Value investing myths

If something is repeated often enough people will eventually start to believe it.  Buffett always buys "good" companies, and Graham bought companies on the verge of bankruptcy.  Investors who buy into good companies doen't need to worry about the price they pay.  Whereas Graham investors need to be worried because eventually all net-nets go to zero.

Sometimes the truth is more nuanced.  Would Buffett disciples be surprised to read a story about Buffett buying in and out of a small stocks in his personal portfolio?  Would investors be surprised to read a quote by Graham about preferring quality factors in companies they look at?

On Buffett: In 1999 he purchased a $3.3m stake in Bell Industries.  The technology company was in the process of restructuring and had sold off a large division.  Buffett purchased his Bell stake in December of 1999 and by January 18th of 2000 he had already sold out for a quick 50% gain.  The famed 'buy and hold' investor had purchased into a tiny tech stock and flipped it for an 80% gain in less than two months.  The LA Times sums up the investment perfectly:

"Buffett, 70, made his wealth and reputation as a long-term, buy-and-hold investor by using Berkshire as his vehicle for buying major stakes in companies and then patiently waiting years for those investments to soar in value.

But as his earlier experience with Bell showed, that's not always Buffett's practice when he pulls out his own wallet. In that case, Buffett bought a 5.3% stake in Bell in early December 1999, triggered a surge in Bell's market price, and then dumped his stake a month later for a profit of about $1 million, or 50% on his original investment." (source)

Now onto Benjamin Graham.  Graham is often associated with purchasing stocks feature low statistical measures such as price to book, or price to earnings.  One area that Graham has left a mark is by suggesting investors who purchase companies trading below NCAV can consistently outperform the market.  Lost in the past 70s years has been some of Grahams warnings and suggestions around buying net-nets.  Graham as shown below suggested investors purchase net-nets with high earning power, high returns on equity, or an imminent catalyst.  His original framework has been diluted to "buy anything trading below NCAV no matter how terrible the company is".  Here is what Graham originally wrote:

"Nevertheless, the securities analyst should exercise as much discrimination as possible in the choice of issues falling within this category. He will lean toward those for which he sees a fairly imminent prospect of some one of the favorable developments listed above. Or else he will be partial to such as reveal other attractive statistical features  besides their liquid-asset position, e.g., satisfactory current earnings and dividends or a high average earning power in the past. The analyst will avoid issues that have been losing their current assets at a rapid rate and show no definite signs of ceasing to do so." (Security Analysis p595-596)

His plea to appreciate quality wasn't isolated to those paragraphs.  Sprinkled throughout Security Analysis are recommendations that investors look for higher quality companies over lower quality companies.  At one point he even recommended that investors simply buy the best company in each industry when the entire industry hit its low point in the business cycle.

How is it that these messages have been lost to the sands of time?  But more importantly does that mean anything for us now?

CreditBubbleStocks has captured the current sentiment towards value investing with his post titled "Value Investors Obsessed With "Compounders", ROE; Don't Care About Liquidation Value Or Margin Of Safety"  The post is short and worth reading, his point is that what is considered value investing today bears little resemblance to what value investing has traditionally been.

Value investing has morphed from buying average things cheap to buying companies with high returns on equity.  I have read a few blog posts where Buffett disciples proclaim that there is no price too high to pay for a company with high returns on equity.  Of course this line of thinking is lunacy.  As a company grows larger their returns fall, this isn't math, it's common sense.  If a company can grow at 20% forever they will eventually run out of humans to sell things to.  A perfect example is Wells Fargo, which is praised for their high returns on equity.  A few months back I ran a simple simulation and if they can continue to grow at 15% a year in less than 20 years they will be the only bank in the US with 100% marketshare.  It's possibly they can keep up their high returns on equity due to financial engineering, but it's more likely their returns will naturally fall as they grow.  Nothing can grow forever.

What Buffett, Graham, Schloss and others realized was that buying anything for far below what it was worth was a winning proposition.  These famed value investors kept things simple, they purchased obvious values and didn't base their investment on assumptions or approximations of the future.  American Express in the wake of a scandal was a good purchase for Buffett and is a great example.  If one thinks about the salad oil scandal it fits Graham's advice better than the platitude of a great company at a marginal (high?) price.

