and why they're a bank mystifies me.

What has always intrigued me, and why I looked at them again is their valuation.  The bank has a tangible book value per share of $17.99 and a share price of $8.  The bank trades for 44% of tangible book value.  Incidentally this is the same price to tangible book ratio they traded at in 2014 when I last took a look at them.  Two and a half years into a historic small bank bull market and this stock's price is nearly unchanged along with it's valuation.  It's in situations like this that opportunity can exist, it doesn't always exist, but there is potential.

There is a lot to dislike about this bank.  It's easy to go overboard when looking at a bank still trading with a deeply distressed valuation.  I want to do them justice, this can work out very well for investors as you'll see, but you need to accept before buying in at this valuation.  Let's start by clearing the air with everything that's terrible about the bank.

First they are a small business lender and small businesses have a higher failure rate when compared to established business lending.  But if that weren't enough Enterprise Bank seeks out distressed small businesses.  The bank describes themselves in their annual report as lending to start-ups and small businesses in distress.  For the risk they're taking they aren't making that much money.  In the most recent quarter they had a net interest margin of 5%.  That's hardly compensation for the risk, and it's even worse when you realize they're a levered institution with the majority of their funding from the FHLB and brokered CDs.

Their business model is similar to someone driving a car very fast on an icy road.  There aren't any problems as long as the car stays straight and if the drives doesn't make any sudden movements, but the smallest nudge of the wheel can end in catastrophe.  To management's credit the bank has been traveling this icy road for a while without crashing, but that doesn't mean it's safe, or a crash isn't a wheel nudge away.

If anyone is looking for a good sleep aid I'd recommend reading the first 25 pages of their 2015 annual report.  To say it's unique or unusual discounts what it really is.  In the opening letter management summarizes the company's results then launches into a dissertation as to why they disagree with their regulators regarding revenue and income recognition.

Maybe I suffer from insomnia, or I enjoy the nitty gritty detail of bank regulatory disagreements, but whatever it is I charged through.  In the eyes of a bank regulator a loan is to be classified as "non-accrual" when the loan is more than 90 days past due.  A non-accrual loan can be considered in collection when the bank expects to turn their non-accrual loan into cash within 30 days.  The essence of the bank's argument is that they have a lot of non-accrual loans that they believe are in collection even though collection can take months or years for them.  The bank believes they shouldn't have to classify these loans and that any interest received on them should be recognized as income.

The bank believes they're a special case because they deal with distressed commercial borrowers and it's hard to sell commercial real estate.  My contention is it's hard to sell commercial real estate if the price is too high, or if the real estate holds little value.  It's very easy to sell commercial real estate in areas with strong commercial growth and limited space.  Incidentally those are two overriding traits of the area the bank is located in, yet somehow they were stuck with the dud properties.

It turns out the bank wasn't lending where they're located, a prosporous neighborhood (their current location withstanding) down the street from old money estates.  They were lending in distressed neighborhoods betting on a turnaround.  To make matters worse the bank happened to lend to almost all of the borrowers said neighborhood, and in 2008 when everyone ran for the exit Enterprise was left holding the bag.

The bank has dug themselves out of the pit they found themselves in, but this story illustrates some of the issues they face when selling property.  The properties are not prime commercial real estate.

Let's get back to their income argument with the regulator.  The bank argues that it should have $1m more in income that their regulator won't let it recognize because of accounting rules.  They claim they've received $1m in cash payments on non-accrual loans that hasn't been fully recognized on the income statement.  This is partially true, but also misleading.  On their regulatory financials this $1m in cash received has been applied to the balances of the loans.  The resulting loans are de-risked on the balance sheet, but does nothing for their income statement.  On their GAAP financials the bank has pushed through some of this interest income, but it's lumpy rather than consistent as the company would like.  This money didn't just disappear, it found its way onto the financial statements, just not where management would have liked to see it appear.

I find it noteworthy that so much ink was spilled describing this issue.  I could feel management's anger over the issue as I read their annual report.  They feel this is a hidden asset that shareholders should know about.  My sense is they might feel that if this $1m in income had been reported then they wouldn't be trading at the valuation they're trading at.  I'm guessing, but I don't think that's the reason for the low valuation.

The bank is operating in a very risky segment of the market.  They have a risky business model, and it's built on hot money funding.  For all of this risk the bank isn't printing profits.  They have capped their upside, but unlimited downside.  This is why they have a low valuation.

It isn't all bad news though.  The bank weathered the financial crisis and remains well-capitalized.  They paused the hunt for new business in order to ensure Basel III compliance.  The bank will remain compliant once Basel III is implemented and they don't expect any interruptions in their business.

