Saturday, July 27, 2013

10 Investing Lessons Learned

Ten years ago this week, I started my first job in the investment industry and it seemed a fairly decent occasion to reflect upon some of the key principles I've learned thus far in my career. 

  1. Patience is paramount. Having worked with a number of ultra-high net worth individuals, I learned that the common theme in their portfolios was patience. Not a single one was on the phone with us multiple times a day placing trades. Sure, the clients had questions about their holdings now and then, but they stuck to the agreed-upon strategies and were letting time do the work. In some cases, they still held onto shares of companies that their grandparents had bought half a century earlier and were simply letting the dividends roll in year after year.

  2. Always consider incentives. Investors typically spend the majority of their research time investigating the company's income statement, balance sheet, and cash flow statement. While the information on these statements is obviously important, I've found that far less time is spent researching executive incentives and pay packages, which can be found in the annual proxy statement (14A) in the U.S. (In some markets, this information can be found in the annual report.) Unlike the historical financial statements tell you what's already happened, reviewing management's incentives can help you understand how management will steer the company going forward.

  3. You need to have a good information filter. With so much financial information available today, it's essential to know what's important and what isn't. This comes with experience, but a good rule-of-thumb is to focus on information pertinent to a company's competitive positioning within the industry.

  4. The best investments you make are usually the ones where your get the most criticism. With investing, it rarely pays to be on the side of the cheerleaders. Indeed, some of the best investments I've made received initial criticism -- and the more passionate the criticism, the better; conversely, when I hear someone say "good call" about a recent investment, I start to wonder if I missed something important. Being able to stand alone in your convictions is a key ingredient to successful long-term investing.

  5. There’s no substitute for dividends. Despite the recent enthusiasm for "total yield" and similar measures that lump in buybacks and debt repayments with dividends, the bottom line is that only dividends put cash in shareholders' pockets today. None of the aforementioned successful investors that I worked with talked about how they were "living off their buybacks" and none of them manufactured their own dividends by selling partial stakes every quarter. That works in theory, but less so in practice.

  6. Process matters more than short-term results. Whether you're evaluating a mutual fund manager or reviewing your own strategies, short-term returns are largely a matter of luck rather than skill. Instead, focus on the investment selection process, as over time the process will have a more meaningful impact on returns. If you're going to review performance, pay closer attention to five-year returns as that's typically enough time to reveal the success of an investment strategy. Legendary investor Philip Fisher asked his clients for three years before they judged his results. Whichever time frame you prefer, the point is to not focus on quarter-to-quarter or even year-to-year results as a measure of investor skill.

  7. Keep costs to a minimum. The more capital you have to compound, the better. Some trading costs are unavoidable, but the key is to keep them to a minimum. A good rule-of-thumb is to keep commissions below 2% of each investment (e.g. invest more than $500 at a time if commissions are $10) -- and ideally much less. It's also smart to practice good capital location to keep a lid on tax costs -- i.e. to the extent possible, keep dividend paying stocks in tax-advantaged accounts like IRAs and your non-dividend paying stocks in taxable accounts.

  8. Actively seek feedback. Investing without feedback can slow your learning process, create or enable biases, and increase the odds of permanent losses as you're more likely to commit avoidable mistakes. If you can, find a trusted investing partner to run your ideas by -- and ideally one that isn't afraid to be critical and provide feedback. Even if you're confident in your abilities as an investor and think you can go it alone, consider the Warren Buffett/Charlie Munger partnership -- even the most capable investors of our time value the benefits of an investing partnership.

  9. Keep good records. A common denominator among the investors I admire is they meticulously keep track of each investment's thesis and their progress using spreadsheets and/or notebooks. The purpose of this exercise is to reduce biases that may skew your memory of why you bought the stock in the first place. Similarly, it can help you understand when the time is right to sell the stock.

  10. Read, think, and teach. Another common denominator among great investors is that they're bookworms. Sure, devour as many annual reports, investing books, and shareholder letters as you can, but you can also get valuable perspective from non-finance books. The Tao Te Ching, for example, provides some great insight about the value of patience. As you improve your knowledge base, don't forget that investing isn't an easy topic and there are many people seeking reliable answers. When its prudent -- and you know the answer -- don't shy away from opportunities to teach and help others become better investors. As the Roman philosopher Seneca said, "Welcome those whom you yourself can improve. The process is mutual; for men learn while they teach."

If you have any lessons to share from your investing experience, I'd like to hear them! Please share them in the comments section below or on Twitter @toddwenning. 


@toddwenning on Twitter

Sunday, July 21, 2013

Philip Fisher's 15 Points to Look for in a Common Stock

After reading Peter Lynch's Beating the Street a few weeks ago, I decided to read another investing classic: Philip Fisher's Common Stocks and Uncommon Profits. As one of the pioneers of the modern investing industry, Fisher is often credited with laying the groundwork for what we know as growth investing today.

First written in 1958 -- nearly 25 years after Graham and Dodd's Security Analysis established the framework for value investing --  Common Stocks and Uncommon Profits is cut from a very different cloth than Graham and Dodd. For instance, at many points in the book, Fisher says a high price-to-earnings ratio should not be an automatic turn-off for investors.

Here's one such example:
If the company is deliberately and consistently developing new sources of earning power, and if the industry is one promising to afford equal growth spurts in the future, the price-earnings ratio five or ten years in the future is rather sure to be as much above that of the average stock as it is today...This is why some of the stocks that at first glance appear highest priced may, upon analysis, be the biggest bargains. 
This approach is clearly different from traditional value investing. No "net-nets" or "cigar butts" here -- Fisher is more interested in finding and investing in the few excellent companies in the market. Valuation may matter, but it's secondary to identifying top-notch businesses.