For those who manage billions of dollars it is difficult to find truly cheap companies.  But for anyone who isn't managing billions I firmly believe the best course of action is to find decent companies selling for absurdly low values.  But like Buffett and Bell Industries I'm also not opposed to buying something below average if the price warrants it and selling when the opportunity arises.

One characterization I hate is that companies that don't earn their cost of capital are worthless.  When I read things like this I have the thought that if this statement were true then American enterprise would cease to exist.  Do you think the company that services your furnace earns their cost of capital?  Or the local grocery store, or your mechanic, or almost any non-Wall Street company?  The large majority of companies in America and around the world provide a service for customers, pay employees an income and provide an owner a modest income with a little bit left over to reinvest in the future.  Without these companies our lives would be much more difficult, imagine fixing your own furnace, car, and growing your own food!  It seems like we would all be a lot poorer if it weren't for low margin companies that don't earn their cost of capital.

Yet in the world of Wall Street and academic finance a family owned grocery store should either close their doors, or engage in financial engineering to artificially boost their financial metrics that pile on risk.  Of course Wall Street is very happy to sell said products that achieve these goals, maybe that's why there's such a push?

This about the absurdity of return on equity for a few moments.  Consider a company that has $100 in capital, and earns $5 a year.  At present they have a paltry 5% return on equity.  If the company were to take on $99 in debt that costs 3% a year their earnings are now reduced to $2 a year.  But that $2 in earnings on $1 in equity is now an astounding 200% return on equity.  My example is clearly simplified, the $99 in debt goes somewhere and doesn't magically make equity disappear.  Of course if a company did want to make that money disappear they'd simply buy back shares.  This example company would be a darling of Wall Street, with high returns on equity and giant per-share figures.  Of course to hit these metrics the company went from being stable to increasingly fragile.  A slight bump in revenue could send the company into bankruptcy court for a default.

I had a conversation with someone recently where they mentioned they considered a 10% return on equity to be the bare minimum a bank should be making, and that banks below that were considered below average.  This investor said they only looked at banks that earned 15% on their equity, a value they considered appropriate for a US bank.  Interesting enough a bank earning 10% on equity or higher isn't just average, they're far above average.  In the most recent quarter the average return on equity for all banks in the US was 7.75%.  Banks earning 15% or more on their equity are in the top 12% of US banks, of which only a handful are traded.  What this person considered average criteria to themselves was actually very stringent criteria for an investment.

Many investors need to stop fooling themselves about what they're doing.  There is nothing special to buying high growth companies, or companies with great brands.  This alone forms the basis for most of the market, the market is obsessed with growth and growing companies.  There's nothing wrong with looking for good companies, or for looking for great brands, but don't make the mistake of paying too much.  There are many wealthy investors who have made fortunes buying stocks of great companies in bear markets from disenfranchised investors whose growth narrative vanished before their eyes.

At the right price many companies are worth a purchase.  But to me the sweet spot is finding a good company at a very low price.  These companies don't always have great ROE's, but at some point 50% of book value and a few times earnings is good enough for me.  Two examples of companies that fit this description are Pardee Resources or Citizens Bancshares that I profiled recently.  My portfolio is filled with companies like this, Installux, PD-Rx, Solitron, Precia Molen, Conduril, Kopp Glass, Conrad Industries and others to name a few.  It's easier to find small companies with average or above average operations at great prices compared to compounders at anything less than nosebleed prices.  Would I ever consider buying a compounding company?  Absolutely, when the price is right.  I purchased some Berkshire in the midst of the financial crisis for example.

If I could encourage value investors, or aspiring value investors to do one thing it would be to use their imagination.  Acquiring companies, private equity firms, and budding managers use their imagination to take many sleepy companies to great companies by thinning the ranks, introducing new products, or selling unprofitable divisions.  Yet many value investors invest as if what is happening now will happen forever.  Just like Wells Fargo won't grow at 15% forever a small company with a profitable niche selling for a few times earnings won't be independent for long, they'll be acquired.  The most dangerous type of thinking of investing is to think about things as if they were linear events.

The whole premise of valuing investing is purchasing something for less than it's worth.  But I feel that value investing has hit it's 1998 moment where we're inventing new metrics like 'eyeballs per click' and other goofy things to justify a new narrative.  If one looks deep enough, or in enough offbeat corners of the market they will always find value.

