Latest interview on Benzinga PreMarket show

This past Friday I had the pleasure of being a guest on the Benzinga PreMarket show again.  I enjoy discussing banks and bank investing with the Benzinga listeners.  A link to the video is below.

I discussed a few items that I intend to post about in-depth in the future.

  • Recently I spent some time reviewing the Q4 numbers for the US banking industry.  Specifically I investigated the narrative that this low rate environment was causing margin compression and making it hard for banks to make money.  What we found was that the majority of US banks have experienced expanding net interest margins over the past year.
  • One area of the banking market I've spent some time looking at recently are the regional banks. These are discussed in the show.  Two regional banks stand out as more attractively valued: FITB and STI.  

Leverage and success

What drives success?  Everyone who succeeds credits something different for their success.  Some credit hard work.  Others credit being in the right place at the right time.  Some credit parents, friends, a boss, a wife, the list goes on.  The problem with success is that it's hard to duplicate.  No two people live the same lives and no two situations are identical.  I've always enjoyed studying failure because there are clear failure patterns.  People fail in many of the same ways.  Failure can be avoided and studied.  Sometimes the absence of failure can results in success, but success is more complicated.

It's bothered me that there is no formula for success.  Of course if there were a formula then everyone would follow it and the formula would stop working.  As I've thought about successful individuals and successful businesses a pattern started to emerge, a recurrence of leverage.  I've been thinking about this idea for a few months and I finally decided that sitting down and typing it out might help me finally solidify my thoughts.

About a year ago I wrote a post on scalable businesses and growth.  Looking back at that post it was the first time I'd really thought about this idea of leverage.

Why is it that some companies start and fail to grow, or take decades to grow?  Why is it that other companies begin to grow and their results compound exponentially?  Is it the managers involved? The business model?  Some secret no one else has discovered?

Most small businesses stay small businesses forever.  A local plumber with a single van isn't likely to grow his business into a plumbing empire with a nationwide network of plumbers.  But why is it that some companies that start small such as a software company can grow large quickly?  The business model has a lot to do with this growth, but that's not all.

Leverage is a misunderstood concept.  When many investors think of leverage they immediately think of financial leverage, that is taking on debt to purchase an asset.  Financial leverage can work in an investors favor, but there are other types of leverage as well.

Think about the plumber and their business.  The plumber makes service calls and charges an hourly fee per service call.  They also sell parts for a small markup.  If the plumber wants to double their income they either need to double their hourly rate, mark up parts, or work double the hours or some combination of all three.  Another alternative is to hire a second plumber.  The problem with hiring a second plumber is part of that plumbers earnings go towards their salary.  For the initial plumber to double their salary they might need to hire two or three additional plumbers.  At this point the original plumber is probably going to be doing less plumbing and more administration, finding additional clients, advertising and working with their accountant.  To make up for this loss of billable hours they might need to hire an additional plumber or two.

Notice in this example each additional plumbers marginal profit for the company shrinks.  This is because each worker incurs overhead that accumulates across all workers.  Eventually if the company grows large enough the owner will need to hire managers to manage plumbers.  These managers aren't billable and aren't selling parts so they are almost a pure expense.  If the company continues to grow managers will need to be hired to manage the managers who manage the plumbers and on and on.  In the business of selling time (billing hourly) a company faces a natural size limit.

Let's consider a different type of business, a company that manufactures shoes.  This company starts out and buys a shoe machine.  Workers throw in raw material and the machine creates a completed shoe.  The machine can be purchased for $1m.  The company purchases some raw material, fires up the machine and starts producing shoes.  Until the company has produced and sold shoes for $1m plus their raw material and labor costs they are operating at a loss.  Their shoe sales have not covered the cost of their expenses yet.  For each additional shoe sold the marginal loss shrinks as they get close to $1m.  Once they hit $1m the company starts to earn a very tiny marginal profit per shoe sold.  If the shoes are popular and they sell tens or hundreds of millions the marginal profit will continue to grow as long as the single machine can keep up with demand.