What's even better is the opportunity set for investors if the bank does nothing other than work down their non-accrual loans and sell off their foreclosed real estate.  The bank has $10m in non-accrual loans, and at any other bank if those loans were brought current they'd continue to accrue interest and generate income.  In a traditional setting with a 5% NIM the bank would earn $500k in additional operating income if the $10m in non-accrual loans were current.  But given Enterprises specialty with investing in distressed and liquidating opportunities we can presume that the bank intends to collect and liquidate the $10m worth of troubled assets.  They also have $4m in foreclosed property on their balance sheet.  This means there is $14m worth of assets waiting to be realized once the bank can find buyers.  Let's discount these assets by 25% and say they ultimately collect $10m.  This is an overly conservative hair-cut, the bank has never charged off loans in an amount that's anywhere near this haircut.  The $10m collected would become equity and the bank's tangible equity would increase from $15.9m to $26m, which is $29.84 per share.

To summarize the opportunity, if the bank does nothing else related to banking, but instead focuses entirely on selling down their OREO portfolio and collecting on non-accrual loans they can almost double tangible book value per share for shareholders.

Beyond this the bank has worked to improve their operations.  Their return on equity is slightly over 7%, which is average for a bank their size.  The bank's efficiency ratio is in the 80s, and management noted in their letter they are working to lower it.  If the bank were to drop five to ten points of their efficiency ratio as well as work down bad assets investors could be looking at a tangible book value per share in the low to mid $30s.  That's attractive considering shares are at $8 right now.

I really like bank investments where the investment thesis rests on the company working off bad assets compared instead of needing to improve their internal operations.  It's easier to work off assets versus changing company culture, or changing morale.  In my newsletter I wrote about Summit Financial (SMMF), a bank that was in a similar position a few years ago, since then it's up over 150% as bad assets have dropped out of view.  Enterprise Bank has a worse starting point, but the appreciation potential is higher as well.

The risk to a situation like this is making sure the bank itself will stay strong and healthy long enough to work off the bad assets.  If the economy takes a dive before they can collect on their non-accrual loans and sell foreclosed properties then the bank will be in a bad situation.  New foreclosures and bad loans could swamp the bank's capital, especially given their focus on distressed assets.  In that situation the bank would be taken over by the FDIC and assets sold, ultimately to another bank that was stronger capitalized would realize those gains.

The reason this bank is trading at such a steep discount is because the market isn't sure whether they can work off their bad assets before the next crisis hits.  If they can this stock should quadruple or quintuple, if they can't then it's a zero.  Lottery ticket?  Perhaps..

Disclosure: No position


Benzinga PreMarket bank discussion

Last week I had the opportunity to be a guest on the Benzinga PreMarket show again.  A link to the segment is below.

While on the show I discussed a few ideas:

  • Opportunity amongst the busted merger of New York Community Bank and Astoria Financial.
  • Avoiding banks with long dated exposure
  • BNC Bancorp as a potential idea
  • High priced bank stocks.
You can listen here:

Why investors and management don't see eye to eye

Why is it that businesspeople and investors see businesses differently?  A friend mentioned a derivation of this analogy to me years ago and I brushed it off.  But recently I started to think about it again, and the simplicity of it hit me as brilliant.  As an analogy there are obvious flaws, but maybe, just maybe this will be good enough to become a framework, or a mental model, or latticework, or whatever other trendy thing analogies are now called.

I present to you The Box.

Think of every business as a box, a very simple box.  The box takes inputs, these inputs are materials, labor, or really anything.  The box outputs a something.  Some boxes create things for other boxes and some boxes create things for people.  These boxes all live together in their box world.

Every box can be described the exact same way with three statements, a balance sheet, an income statement and a cash flow statement.  These three statements describe everything the box is doing.  It describes the items the box is purchasing from other boxes as well as the output of the box itself.  The statements describe what the boxes are doing inside the box.

Using the same three statements every box can be compared to any other box and measured against any other box.  In the box world there is an industry of box watchers.  The box watchers aren't allowed to look inside any of the boxes.  Although from time to time a box watcher will take a peek inside a box, or talk to someone who works in a box.  

To the box watchers all boxes are the same.  They all have inputs, produce output and can be described the same way.  Box watchers are hyper focused on the size of the box.  Is the box growing or shrinking?  Box watchers live for the four times a year that the boxes produce their description statements.  Box watchers believe that boxes should combine with other boxes, or at times cut themselves in half.  Small boxes should combine with other small boxes, but once a box is too big it should split itself apart.  The combinations rarely alter anything inside the box, or change the box's inputs or outputs, but that doesn't matter.  These combinations and reductions are important to the watchers.

For a box watcher differences in a box's input and outputs can be described with simple mathematical formulas.  They believe that two boxes the exact same size should be described the exact same way with their financial description documents.  After all, if both boxes have the same inputs, are the same size, and produce the same output how could their financials be different?

The reality inside of each box is much different than what box watchers see.  On the outside a box is a box is a box.  It's inside that box where the action happens.