I outline my full system for finding undervalued companies in my Oddball Investing mini-course. Check it out here

Special situation opportunity in Harvard Illinois Bancorp

Management at many small companies is often accused of being 'asleep at the switch', a figurative expression for failing to act quickly.  But it's not often that proof of a company's management physically asleep during corporate meetings appears on the internet as is the case with Harvard Illinois Bancorp (HARI).  The picture below was taken by bank activist investor Joseph Stilwell at the Harvard Illinois Bancorp annual meeting, it shows the Chairman taking a nap during a portion of their meeting.  We don't know why he's asleep so we can only speculate.  I'm guessing it's from all the wild nights at the country club after so many long days of golf..

Harvard Illinois Bancorp is a bank with $170m in assets located in Harvard, Illinois.  Harvard is a small town located a few miles from the Wisconsin border and many miles from anything else.  The bank has three branches and has been serving their local community since 1917.

Before October 1st Harvard Illinois Bancorp was a fairly standard small bank value investment.  They began as a mutual bank that converted to a public holding structure in 2010.  After the IPO the bank traded for less than book value and has earned just shy of $1m in the trailing twelve months.  Famed mutual-conversion activist investor Joseph Stilwell owns 9.87% and has been both pushing for a sale and initiating proxy fights at the bank.

This almost looks like just another sleepy bank trading at a depressed valuation waiting for a sale to occur.  The bank released news on October 1st that makes an investment much more interesting.  At the beginning of October the company noted that $18.1m in repurchase agreements sold to them by Pennant Management on loans backed by the USDA were potentially fraudulent.  The bank isn't sure what they're going to do about the loans, if they write them down completely their book value will be reduced to zero and regulators will most likely force them to raise additional capital.  If the company is able to recover some or all of the value from these loans then the company is cheap.

How did this happen?  Pennant Management is an investment advisor firm located in Milwaukee, Wisconsin that manages an $850m loan portfolio.  Purportedly a Florida businessman named Nikesh Patel had his company fabricate $170m in loans allegedly guaranteed by the USDA that they sold to Pennant Management.  Patel used the proceeds to fund a lavish lifestyle and open a restaurant business in India.  Pennant Management has sued Patel's company for selling them 25 loans, which were then placed in client portfolios or sold to clients such as Harvard Illinois Bancorp.

The case is interesting in that Pennant felt they were protected by the USDA guarantee.  Patel's company was a USDA approved lender and had supposedly been vetted rigorously.  It's unclear how much vetting Pennant did on their own, or if they just relied on the USDA stamp of approval.  Pennant only purchased guaranteed loans with the expectation that if something were wrong with the underlying credit the USDA would back the loan.  The problem is the USDA claims they have no record of any of the loans that Patel sold.  Given this evidence the USDA states that it's unlikely they will back the loans because there were no loans in the first place.

Given these facts it appears that Harvard Illinois is stuck in a bind.  They have a large amount of securities that are completely worthless.  Pennant Management has claimed that they intend to do their best to recover as much as possible for their clients.  Pennant and their parent company manage over $30b, so it might be possible for them to reimburse some of their client's loss out of their own coffers.

The investment case here rests on the expected outcome from the securities fraud.  If Harvard Illinois recovers 100% of their investment then this is a bank with a $6m market cap that has equity of $20m and earned $1m in the past year.

If the bank is required to write down the entire amount of their holdings and raise capital the value becomes unclear.  If their capital is eliminated from the write down they will be required to raise about $13m by the FDIC.  With Stilwell pushing for a sale it's likely the bank might just decide to sell rather than find capital.  But in such a situation it's unclear whether shareholders would receive anything other than a tax loss carry forward.

The opportunity lies somewhere in the middle.  Clearly the best case scenario is one where the bank recovers their entire investment, but I view that scenario as unlikely.  What will probably happen is they'll end up writing down a portion of their investment and then suing to recover the rest.  The question is how much can they recover, and how long will it take?  If more than 50% of the funds are recovered then Harvard Illinois Bancorp looks very cheap at these levels.  If less than 30% is expected to be recovered then this is fairly priced.  Anything less than a 30% recovery would probably be a total loss given the potential for a capital raise.

Disclosure: No position

Value Investing Seminar [recording]

I recently participated in a Value Investing Seminar hosted by Marketfy.  It was an enjoyable experience for both me and listeners I've talked to.