For the shoe company the way they can increase profits is by increasing sales and maximizing output on their shoe machine.  When the machine's output is maximized they'll need to buy a second machine which will decrease their profits until throughput can be maximized on that machine as well.

The shoe company is ultimately limited by consumer demand for their product.  The capacity to create shoes is much higher than their costs and their cost structure rewards them for output.  They will run out of customers before they run into scaling problems.

I used these examples to illustrate the idea of operating leverage.  The plumbing company has very little operating leverage whereas the shoe company has significant operating leverage.  Operating leverage can come in a few varieties.  One is the shoe company that might make a small profit on many items compared to a business that sells very few items with very high margins.  The best type of operating leverage is a company that sells a lot of products with high margins, a company such as Apple.

Let's take this concept one step further.  Consider an individual working for someone else; the classic cube dweller.  They have the least amount of leverage.  If they double their hours worked their pay remains the same.  Regardless of the amount of effort put into the system they receive the same output.  The office worker has the least leverage because like the plumber they're simply selling their time to a company.  The difference is the plumber can grow their business and hire other plumbers.  Even if the plumbers business is ultimately limited by overhead they have a small amount of leverage whereas the office worker has none.

A business owner has leverage regardless of the size of their company.  This is because they have the ability to hire additional employees if their workload grows.  If a business is selling a product operational leverage is created.  For the office worker looking to increase their income I'd encourage them to set up some sort of size business selling something other than their time.  Any additional amount of leverage can be financially beneficial.

When most people think of leverage they think of financial leverage in the form of debt financing.  Most of the time financing assets doesn't make sense unless the asset has appreciation or cash flow potential.

Non-investors love to talk about how much money they made on their house.  The problem is most don't realize the only reason they made money is because they purchase was highly levered.  Take for example a person purchasing a $100,000 house with $20,000 down.  Presume the house appreciates 2% a year for 10 years before the owner sells it for $120,000.  The final sale price is 20% higher than the purchase price, but for the leveraged individual they approximately doubled their money.

Many of you would point out that home ownership isn't always a guaranteed return.  A lot of homeowners lost money on their houses and their levered investments came to haunt them.

Leverage cuts both ways, both financial and operating leverage.  A company with significant operating leverage can realize large losses the moment their sales volume slides below break-even.  The further the slide the larger the losses.  This isn't true for a business built on selling time.  For a business with no leverage sales scale linearly with hours billed.  If 50% less hours are billed revenue is 50% lower.

Financial leverage enables us to buy more than we can afford with cash, and increase our returns, but if interest payments can't be met it's all for naught.

What does all of this have to do with success?  As I've looked at successful people a theme has become clear, all have leverage in their life.  Some have achieved success through financial leverage, others through operational leverage, but always leverage.

To illustrate this point consider two investment managers, one with $1m in AUM and one with $1b in AUM.  Both work hard and earn 15% for their fund.  The manager with the smaller AUM earned $150,000 for their investors whereas the manager with $1b earned $150,000,000 for their investors.  The exact same return yet vastly different nominal results from asset size.  Incentives reward managers who have larger funds regardless of performance.  This incentive is simply the leverage effect.  Smaller amounts of capital with less leverage require higher returns.

One thing about the leverage effect is it isn't fair.  In the above example both managers might have worked equally as hard but the manager with a larger asset base earned more due to their size.  This is the same in business, in real estate, and in life in general.

I've noticed that sometimes people will look at someone who has used leverage explicitly (such as Buffett's insurance float) and try to discount that factor.  The Economist wrote an article a year or two ago trying to calculate Buffett's returns unlevered.  They weren't anything special, but that's the point.  If one doesn't include some sort of leverage in their life it is hard to get above average results.  I'd go as far as saying that above average results can only be achieved through the use of leverage.  It's impossible to do it unlevered.  Levered results should be rewarded and credited to the individual because the individual who used leverage successfully managed their risk.  For every Warren Buffett there are dozens of investors who levered their portfolios and blew up because they disregarded risk management.