Each box is completely different, no two boxes have the same workers, and the workers are what set each box apart.  The managers who are in charge of the boxes are worried about securing their box's inputs and making sure production inside the box continues.  Workers are fickle.  They are constantly dealing with issues related to other workers and outside issues (with family, friends, and relatives).  Sometimes workers have kids who get sick, and the sick kid preoccupies their mind for the day reducing output.  Other times workers don't get along but are forced by a manager to work together.  The output from feuding workers is drastically less than the output from workers who enjoy each others company, or workers who have complimentary skills.  All of these preoccupations and personality conflicts multiply across the box.  It is rarely one issue that impacts inefficiencies, but hundreds or thousands of issues, all different, all happening at once.

Box managers spend most of their time worrying about issues related to their workers.  And when it's not their own workers it's workers from other boxes.  Sometimes the workers of a supplying box are so distracted their quality suffers and downstream boxes are forced to implement processes and procedures to handle the poor quality inputs.  

Inside the boxes everything can be reduced to a people problem.  It's the people who work together that take the inputs and generate the outputs.  It's the people at other boxes that consume the output, and people at other boxes that create the inputs.  Inside the box world what's happening takes the backseat to people.  People are everything inside the box world.  A motivational manager is the difference between underperforming workers and performing workers.

Boxes themselves are interchangeable.  A box with a specific input can find that input as the output from a number of different boxes.  Likewise what a box produces can be consumed by people or other boxes, interchangeably.  It's different inside a box.  People are an ecosystem.  They aren't interchangeable.  People have specific skills and personalities, taking a person from one box and putting them in a different boxes doesn't mean the results generated in the first will follow to the second.  

What frustrates box watchers is they don't understand what's happening inside the box.  To them all boxes are the same.  Boxes that are shaped the same and do the same things should have the same results given a set of inputs.  To a box watcher fixing outputs is as simple as fixing the inputs and tweaking a few items on the financial statements.

Box management is frustrated by the box watchers.  Everything is so simple to the box watchers, if only those watchers knew what happened inside the box!  Box managers try to appease the watchers by using their terms and superficially managing inputs and outputs, but box managers know that changing the box's financials isn't as simple as rearranging the inputs and outputs.  Box managers know that production is efficient because of their people, or that production is inefficient because of a few people.  People that need to be nurtured and coddled and dealt with individually.

Box watchers can exert enough pressure that a box tries to change itself.  It rarely works, the box is the way it is due to the people it has.  The only way a box can reinvent itself is by gutting the inside of the box and starting over.  A process that isn't much different than creating a box from scratch.

It should be apparent that the box watchers and box dwellers will never see eye to eye.  They won't because they're looking at different things.  Inside the box (business) employees are concerned about the day to day operational aspects.  The box watchers (investment analysts/investment industry) is only concerned with the financial statements the businesses produce.  Without the detailed operational knowledge about what happens in a business an investor can only make broad claims and judgements.

The danger to investors is when they adopt the box watcher mentality.  Box watchers are paid to watch boxes, not produce investment returns.  Investors are paid by understanding what happens inside the box.  A curious quirk to this entire analogy is that one doesn't need to become an expert on what's in the boxes to take advantage of this knowledge that each box is different.  Some investors recognize this situation and believe the key to earning outsize returns is to know who is in each box and what they're doing.  My own view is that this is the wrong approach.

The right approach is to understand that what happens in each box is different, but why things happen isn't as important as understanding the differences reflected in the financial statements.  Understanding the differences between the boxes is fundamental to making an investment decision.  Ineffient boxes will rarely become efficient boxes.  And efficient boxes will probably remain efficient .  Don't invest in an inefficient box thinking it'll become efficient, instead incorporate a discount or premium for these differences.  Just because a box is inefficient doesn't mean it doesn't have value either.


When do you give up on a stock?

In most houses there is a closet, or a cabinet where miscellaneous things are stored.  And by stored I mean they're shoved into this space carelessly and needlessly never to be used again.  When people are placing objects in this space it's common to think "I might need this again so I can't throw it away, but I don't need it now, and won't for a while so I'll store it.."  Depending on ones discipline these storage spaces can vary in size from somewhere small such as the corner of a desk to consuming an entire house.  Portfolios mimic these storage spaces with positions that we haven't given up on yet, but just haven't realized their potential yet.  Maybe we'll need the position later, but surely it isn't doing anything now.

Deciding on when to give up on a stock is a difficult choice.  But to get there we need to have a short discussion on liquidity.  In true John Kerry circa 2004 fashion I'm about to conduct a "flip flop."  In the past I've claimed that a stocks are/can be cheap because of illiquidity.  I've come to realize that illiquidity isn't something that manifests itself on its own, it isn't a force like gravity.  Instead illiquidity is a symptom of something wrong with a company.

The narrative in the market is that companies become illiquid because they're boring, old fashioned, or "too small".  In a minority of instances there are structural issues that results in the lack of liquidity.  A structural issue might be one where an insider owns 95% of the outstanding shares and the shares trade for $1,000 per share each.  But these situations are true outliers.  Most illiquidity is due to company specific issues.