In my presentation I covered my investment process, an oddball stock highlighted in the Oddball Stocks Newsletter, my rationale for investing in banks, and a bank also profiled in the newsletter.  If you didn't have a chance to watch the seminar live you haven't missed out.  You can now watch it anytime, I've linked to it below.  I presented and took questions for an hour, my presentation is the first in the video right after the introduction.

Many of the questions related to my presentation centered around investing in foreign stocks.  I wrote a post explaining how I think about foreign stock investment as well as my process for investing in foreign stocks.  There were unfortunately more questions than I had time to answer.  And most unfortunate is that I never received a list of the unasked questions.  If you watch the video and have a question could you please email me with the subject [seminar question] and ask your question?  I'll then do a post where I answer all of the questions I receive.

Presentation Outline and Newsletter Sample

I know when I watch a seminar I like to have a copy of the presentation slides to work through on my own.  I've posted the slides as a PDF linked below.

If you watch the video or look through my slides I think you'll notice two things.  The first is that I don't have any secrets besides turning over a lot of rocks.  The second is that this is labor intensive and can be frustrating if you don't know exactly where to look.  Fortunately the reward discovering  investment opportunities such as Pardee Resources and Citizens Bancshares.

If Pardee or Citizens seems attractive to you then the next step is to research the companies.  Citizens Bancshares is an SEC filing company, most readers won't have any trouble finding information on them.  Pardee Resources on the other hand is a dark company, they don't file any reports with the SEC.  Investors need to purchase a share and then contact the company with proof of ownership to obtain financial information.  I created my presentation from my writeup of Pardee for subscribers to the Oddball Stocks Newsletter.  I don't sell past issues, but thought that now that my thesis for Pardee was out in the open that maybe it was time to share my original thinking.  Linked below you'll find a sample of the newsletter featuring the Pardee writeup.  If you like companies such as Pardee and are looking for more then consider subscribing to the Oddball Stocks Newsletter.

Subscription information:

Disclosure: Long Pardee, Citizens Bancshares

Portfolio Strategies: Foreign stocks and low information stocks

Most investors hold the majority of their portfolios in domestic stocks.  This isn't a surprise, investing domestically is familiar, and feels 'safer' than investing abroad.  For investors willing to explore the unfamiliar I believe there are advantages to geographically diversifying a portfolio.

Investing exhibits a strong locality bias.  Investors are more likely to invest in a local company compared to a company located on the other side of the country.  Investors are more likely to invest in a company in the same state rather than one in a different state.  I've met investors who only invest in Pittsburgh companies.  It's not uncommon to find a fund that specializes in a small local sector.

The world is a big place with many different types of people and just as many different types of securities.  In a local market there might be 3-5-15 different companies to choose from, whereas worldwide there are over 60,000 public stocks.  Unless an investor specifically wants to limit their strategy to a narrow geographic niche it's reasonable to assume that globally there would be many more potential investment opportunities.

The difficulty with investing abroad is the difficulty with anything abroad, it's different.  I live in the United States and I've traveled to Canada a number of times.  Canada and the US are extremely similar, they look the same, we speak (almost) the same, our cars are the same etc.  But for all the similarities there are slight differences.  When I visit Canada the differences are noticeable, they are slight, but noticeable.  A related thought is that I'm always amazed at is how culturally united the US is. I can travel to the other side of the country and everyone speaks the same, they have the same stores, and I can navigate without any issues.  Going from Pittsburgh to Salt Lake City is more similar than Pittsburgh to Toronto.

Many of the complaints I hear about foreign stocks could also be made about companies that are low information stocks.  These are companies that are dark whose shareholders need to buy a share then contact management for further information.

There are two objections I commonly hear about foreign stocks and low information stocks.  The first is that it's hard to get information, and the second is how do you know it's true?

The first step is finding stocks to research in a broader manner.  I prefer to create wide screens focused on a single country then go through the screen results one by one.  If a country is small enough I won't use a screen, I'll just look at each stock listed in the country.  An example of a screen I might employ would be all stocks in Germany selling for 1.25x book value or less.  I would then work through the list sequentially.