The question then becomes "how do I incorporate leverage into my life?"  The first thing most think of is "I need to better utilize financial leverage, more debt, a bigger mortgage etc."  This is the wrong conclusion.  Financial leverage for individuals is only really acceptable to purchase appreciating assets.  That means financing a house (maybe), or financing a business purchase.  Otherwise leveraging up for depreciating assets (cars, TVs, vacations), or assets that don't generate cash flow limits individual financial success.  But as I discussed above there are other ways to incorporate leverage into ones life.  What about selling a product on the side or starting a business?

I believe it's possible for employees to obtain a slight amount of leverage without starting a business.  One way to do it is to negotiate a pay package based on personal performance.  This is the traditional sales model, a salesperson is paid for the revenue they generate.  But why can't other employees be paid for the impact they make on their business?  Employees who work harder should reap larger rewards.  Part of the reason companies are fearful of doing this is that it exposes that some employees don't work that hard at all and there is likely a lot of fat that could be cut.

Leverage doesn't always need to be obtained through financing or outside investment either.  It's possible to create a business with sweat equity where operational leverage is created through hard work.  If possible this is the best type of leverage to look for.

While there isn't a formula for success one thing is clear.  Abnormal success doesn't occur without some sort of leverage.  The trick is finding how to best incorporate leverage as well as manage the risk.

Listen to Me on the Bulldog Investor Podcast

I was recently a guest on Fred Rockwell's Bulldog Investor podcast.  We talked about a number of things including risk, small stocks and bank stocks.

A Short Essay On Why I Write and Why I Share For Free

You might be wondering why I give interviews like this, or why I give 'secrets' away on the blog freely.  This is a subject I'm not sure I've ever discussed on here and because I love to talk I can't fathom leaving a post as two sentences with a link.  So without further ado..

I grew up in the pre-Internet era.  If there was a song I heard on the radio and I wanted a copy I had two choices, I could put a blank cassette in my boom box and when I heard the song run across the room and quickly press record.  Or I could go to the local music store and hope they had a copy in stock.  If I didn't know the name of the song I'd have to call the radio station and ask, or ask friends to try to identify it.  It sounds clumsy now, but that's all that existed.

The way to find new music was from the radio or friends.  The radio was the traditional mainstream stuff.  I had a few friends who were a bit more out there and they somehow had this connection to local bands and the weirder music.  If someone had an album that they wanted everyone to hear they'd make cassettes and give out copies.  Outside of spending money at random to find a new band the only way I found something was if a friend gave away music to me for free.  Many times I went on to purchase other albums, or even the album I had the cassette of.  But I needed the introduction first.

I loved the idea that music could be shared freely.  I liked the idea even more that the Grateful Dead and Phish built enormous followings by encouraging fans to give away their music.  Instead of cutting into their revenue the Dead and Phish saw the free sharing increase their revenues.

When I started to write Oddball Stocks I had no goals or ambition about what this site might turn into.  It was a dumping ground for my thoughts as I researched stocks.  An online blog was a place I could access from anywhere so I could recover my thoughts.  This might sound strange, but if you've ever seen me hunt around the house for 30m trying to find my keys it might make sense.  It's not uncommon for me to walk out of one room with a screwdriver in my hand and into the next with nothing and no idea where the screwdriver went.  A blog was a way to make sure I didn't forget what I'd read or researched.  A byproduct of writing is that it helps to clarify thoughts.  The more I wrote the more I realized I was the one benefiting the most from writing.  It helped me form my ideas and remember them.  And if I did by chance forget them I could always re-read them online.

I had the option of keeping my blog private when I started but thought back to my experience with music sharing.  I thought that maybe if someone could benefit from my thoughts then it might be worth it.