What causes investor excitement and creates a situation where someone might want to trade a stock?  Why is GE liquid?  Why is Fastenal liquid?  They are both boring industrial companies that most investors would have a hard time explaining.  Fastenal makes nuts and bolts.  I've never witnessed someone standing in the bolt aisle of Home Depot pondering which brand of bolt is the most rugged.  I've never seen marketing material that proclaims "We use Fastenal bolts which leads to superior quality."  I guarantee if I went down to my garage and examined every nut and bolt in my tool chest I wouldn't find a brand name stamped on any.  But somehow there is excitement around this brand and the stock is liquid.

If a company can generate repeatable returns and shows growth it creates investor excitement regardless of the industry or product.  That excitement is quickly socialized throughout the investor world and other investors want to buy into that excitement.  The increased interest provides a ready source of buyers for current stock holders creating liquidity.  Sometimes it isn't excitement that investors crave, it's a dividend yield, or stability, or a historic brand name.  But there is a factor that generates interest, and the interest leads to a positive feedback cycle.  This is liquidity.

Illiquidity is the exact opposite.  The company has a deadly sin that they're carrying around with them.  Some investors discover this sin before they buy and decide to pass.  Other investors don't recognize the gravity of the situation before they purchase their shares.  A few quarters or years later they realize the error of their ways and look to sell, but there are no buyers, most everyone else has identified the cardinal sin and refuses to buy.  They refuse to buy unless the price is low enough to overlook the sin.  And even then most investors won't buy.  This "sin" can range from withholding information to overpaid management and anything in between.

A friend and I were recently discussing how people have different perspectives on potential deals depending on where they live geographically.  In general when presented with a deal people who live in the East and in cities have the following response "This looks too good to be true, I wonder what the gotcha is? How am I being played?"  They approach a deal skeptically until it can be proved otherwise.  Whereas in the Midwest and South when presented with a good deal most people think "that's so nice of them to give me an offer like that."  I've lived both experiences, and while the 'nice' attitude has never led to any ruffled feathers the cynical attitude has left more money in my pocket.

This same attitude is true for small, cheap and illiquid stocks.  Seasoned market veterans see something that rarely trades with a low multiple and think "what skeletons are in the closet?"  Whereas less informed investors think "wow, what a great deal! It's undiscovered!"

I can identify with both attitudes.  When I first started looking at these stocks I had the second attitude.  I thought I was discovering gold for the first time in Alaska.  I was finding these giant nuggets laying on the beach.  What I found out was starving grizzly bears roamed those same beaches full of gold and I was blissfully unaware that they were empty because everyone else knew it.

Now as a skeptic I look at these illiquid situations differently.  I'm cynical and think "what's wrong?" But there's a caveat to all of this.  Most investors pass on a stock if there is a bit of hair, I will buy a stock with hair if the price is right.  And if the price is that good I will wallow and roll in that hair and enjoy it because I got such a good deal.

Let's just say you purchased a stock with a whoolly mammoth amount of hair, but you also barely paid anything.  Maybe the seller even threw in a "free" operating businesses on top of that discounted cash you paid.  And you're sitting on this pile of assets for years and nothing is happening.  Then one day a tiny thought occurs in the back of your mind "what if nothing will EVER happen?"  Thoughts like that are easy to ignore when they're small.  But over time a thought repeated becomes magnified until suddenly one day you are convinced that nothing will ever happen to the stock...ever.

It's at this point when you realize you own a stock frozen in time that you're faced with the decision on whether to give up on the name.  Sometimes it's hard to give up, maybe the stock is illiquid and you are afraid you can't sell.  It's probably illiquid because everyone else knew it was going nowhere already.  What do you do?

The starting point on giving up on a stock is the same starting point for purchasing a position.  Why did you initially buy the stock?  What was the attractive feature?  If the original thesis is no longer intact, or it's changed, or morphed, or you forgot why you purchased then it's time to re-evaluate.  Look at the company with fresh eyes.  Would it earn a spot in the portfolio today?  Could you pitch the stock to a friend and by the end of the pitch your friend is getting out their phone to purchase?  This "friend test" is only valid if they weren't getting out their Blackberry or Apple Newton the first time you pitched the stock.  Pitch a stock to a disinterested friend.

Pitching a stock verbally to someone carries a significant advantage.  It forces you to be concise, few friends are going to listen to a rambling treatise.  In communicating verbally one needs to get to the most important facts first and elaborate on them with just enough detail to carry the argument.  We naturally organize our thoughts in an efficient manner.  We start with a hook and then back the hook, or the most important piece of information up with details and fill in gaps.  Yet when most pitch a stock in writing readers need to to use a magnifying glass and an hour searching for the point of the pitch.

If a company has completely changed during your holding period it's valid to sell.  It doesn't make sense to become sentimental about a stock.  Sometimes the company doesn't change at all, but the company's story becomes stale or outdated.  A great example of this is a potentially ground breaking company that spends years testing and trialing their product.  In the meantime their ground breaking developments are surpassed by other companies in the industry with similar inventions.  The failure of the company to release their product quickly led to a situation where other competitors developed a similar product and beat them to the market.  The company and their product might be the same, but the opportunity set has shrunk.