It's at this point that a little creativity needs to be employed.  I prefer to read an annual report for companies that I invest in, but sometimes they're hard to come by.  Most foreign exchanges have information on listed companies such as summary financial statements and a link to news postings.  Some exchanges have full financials, or links to them.  In other countries it's necessary to find the name of the securities regulator and look up companies through their website.  Here's a little trick, Google the company on the domestic Google, you'll get better results.  For example Googling "Precia" on brings back much better results compared to the same search on

Fortunately for me as an English speaker, and you as an English reader we have an advantage in the investing world.  Many companies worldwide put their full reports in English, or English updates that provide enough context to muddle through the foreign language annual report.  I've used translation sites with some success as well.  I've found that Romance languages translate into English well, whereas Asian languages do not.  English is a very popular language for business and most large companies accommodate this.  Small companies in smaller markets usually don't publish reports in English, but sometimes they do.  My experience has been the smaller the country the more likely it is for a company to publish reports in English.

The language and understanding barrier is a hard one for most investors to get over.  I want to look at the issue differently.  When investing domestically we read annual reports cover to cover because we can, and because we've been told that we need to know all of that information to make an informed decision.

I want to propose that not all of the information in an annual report is necessary to make a good investment decision.  I'd go a step further and say the amount of information needed to make a decision to invest is directly proportional to the company's valuation.  If my investment thesis is that a company will grow at 15% for the next three years then I need to have channel checks and a lot of supporting information before I feel comfortable with that decision.  If a company is selling for 50% of their net cash and are profitable I just need to ensure I'm not walking into a trap.  I prefer to not buy investments where the outcome of my investment hinges on fine print buried on page 178 of an annual report.

If a company's valuation is low enough, and I can adequately diversify then an investment decision is reduced to defining the thesis and getting enough information to confirm or deny it.  When investing in any lower information stock I think it's worth keeping in mind that there will always be another cheap company.  If there are any unresolved questions, or something that doesn't sit right you should move on without hesitation.  As mentioned above, there are over 60,000 stocks in the world.  If you are going to have a portfolio of 50 names it's likely you'll be able to find 50 stocks that fit your criteria perfectly if you're patient.

My first criteria for a foreign investment is a stable and solid balance sheet.  This is because a strong balance sheet protects me against errors.  If I can buy a company with a net cash position that is generating free cash flow I can afford to be patient and wait for my desired outcome.  A larger gap between fair value and my purchase price gives me room for error.  If I purchase a company at 30% of book value and it turns out it's only worth 60% instead of 100% I will still double my money.  This is an important point, the larger the valuation gap the safer the investment.  This is true as long as the company is operating in a business as usual manner.  A company that was profitable for decades and then lost their biggest client isn't a business as usual investment.

The second criteria for a foreign investment is that it needs to be based on valuation, not a specific event.  In the US it's possible to participate in special situations where the outcome of an event is binary and results in a gain or loss.  Usually these situations require additional research and have the potential to be very profitable.  I won't invest in situations like this in Europe, or abroad.  I want to keep my investments simple.  I am looking for average or above average companies at very low valuations.

One way that I keep myself safe with foreign or low information companies is by buying companies where the owners have a large ownership stake.  Additionally I prefer companies that pay dividends, and especially companies whose owners pay themselves via dividends.  Dividends are more common outside the US.  It isn't hard to meet this criteria.

My process for investing overseas isn't any different from my process investing domestically.  But I've found something interesting.  Earlier this year I looked at my performance from domestic stocks compared to foreign stocks.  I have done much better investing in non-US companies.  I spent a lot of time thinking about this and I believe it can be attributed to the fact that I'm much more selective when investing abroad because I want to ensure a great margin of safety, but also because I'm trying to protect against things I might not know.  In the US I feel more comfortable with companies I research and at times I've been known to take a flyer on a questionable net-net or something else because I feel like I have a good grasp of the situation.  Sometimes these things work out, but sometimes they don't.

A post like this wouldn't be complete without a paragraph on fraud.  My impression is that investors have a universal view of fraud.  That view is that fraud doesn't happen in their own country, but it happens everywhere else.  My own view is that there are fraudulent companies everywhere, nowhere is safe.  Use common sense, if a company appears too good to be true it probably is.  It's not worth spending time on fairy tale companies when there are tens of thousands of other companies to look through.

For more on how I manage my portfolio check out my Oddball Investing mini-course.