A funny thing happened when I gave away my thoughts and ideas, it became like the Phish tapes.  The blog went crazy.  You, my readers started showing up from all corners of the world.  It's humbling to think that while I sleep or take a walk that someone in Mongolia or South Africa is reading something I wrote.  And while the sharing has helped a number of you it's also helped me.  I've made some incredibly meaningful connections through this blog, connections and friendships I wouldn't have otherwise.

With success comes detractors.  I've had a few readers accuse me of giving away too many secrets about small stocks.  My advice to them is if I can find this information out then someone else can as well, and not everyone is bound to some secret pink sheet honor code of conduct if there even is such a thing.  When looking at a small stock there is a natural inclination to think to oneself that you've discovered something new that no one else knows about.  What I've found is the longer I write on here the less I have that feeling.  I can write about the most obscure company in the world and a few readers come out of the woodwork letting me know they and others have been following it for years.

The problem is I'm not selling a magic bullet.  My approach is hard work.  Look at hundreds or thousands of stocks and find the best to research further.  From those whittle it down to a few worth investing in.  There is no magic formula, just time and effort.  It's like dieting, you can tell people to eat less and exercise but not many people follow through with it.  The formula for losing weight is simple, but hard to follow.

What I intended to be a few short paragraphs turned into something a bit longer.  In the end I don't have the slightest bit of regret in sharing with others how to find hidden value stocks.  The rewards to both you and myself have been too great to stop.  So I'll continue writing here and writing about these little names in the Oddball Stocks Newsletter....

The value imposers

I was riding on a ski lift with an apparently successful investor from New Zealand.  Each January he flew to Utah to ski for three weeks with his family.  I couldn't even imagine how much airfare and lodging must have cost.  Our conversation naturally drifted to investing.  He asked what type of investor I was to which I responded "a value investor."  He had a puzzled look and said "what does that mean?" I said "I look for undervalued stocks, companies trading for $,.50 that are worth $1."  The man laughed and said "Isn't that what all investors are doing? Looking for undervalued stocks?"

That ski lift ride was 10 minutes long, but the conversation has stuck with me the last three years.  It serves as a constant reminder to invest differently.

As Warren Buffett's investing style has shifted from small neglected companies to elephants the sentiment of value investing seems to have shifted with him.  Articles about value investors from the 1970s and 1980s are full of quotes about finding companies the market has left for dead yet full of value.  Companies where their real estate is worth more than their market cap alone, or companies where coffers stuffed with cash are disregarded because there is no growth.

Buffett is arguably one of the most successful investors of all time.  He might be outdone by Rockefeller or Carnegie, but until Buffett passes from this life into the History Channel no one's counting.  Buffett has matured from a small time investor at the fringe of the market to a star that the rest of the market orbits around.  If Buffett wants to speak anyone with a camera listens.  His quotes have found a home in almost any market situation.  Even a trader might be caught saying "Be fearful when others are greedy."  Buffett quotes are like horoscopes, ambiguous enough that they apply to any investor in any market situation.

As Buffett's company Berkshire Hathaway grew from cigar butt stocks (small neglected companies) to larger names his strategy shifted.  He started to buy larger companies whose growth wasn't appreciated.  After all with billions of dollars in capital he was effectively forced out of smaller names.  When Buffett bought undervalued growth the market purchased it too.  Then another shift happened, Buffett could no longer buy undervalued growth and simply had to look for wonderful companies selling at any price that wasn't outrageous.  If a large enough company comes calling and they aren't asking too much he'll probably buy.  Why?  He has to keep feeding the beast.  Berkshire Hathaway is a victim of compounding.  The company has grown so large and so successful they have an increasing amount of cash that needs to be put to work each year.  Buffett could hardly be criticized, he has built one of America's largest companies and made himself into one of America's richest men in the process.  So what if he has to lower his standards a bit?

Berkshire Hathaway's pool of potential investments is limited to maybe 100 public companies and a similar number of private companies.  But just because he's limited doesn't mean we should be limited.  Buffett will probably outperform the market over the next decade, but my guess is Berkshire's returns gently glide to be inline with the market.  Why?  Because at a certain size his company is a proxy for the market.  As the American economy goes so goes Berkshire Hathaway.