I want to deviate and discuss an item of importance related to the last point: companies that have trouble shipping products.  Businesses can't make money from promises, they can only make it via shipped products and services.  If a company has issues executing and releasing their products the company has a cultural issue, potentially a cardinal sin.  Unless a company is developing a new type of rocket engine or advanced satellite system it should be able to ship frequently.  But even rockets aren't an excuse, there are startups in the space industry that are frequently releasing new rocket designs.

When a company can't ship a product it's a failure of the personalities involved.  I've personally been involved on teams that both release products regularly, and others that fail to do so.  The ones that fail to ship are either plagued with poor quality team members, or have high level management issues.  If a company hires low quality workers it's a sign of the quality of management.  Low quality management hires low quality workers.  It requires a complete management cultural shift to change the hiring process.  This shift is about as common as snow in July.  The best way to hire quality workers is to have a high quality management team that is not intimidated by their subordinates that hires people smarter than themselves.

The single largest reason for a company's failure to ship products is a failure in management.  I've seen situations where management is like a piece of grass swaying in the wind.  One week they're heading one direction and the next week they've changed directions.  Without a steady direction a product team has a difficult time executing, they are always chasing their tails.  Another common scenario is when management team members are perfectionists.  Companies need to be satisfied releasing products that aren't perfect initially but then continually working to refine the product.  No one can release a perfect product on the first try, but that doesn't stop hordes of product managers from trying.  Beware of perfectionists, they can destroy a company.  Sometimes a product is just "good enough."

The best reason to consider giving up on a stock is when the value proposition isn't as good as the alternative.  Imagine a situation where you buy an undervalued stock with the expectation that it could appreciate a certain amount, say 50% and four years later the stock has barely budged.  Now as you evaluate the holding you're confronted with a similar situation that has the potential to appreciate 100%.  Given this scenario it's reasonable to give up on the first position and use the proceeds to purchase the second position.  The caveat to this is to beware of your forecasting ability.  Anyone can create a "fair value" out of thin air.  Look back at your prior predictions and evaluate how they turned out.  If you always expect a stock to appreciate 50% and instead they settle at a fair value 25-30% above your purchase price then you over estimate fair value and should revise your estimates downwards going forward.  My sense is most investors fall in this camp.  They expect everything they buy to appreciate 3x/5x/10x and then two years later sell once it's appreciated 103%.

It's better to be consistent with lower returns verses less consistent with higher returns.  Consistency is what generates long term results.  Likewise it's better when your accuracy in forecasting the probability of a loss is higher.  Long term returns are the direct result of the lack of losses.  This concept won't find many followers in a raging bull market, but it'll become the siren song as the market crashes.

To summarize at this point if you're holding a stock where the story changed, the company changed, the company failed to execute on plans or you have better opportunities it's time to sell.  Now let's talk about the hardest time to hold.

There are dozens of small companies off the radar that are selling at extremely low valuations with low liquidity and anemic progress.  These are the classic "value traps" where investors whittle away opportunity cost for years.  They're illiquid, so as mentioned above they have issues with them reducing investor interest a well.  I own a few of these in my portfolio.  The types of stocks where if someone discovered them they'd be worth 3x-4x their current value.  The problem is the story hasn't changed yet they still offer excellent value.  What's an investor to do?

I can have extreme patience when a holding is unfairly valued and the company is moving in the right direction.  I don't have much patience, and will actively avoid situations where a company is a melting ice cube.  If a company is eating outside capital, or eating their own capital in an effort to stay afloat or transform then time is positioned against the investor.  The company is hoping their transformation or new products will outrun their limited time frame.  Sometimes this happens, but often it doesn't.

The best situation is one where a company is growing, even very slowly and can fund themselves out of profits.  If a company is profitable but the market doesn't recognize their current plight shareholders who are patience accrue value to their investment by doing nothing.  When a company pays a dividend and returns cash to shareholders it makes being patient much easier.  The hardest time to own a stock is when nothing is happening quarter after quarter and year after year.  Even if a company is slowly growing and paying a dividend, the lack of inaction cultivates seeds of doubt in our minds.

Most of the time investors give up on stocks because nothing is happening.  It's a crazy premise when considered.  Do farmers give up on corn because they don't see it growing daily? Investors are like my kids who will sometimes ask "did I grow last night? How much taller am I today?" as if each night they add an inch or two.

To carry with the farming analogy.  Plant your investment seeds and wait for them to grow.  If the plant is on track and healthy see it through to harvest no matter how long it takes.  If at some point during the growing season you notice the plant isn't growing, or something is wrong with it then it's time to cut loose and move on.  But otherwise stay the course.