TTA Holdings, a very cheap Australian net-net

A few years ago I ran a screen for Australia and came back with less than five companies selling below NCAV.  Things change quickly of the 1,905 companies listed in Australia 622 are now trading below 80% of book value.  Of course when that much of the market is selling below book there are bound to be stocks trading below NCAV as well, TTA Holdings (TTA.Australia) is one of them.

TTA Holdings is the Australian subsidiary of TEAC, a Japanese technology company.  TEAC manufactures and sells everything from LED TV's to audio recording equipment to CD-ROM drives. TTA Holdings is the regional distributor of TEAC's products in Australia.

The company fits a common net-net stereotype, a company struggling with revenue declines.  TTA Holdings has seen their revenue shrink from $62m in 2010 to a recent $51m.  As revenue has declined the company's earnings and dividend have fallen as well as seen in the table below:

Even with declining sales and earnings TTA Holdings could be interesting from an investment perspective.  The company has a market cap of $5.8m against a NCAV of $9.8m, and equity of $18m.

From a pure numbers stand point this seems like a decent enough investment.  Buy $9.8m of current assets, and $18m of equity for $5.8m and wait for the company to turn things around.  Management is of course telling investors that they're working to turn things around, although the results tell a different story.

There's a line in the company's annual report and their most recent trading statement that triggered the first red flag for me.  The company attributed losses to incentives offered to dealers to clear out older inventory.  A statement like that seems innocuous, and maybe it is, but I have a reason to believe it's otherwise.

Sometimes with an investment we can gain insight from unusual sources.  In the case of TTA Holdings I have a very close relative who was in sales at a US TEAC subsidiary.  The stories he told were legendary, channel stuffing, tricks to make quarterly numbers, pressure tactics, and others.  If you can imagine a terrible sales tactic they were encouraged to use it.  Not only by the local US branch, but by their Japanese parent.  Their parent company had a culture that cared about the numbers and not much else.  Whereas most investors praise companies that are focused on the numbers it's cultures like this that worry me as an investor.  

What are the incentives offered to customers to clear their old inventory?  Are they simply rebates, or are they more aggressive tactics?  The problem with a company whose sales forces does whatever it takes to get the job done is that they can burn relationships with clients.  A company can get away with this for a while if they're in a market leading position.  Comcast can ignore customers without fear of customer attrition.  If a smaller company ignores or alienates their customers they'll find themselves without any customers.  Reputations travel fast in the business world.

Besides the company's sales tactics there are a few issues with their financial statements that make me hesitant to invest in TTA Holdings.  The first is that the company is deriving a significant amount of their earnings from foreign currency gains.  If one only looks at their bottom line then TTA Holdings earned a profit last year.  But on further inspection they incurred an operating loss and had a currency translation gain for a profit.  Currencies are very volatile and shouldn't be relied on for continued profits.  It's better to invest in a business who can price their products for more than their cost and sell at that price.

The company has also begun to incur debt to fund their operations.  While they had a $464k profit on their income statement they consumed $6.7m according to their cash flow statement.  I don't make a big deal about cash flow on this site because in most cases the companies I look at have cash flow that mirrors earnings.  When those two values diverge it's a warning flag to research further.

In the case of TTA Holdings the company is paying out more to suppliers and employees than they're bringing in from receipts.  They're funding the shortfall with short term debt to the tune of $7m.  The bank borrowing is due in less than a year, which indicates the company expects things to turn around quickly from a cash flow perspective.

Unfortunately their latest press release is more bad news.  In the first four months of the latest year the company lost $3.2m that they again attribute to inventory issues.  The press release didn't include financial information but with a loss this size it's possible much of the margin of safety provided by the company's assets has been eroded.

While the company initially appeared cheap after a much closer inspection the investment case began to fall apart.  In the most recent annual meeting transcript for FRMO Murray Stahl has an insightful point.  He said if a fund manager were tracking the S&P and wanted to outperform instead of looking for stocks that would do better they should purchase the index and not invest in the worst constitution.  Buying 499 S&P companies and avoiding the worst would result in the index being beat.

Many times investors are so blinded to potential gains that they forget to look at what could be lost.  When I looked at TTA Holdings I see a very cheap company at a low valuation.  But I also see a situation where the potential for a loss is very significant, potentially greater than the potential for a gain.  This stock could shoot higher, but if I think of Stahl's statement I merely need to avoid the losers to do well.