My point is that Buffett has become the market, and at this point mimicking what he does gives results no different than what the market generally does.  Why not buy an index fund?

If as an investor you want different results from the market you need to do something different than the market.  Everyone in the market wants growing companies.  How do I know this?  Browse the mutual fund selection at any discount brokerage.  What is the term that appears most? Growth.  I did a quick search and Fidelity offers me 374 growth funds verses 288 value funds.  But I'd say this number is skewed.  I read the summaries on a few of the value funds and they all mentioned they look for growing high quality companies in a value manner.  Even the value funds are growth funds.

Is growth bad?  Not at all, we all want things to grow.  If something isn't growing it's shrinking.  I want my portfolio to grow, my relationships to grow, my knowledge to grow, my kids to grow, everything to grow.  And so does everyone else.  We all want growth.  If most mutual funds are looking for the same thing is there any question as to why most slightly under-perform roughly by the amount of their fees?  Of course not, it's because they're all doing the same thing, looking in the same places for the same types of companies doing the same things.

When everyone is doing the same thing an industry becomes an arms race.  Who can find the growth the quickest, who has the better tools, who has the smartest analysts and who can get better information.  This is the efficient market, the knowledge arms race for growth.

This arms race extends beyond mutual funds to hedge funds.  Many hedge funds think differently together resulting in crowded trades.  Individual investors see these clusters of fund managers in the same names and naturally gravitate towards the same companies, like moths to a light.

There is an alternative.  For those of us without Wharton, Harvard, or Columbia analysts or those of us who aren't managing billions, or even for those of us who are.  The answer is to think and act differently.

One of the reasons value investing was so unique when Graham first wrote about it was because it was so different.  At the time investors wanted high yielding stocks.  A high yielding stock was desirable.  It didn't matter what assets or earnings the company had, only their dividend.  As time has progressed the metrics the market considers important have shifted.  Instead of dividends it's ROE, growth, moats and EV/EBITDA multiples.

If you want different results from the market then you need to think and act differently.  There will always be a few managers who win the arms race, but silently mimicking them isn't helpful unless you want to join the race.  One needs to look at things differently.  If the market is looking for growth and high ROE then what are they glossing over that's important?  The key to success is finding what others have missed.

Being different is difficult, there are few friends and you need to pave your own path.  I have never marched with the crowd, for some reason I came out of my mother's womb wanting to go my own path.  To me marching in a different direction is natural, I'm curious, I follow seemingly endless hunches or attractions and hope to learn a little on the way.  This extends to my investing, I'm attracted to the nooks and crannies of the market simply because no one else is there.  If what I do is unnatural for you that's fine, don't mimic me, do your own thing.  To me the key to success is being different and thinking differently.

I find success fascinating.  There are plenty of high powered CEO's who grew up in the right suburbs, went to the right colleges and climbed the right ladders.  The financial media loves them, but to me they're boring.  I find the successful entrepreneurs fascinating.  People who never went to college and own multi-million dollar landscaping companies.  People who left high powered jobs to start something different like a cupcake business.  The ones who saw opportunity and acted on it.  The ones who risked failure, or the loss of their reputation to do something different.  People who are obsessed with something and won't give up until they are satisfied with a solution.  These are the success stories I love to hear about.

While I love success I am even more fascinated by failure.  There are common failure paths that most companies or individuals take.  These are well trod out paths that some can see coming.  Why do so many companies with well educated executives fail so miserably?  As an investor spotting failure and avoiding it can be extremely profitable.  Most companies that fail follow the crowd, they fail to take risks and do things differently.  Some industries fail together as each company marches in lock step toward imminent death.

Buffett's success came from being different.  He created a new type of investment company.  It's a shame that instead of learning that lesson from him investors have instead embraced trying to copy him.  If you want different investment results than the market you need to think and invest differently.  If you don't you might as well invest in an index fund and forget about the market.

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