Three Simple heuristics

A heuristic is defined as a process or a method.  I have a few simple heuristics I've employed throughout life, and especially in investing.  The results from these heuristics aren't ironclad, but they have pointed me in the general direction more often than they've failed me.  They're simple things to keep in mind that get you in the ball park of reality quickly without doing much work.

How to tell if someone has money

There is a verse in the Bible that says "where your treasure is, there your heart will be also".  I've come to realize that this saying is one of the best litmus tests to whether a person is wealthy verses just living the high life.

In modern culture if someone lives well, that is they have all of the trappings of wealth people tend to presume that there is real wealth to back it.  This myth was laid bare during the financial crisis.  A lot of people who had all nice things were really just highly levered.

The litmus test is this: when people find out I am involved in investing it elicits one of two responses.  Those with wealth immediately start to talk about investing, they want to know what opportunities I've found or what things I look at.  Those without wealth nod and move onto something more interesting.

The results of this have been fascinating.  We have family friends who live very large.  We've known them for years and yet never a peep about investing.  On the other hand I was at the doctor's office recently and got into a discussion with a technician on how to buy large plots of land, subdivide and resell.  He had quite a property business on the side.

When a person is concerned about investing, business, or preserving money it's a sign that they have money.  Usually all it takes is a mention of one of these things to get a wealthy person to open up about it.  Why?  If you have money you are always on the lookout for other opportunities, and one never knows where an opportunity might come from.

Determine how well a company pays employees

In the age of Glassdoor.com this heuristic isn't as important if a company's employees self-report their salaries.  But it's very telling for companies that are too small for Glassdoor.

Consider a typical American office.  Everyone wears similar dress clothes, works in similar spaces with company supplied material and in many ways are undifferentiated from each other.  Status is granted via titles and corner offices.  But while everyone appears similar their pay might not be.  And while employees across different industries might look and talk the same their pay levels are definitely different.

I've heard it said that buying a nice car is pointless because the only people you're impressing are other drivers you don't know.  This is partially true, and partially incorrect.  As mentioned above most Americans use vehicles and houses to signal their level of prosperity.  I get that there are value investors still wearing their best JC Penny suit from 1984, driving a Datsun and eating mac and cheese for dinner while sitting on millions.  But they are the exception.  For everyone else a raise means they can afford a slightly better car, or a slightly better house.

It's hard to show off your house to your friends.  You can't take it with you, and not everyone is comfortable having friends or strangers over to their house for a party.  The same isn't true for a car.  A car can be shown off by simply driving around.  No one needs to sit in it with you, they can see how nice it is from outside.

My litmus test is this: a company's compensation level can be determined by looking at the cars in the employee parking lot.  Because people tend to want to purchase the most car for their monthly payment the average car is indicative of the average pay.


The posters speak the truth!

Walk down the hall of any company and you'll be confronted with posters.  Sometimes the posters have themes such as "Integrity" or "Ethics" or "Quality".  Let me ask a rhetorical question, do you think Apple has signs in their hallways "Quality Counts!" or "We Build Awesome Products Here"?  No, because Apple employees already know they build high quality products.  It's their nature, it's what they do.  But let me ask, do you think Samsung has posters like that hanging now?

There is almost an infinite set of qualities that are 'good'.  When people embody these qualities they don't need to be reminded to embody them, they already have them.  People need to be reminded about the things they aren't good at, or the things that need improvement.  This is the same with companies.

When I visit a company their signs and corporate material highlight the company's weaknesses, not their strengths.  Pay attention to these things.  

Let me demystify a few common ones:

Safety First - This is a dangerous environment and we employ people who make mistakes, sometimes often.  We need to shock them out of complacency to reduce errors.
Ethics related material - The company has an ethics problem.  Maybe self dealing, maybe cut corners, who knows.  A quick tell on ethics are posters indicate a minor problem, required training a major problem.
Quality related material - The company's employees routinely cut corners and need to be reminded to be careful and take their time.
Do Things Right The First Time - Speaks for itself, lots of re-work happening.


You don't know anything!

The common wisdom is that to be a better investor one needs a edge.  This edge is usually regarded as an informational advantage obtained through superior research, or insider information.  Investors continually inch closer to the line of what could be considered legal in an attempt to reduce the risk of a trade and earn a more guaranteed return.  Informational edges are the "war stories" of investing.  Gather more than 2-3 investors and they'll start sharing stories of famous investors who camped out in a van counting delivery vans in the middle of the night, the crucial piece of information that supposedly netted them millions.

An informational advantage is fleeting.  Nothing lasts forever, and an edge in the investing world has a half-life that rivals francium (which is 22 minutes).  There are simply too many people and too many dollars looking for more dollars.  This is not unlike the washout that happened in the poker world.

In the early 2000s my youngest brother started to ride the poker wave.  Whatever wiring it takes to be good at poker my brother had.  He used to play local games and come away with fat pockets full of his competitor's money.  When poker was all the rage there were a lot of players who had full pockets full of cash in search of a better home.  My brother had some sort of edge that he used to his advantage. Unfortunately for poker players there were structural issue with the game that led to its demise.