Disclosure: No position

Free Value Investing Seminar this Saturday

I often get asked how I find the types of stocks I find, or what my research process is.  I've shared bits and pieces on the blog, but never my full process from start to finish.  This weekend on Saturday the 11th I'm going to be participating in a value investing strategies webinar where I will be walking through my investment process from start to finish.

I'm going to show how I look for unlisted stocks, and what makes a good investment verses what should be avoided.  I'll be sharing examples of investments that haven't been mentioned publicly on this blog.

I will also be walking attendees through my bank investing process.  Again I will be sharing a few banks that I find unusually attractive.

This seminar is free to attend and all attendees will get a full recording of the event.  I will be taking questions during my session, if you have ever had a question on my investment process this could be the time to ask.

The seminar starts at 11am on Saturday October 11th.  I will be presenting from 11am-12pm.  The speaker lineup is excellent with Toby Carlisle, Dave Waters, Tim Melvin, and Kristin Bentz also presenting.

Portfolio Strategies: Growth Investing and Wonderful Businesses

Everyone is special these days.  Everyone a winner, children's soccer teams don't even keep score anymore.  Likewise it seems that most value investors have convinced themselves that everything they invest in is a 'wonderful business' (a growing company with a sustainable advantage).  And of course Warren Buffett prefers these wonderful businesses himself, so why shouldn't everyone else?  How does a business become wonderful?  In Buffett's case a wonderful business is self-referencing.  But how do the rest of us find these mythical high growth companies that will generate fabulous shareholder returns for years?

Many investors think of growth in terms of high returns on invested capital (ROIC), or high returns on equity (ROE).  The problem is both of those figures are backwards looking.  An ROE metric, or ROIC metric will tell you what a company did in the past, not what they'll do in the future.  ROE's are not predictive, think of a pager company in the late 1990s.  They were posting fantastic ROEs, now their products are being sold in slummy parts of town next to check cashing stores.  A more contemporary example is Blackberry.  A company who posted excellent results year after year, but those results didn't predict the quagmire they're in now as their products fell out of favor.

In some ways it's simple to discover if a business will be successful.  Successful businesses offer products and solutions to clients that provide clients more value compared to the value they give up to purchase the product.  If that last sentence confuses you re-read it and think it through.  A buyer gives up something of value (often money) to purchase something of greater perceived value.  This is the essence of a sale.  If a buyer doesn't perceive value from a product or service greater than what they're giving up they won't purchase, no matter how many steak dinners a salesperson takes them to, or how cool the commercials for the product are.

The first step to finding a growth company is finding a company with a product that satisfies an essential need.  This sounds easier than it is.  There are many products that seem essential, which under the magnifying glass are just 'nice to haves'.  Consider the context of the product.  Users don't need a Macbook to exist, but a graphic design studio might not survive without one.  Often the most successful products fill very specific needs, that if left unfilled would leave the purchaser in a very vulnerable position.

It's easy to see how a company selling products to another business fills this role  Think about a company selling conveyor belts in an assembly plant.  Conveyor belts seem like a commodity item, yet to the purchaser without them their assembly plant would be at a standstill.  They need conveyor belts that are so reliable that they don't need to think about them.  The best products are ones whose users never think of them when they're working well.  The worst products are ones where users are constantly thinking about them.

Maybe it's hard to see where a consumer product fits into this mix.  Why does a person need Under Armor, or Starbucks?  The answer to this is found in Ca$hvertising (I'm currently reading it, and so far would recommend it to those interested in marketing).  The author states that there are eight life forces that we are biologically programmed with the desire to satisfy.  These forces are: survival and enjoyment of life, enjoyment of food and beverages, freedom from fear, pain and danger, sexual companionship, comfortable living conditions, to be superior and win, care and protection of loved ones, and social approval.  Products that serve these life forces satisfy a consumer's biological desire. Consider Starbucks, they fit enjoyment of food, and social approval, two life forces.  Under Armor fits comfortable living conditions and survival, we need clothes to protect us from the elements.

Create a product that meets a life force, effectively make potential customers aware of the product and a company has a success on their hands.

Creating awareness and product marketing is often misunderstood.  Posting quotes on Twitter, or creative ads isn't great marketing.  Marketing is using a medium to sell a product.  As Claude Hopkins said in Scientific Advertising (the Security Analysis of marketing):
"The only purpose of advertising is to make sales.  It is profitable or unprofitable according to its actual sales.  It is not for general effect.  It is not to keep your name before the people... Treat it like a salesman.  Force it to justify itself.  Compare it to other salesmen.  Figure its cost and result."  
Marketing is a different type of sales.  Marketing that can sell products is powerful and valuable.  A great example of this type of marketing is Proctor and Gamble.  They product a variety of products, each is too small for a salesperson to sell to the end consumer.  So the company sells through their marketing.  They treat marketing like a science.  They sell to consumers through their ads in magazines, on the radio and on TV.

For a company to develop the correct product, target its market, and then market and sell effectively takes the correct set of people.  A successful company needs capable management that listens to their employees.  Take this quote from the creator of Crystal Pepsi for example:
"It was a tremendous learning experience. I still think it's the best idea I ever had, and the worst executed. A lot of times as a leader you think, "They don't get it; they don't see my vision." People were saying we should stop and address some issues along the way, and they were right. It would have been nice if I'd made sure the product tasted good. Once you have a great idea and you blow it, you don't get a chance to resurrect it."  
The executive thought the idea was brilliant and charged forward without stopping to consider if the drink ever even tasted good.  The executives reports were telling him to stop and reconsider, he didn't listen, he just marched forward.  As a result Crystal Pepsi was a failure, something that many in the company knew before it launched.

The last ingredient a company needs for growth is a large addressable market.  A company selling barber shop poles is going to struggle to grow as there are only so many barbers, and the number is shrinking.  A growth company needs to be in a growth industry.  There are plenty of niche profits in servicing obsolete markets, but these are long tail declining profits.  Growing profits come from growing markets.

If we put it all together the ingredients for success for a growth company are: product that serves a vital need, excellent marketing and sales, and employees/management that can pull all aspects together.  A company needs all of these elements to become a successful growth company.  It's like a three legged stool, if any leg is missing the stool falls over.

The difficulty a public market investor faces is that much of the vital information needed to make a decision about growth companies isn't in a 10-K or 10-Q.  So how does one go about finding these companies?  Get out and talk!  The best place to start is a company with high margins, and revenue growth.  Spend time talking to the company's customers.  Ask why they purchase from the company under investigation verses a competitor.  Talk to suppliers and former employees.  Then finally talk to management.  Understand where they see the future and how the company plans on getting there.  Good management is key to navigating a company through growth.  Companies hit plateau's that need to be carefully approached.  Often the best leader is one who's been through growth challenges in the past.  A good leader is also one who is willing to listen.  A know-it-all executive is a red flag.

If a company has a great product, and a way to get it to the market then it's the people that make or break the company's success.  Great people will take a great product a very long way.  Lousy people will find a way to destroy products with incredible potential.

Maybe all of this sounds very hard, and like a lot of work.  That's because it is.  The rewards of investing in a growing company compensate for the work required.  It's not uncommon for a growing company to rise 5x, 10x or more over a number of years.  Likewise a growth hopeful won't just sit flat, it'll fall like a rock if expected growth isn't achieved.

In my view growth investing is best left to professionals and individuals who have a lot of time on their hands to do intense feet on the ground research.  Finding good growing companies is a lot of hard work, but hard work alone doesn't ensure success.

One problem with finding growing companies is that there aren't many of them.  There are a lot of companies that are growing, but not a lot of companies that have all of the attributes necessary to take their business from $10m a year to $500m a year.  Most growing companies will stall out, or will encounter culture problems as they hit certain levels.  Very few companies that look good remain that way for decades, or even years.  A big risk with investing in growing companies is paying a growth price for a company whose growth isn't sustainable.

Finding good growing companies that are wonderful businesses is difficult.  You might be wondering if there's an easier strategy?  There is a much simpler way to invest in growth businesses, but the simplicity eliminates a lot of the outsized returns associated with this strategy.  The simple way is to buy the leading company in a growth industry during a temporary downturn.  When industries go through crises it's usually the top company in the industry that comes out stronger.  The top company in an industry is often the most efficient and growing the fastest.  There is a reason they are at the top of their industry.  Buying during a market dip ensures an investor doesn't overpay for this marque company.  While this approach might beat the market, it pales in comparison to the returns of the investor who can correctly identify great growing companies.