In poker you are playing against everyone else at your table.  And for those without much skill, or the inability to find easy tables once their pockets have been cleaned out it's unlikely they will continue to play.  What naturally happens is the easy money leaves the game the quickest and the pool of suckers shrinks.  As the pool of easy money shrinks only players with some amount of skill continue to play.  The same natural selection process continues when previously skilled players become the saps at the table and suffer larger than expected losses.  After years of this process the game becomes one limited to players with a very high skill level all still in the hunt for the perfect edge.  Eventually the pool of players is distilled down to a group with similar skill sets who are equally suited to compete.  Of course there will always be new players entering the game, but if they don't have the skill level held at the top, or extremely deep pockets they will eventually drop out like most other players.

When I asked my brother this summer why he didn't play poker anymore he confirmed my view by saying "it's too hard to make money anymore."  The same thing could be said about any previously ripe investing opportunity "large cap value is picked over" or "compounder growth stocks are overpriced."  It would seem that every area of opportunity is quickly discovered and edges become worthless.

There are two ways to handle this, the first is to dig deeper and search harder for additional information that can give a better edge.  This is the default behavior for most of the market.  I think in most cases information is overrated, at times a red herring, and in certain cases even dangerous.

The problem is we delude ourselves into thinking that by exhaustively researching a company we can rest confidently on our knowledge and make superior decisions.  I have news for those who believe this, whatever you think you know is nothing, you don't know squat!

Is it ever possible to know a subject exhaustively?  Potentially, if you are the person who invented the thing, or are the pre-eminent world leading expert.  At that point you probably have a better grasp of the subject than most.  In these cases maybe your advanced knowledge gives you an edge, but more likely it probably serves to distract you.  You have trouble seeing the forest through the trees because you're so focused on the operational level details of the subject.

I think sometimes we're blinded by how much we think we know that we don't realize how little we know.  Sit back for a moment and contemplate how much we don't know.  You really have NO idea about what anyone is thinking, or what anyone else's motivations are for anything.  This extends beyond acquaintances to even to our spouses and kids.  I can 'know' my family by living with them and observing their patterns.  It allows me to understand how they think, but I never really know what anyone is thinking.  When people tell us what they're thinking we don't have a way to know if that's true or if it's a lie.  Maybe it's partially true and partially a lie, we will never know.  For anyone with kids you're probably nodding along with me.  We think we know our kids, but we really have zero understanding as to what drives some of the wacky decisions they make.  We see them daily but we have no idea what's going on in their head.

If a company states they expect to grow at 10% over the next year are they saying this because they believe it's an easy target and management will receive sizable bonuses?  Or maybe they believe that investors expect 10% so they say it even if they don't have a plan to hit it.  Or it could be a million other reasons.  Maybe the CEO's brother-in-law casually mentioned at a BBQ that he heard all companies in the industry should be growing at 10% and the CEO latched on.  The point is we really have no idea.  And to believe that people will open themselves up and reveal their motivations behind what they say is foolish.

Speaking to a company's management can be helpful to understanding how their business works, or understanding how they view the industry, but beyond that take any talk with a large grain of salt.  As we saw with Valeant the company's management was willing to tell their largest shareholder anything to keep him appeased.  The job of a manager is to make sure operations move forward, and a large part of that is building consensus for decisions.  An executive is quick to find a common ground with an investor, and in doing so builds trust.  But don't be blinded by that trust because sometimes causes us to see only what we want to see.

Now extrapolate the idea that we don't know what one person is thinking to the number of employees at a company.  Is it really possible to know what's going on?  We see the results, but what created those results?  Did a company earn more money because of the quarterly rewards program, or was it a new motivational manager, or did the company start catering lunch and workers simply put in more time at their desks?  Who knows!

Measuring business results isn't a science, there are too many uncontrolled variables.  How many managers divide up departments into equal working groups and then test different work styles with those groups and measure results?  But that's not enough, the groups would need to be mixed up and methods tested again to make sure results were reproducible.  This doesn't happen, and if it does it's rare.  Every business I've interacted with has a sort of dual mandate.  The first mandate is to do things the "correct" and proper way, when there's time.  But when deadlines are approaching the second "git-r-done" mandate comes into play.  The bigger the deadline the more "we'll fix that later" compromises are taken.

So how do you as an outsider know what's happening?  If a company is rushing to a deadline can you understand the magnitude and impact of the decisions that were made?  It's impossible, absolutely impossible.  If each decision has two potential outcomes the possibilities grow exponentially very quickly. And most decisions don't have two outcomes, they have multiple outcomes meaning the graph of the decision tree grows even quicker.  Then multiply these decisions across the number of employees.  It's overwhelming.

When thinking about companies like this it's almost unbelievable that anything ever gets done.  I have worked on the ground level of some large caps and it certainly feels like this.  It appears that every person is spinning their wheels and collectively the company is spinning their wheels.  But even with that spinning each person is usually making a little progress, and a little progress multiplied by a lot of employees means forward movement.

If at this point in this post business analysis seems like futility it's because at times it is.  The information that's important to an investment is probably the information that an outsider might never obtain. It might be information that decision makers never share because it furthers their own agendas, or makes them look bad.  I firmly believe that finding out those hidden agendas is something we'll never do.  If we don't even know what's motivating our spouse or kids to make decisions, and likewise they don't know what we're thinking then why could we can discern the reasons for a manager's decisions, maybe a manager we've spoken to for 20m at most on the phone?

Through all of this there is an actual litmus test for results, it's the company's financial statements.  A company either earned money or it didn't.  It grew or it didn't.

Benjamin Graham pronounced in Security Analysis that the financial results of a company tell us about the quality of a company's management.  Great management produces great results, poor management produces poor results.  Somewhere along the way Phil Fisher came along and told us that there might be secrets we can discover beyond financial results if we dig hard enough.  Fisher played into our common psychology leading us to believe that there is always something more.  When I first started investing I understood the logic of Graham's writings, but I thought I could do better by layering a bit of Fisher on top.  I would understand the numbers first then dig a little deeper to find these secrets that would allow me to out earn peers.

What I'm writing today is that there are no secrets, and if there are good luck finding them.  The secrets are probably located in Florida next to Ponce de Leon's Fountain of Youth.

You cannot out-research others.  The more time you put into research doesn't lead to better results.  Most investments hinge on one or two factors and discovering those factors and the likelihood of their outcome will generate the same results as someone who exhaustively reads the annals of a given industry.  This is what Graham was trying to tell us decades ago, and it took me years of investing for it to sink in.

Instead of trying to understand a company's management or understand the future with complicated decision trees there is a better method.  That method is using the statement of record, a company's financial statements and making one or two probability guesses or bets regarding the future.  As outside investors with very limited information we are relegated to making educated guesses about the future.  If a company is trading for 50% of book value it's up to us to decide whether they will go out of business in the next year as the market has priced, or if they'll last.  If the company is profitable and even has a little growth then the probability of them lasting another year is greater than the probability of them failing.  And in that case they should be worth more than their current valuation.  That's the simple investment case for most value investments.

This thinking can be extended to compounders or growth stocks.  If a company is growing at 25% a year is it more or less probable that they'll continue to grow at that rate?  And if the result is a "more probable" then the next question is "what's that worth?"  These are simple questions, and the answers are simple.  For myself if the question isn't simple, or if determining the answer isn't simple then the investment goes into the "too hard" pile.

When Graham talked about net-nets it was a short-hand way of saying "this company appears too cheap given circumstances and the probability of a gain is higher than the probability of a loss."  He wasn't making a judgement call as to the quality of the business, it wasn't necessary.

A common retort to this is by mentioning that Buffett is an expert business analyst and with all those years of reading 10-K's he can somehow figure all these variables out in his head and make superior decisions.  I don't think that's true.  Buffett was a horse handicapper when he was younger, and he just moved onto business handicapping.  When he made the investments in Goldman Sachs and Bank of America do you think he spent his nights building Excel spreadsheets modeling out derivative exposure and interest rate risk?  No!  I think he looked at the companies and said "with my investment they have a much better chance of being in business in five years verses not being in business."  And with that he invested.  He knew the odds were what mattered, not what the Actuarial Support Department deep in the bowels of Goldman Sachs was doing.

But you might say "But Buffett is constantly on the phone!  He's getting better information that we don't have!"  And while that might be true I believe he's really just getting information that better informs his probability judgements.

My guess is most readers will disregard this post as simplistic, or foolish, or think they're smarter than me (which you probably are) and go on with whatever they've always been doing.  And if the results from doing what you've always been doing are good then why stop?  But if your results aren't what you expect them to be then read on.

There are two ways to apply this.  The first is to stop wasting your time trying to gain a vanishing edge.  This means focusing on a company's financial statements, finding fulcrum points and making a probability judgement about the future.  To me this is the essence of value investing.  I find companies at depressed valuations, make a probability judgement that they're worth more and invest.

The second way to apply this is through a buy and hold strategy.  It is heretical to most investors to promote this strategy, but I think it works.  Find stable companies that are likely to be stable in the future with predictable growth, buy and hold on.  The only way to get burned with this strategy is to pay too much on the initial purchase, or to buy into nonexistent growth.  The best way to apply a buy and hold strategy is to buy companies with lower growth.  Growth that is roughly equal to inflation + GDP growth and don't overpay.

Being an outside investor shouldn't be hard work, if it is you're working too hard or looking for an edge in little nooks and crannies.  The key is to take in all relevant measurable information, the company's financial statements and then make a judgement call on the company's valuation.  Points aren't rewarded to those who read 15 years of annual reports.  Rather points are rewarded to those who can make accurate probability judgements.  All that's required for that is a bit of common sense and some patience.