In the book, Fisher lays out "15 Points to Look for in a Common Stock" that can help investors do just that.

1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?

Fisher splits outstanding companies into two camps: "fortunate and able" and "fortunate because they are able". The former group consists of well-run companies that also benefit from a secular tailwind. Modern examples might be Amazon and eBay, both of whom have benefited mightily from the Internet revolution. As the Internet has grown, so have these companies' fortunes. Some of their success can certainly be attributable to excellent execution, but these companies' long-range sales curves extended as more and more people embraced online shopping.

The latter group consists of companies that create their own luck by reinventing the business by introducing new products or shifting strategy. In the book, Fisher uses the example of DuPont, which expanded its chemical offerings well beyond blasting powder and consequently lengthened its long-range sales curve.

2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?

This may sound a lot like the previous point, but as Fisher says, this point is "a matter of management attitude." Consider Apple: Steve Jobs could have stopped with the iPod and would have been long remembered for revolutionizing the way we listen to music. Early investors would have made good money riding only the iPod's success. But what really made Apple a top-performing stock for the past decade was Jobs' drive to make sure that the iPod was followed by the equally-revolutionary iPhone and iPad products.

Few companies will match Apple's success, but the example does show how identifying companies with management teams intent on staying on the offensive with new products/processes can reward shareholders by having an extended long-range sales curve.

3. How effective are the company's research and development efforts in relation to its size?

Most R&D analysis begins and ends with the tried-and-true "R&D spending as a percentage of sales" metric. Though this ratio can reveal how current R&D spending compares with the past, it tells us very little about what kind of returns the company is getting on each R&D dollar. Admittedly a difficult figure to determine, you can look at the success of recent product launches as a sign of R&D productivity. Ideally, you want a company's R&D spending to be dedicated to creating or enhancing its economic moat. Firms that not only create new products but also create unique production methods will benefit more than companies that just create new products that can be quickly replicated by existing techniques in the industry.

4. Does the company have an above-average sales organization?

This is an often overlooked area of research -- indeed, one that I've under-appreciated over the years. The reason for this common oversight, as Fisher rightly notes, is that there's no accounting measure or ratio -- as there is for research and development, for example -- that captures marketing spending and effectiveness.

But the quality of a sales force matters. Think about it this way: Ever been to a restaurant with crappy service? Even if the food is good, because of a bad service experience you're much less likely to go back or recommend the place to friends. The same thing occurs in business all the time.

Analyzing the quality of a company's sales force requires a more qualitative approach. If you can, ask customers, suppliers, competitors who has the best sales force in the industry. If you can get the company on the phone, ask them how their sales force is rewarded. If you don't have access to those parties, a Google search may reveal something helpful.

5. Does the company have a worthwhile profit margin?

As Fisher puts it, "the greatest long-range investment profits are never obtained by investing in marginal companies." That is, if the company isn't doing anything remarkable, nothing is changing, and its margins are razor-thin, there's no point buying it. In most cases, I look for companies able to consistently generate 10%+ margins. There are exceptions -- for example, firms can have low profit margins and high asset turnover and generate good returns on equity (see: Costco, Wal-Mart, etc.).

6. What is the company doing to maintain or improve profit margins?

The investing community often falls into the trap of extrapolating present trends. If a company's margins have averaged 8% over the last five years, for example, many forecasts will assume about 8% margins over the next five years, too. As such, the market price for the stock has a good chance of implying about 8% margins going forward. So when a company is able to break away from historical trends and boost margins to, say 15%, that will have a profound impact on the stock price and investors who anticipated that move will be rewarded.

7. Does the company have outstanding labor and personnel relations?

Put another way, "Are rank-and-file employees passionate about working for the company?" Though this is rare, when employees are enthusiastic the productivity levels can be extraordinary. It's precisely these companies that can truly deliver better-than-expected profit margins and returns on capital even if the market is skeptical. When doing your research on this point, reach out to people in your network who may work for the company or industry to find out who has passionate employees. LinkedIn, Glassdoor, and other websites may also provide some quality information about employee morale.

8. Does the company have outstanding executive relations?

Similar to Point #7, but more focused on executive motivation and passion for the job. Excessive management pay packages is certainly cause for concern, but you also want the executives to be appropriately compensated. Otherwise, they'll likely have one eye on the business and one eye on the door.

9. Does the company have depth to its management? 

I've debated this point with others in the investment industry and I've heard good counterarguments, but there is something to be said for a company that can retain employees -- especially in this day and age -- for 10+ years and promote them to senior positions.That is usually a sign that highly-skilled people like working for the company (see Point 7) and have bought into the culture and mission. Conversely, a company that needs to frequently hire from the outside might have trouble retaining key employees or might be looking to change the corporate culture. Hiring outside executives to repair a defective corporate culture is often necessary, but it can also disrupt operations for a few years and you may want to put your investing dollars elsewhere unless you know a lot about the specific situation.

10. How good are the company's cost analysis and accounting controls?

Financial sleuths can examine the consistency of a company's assumptions for pension accounting, depreciation, revenue recognition, etc. Firms that frequently change these assumptions to make the numbers "work" each year should be avoided. Also consider management incentives (found on the annual proxy statement) to see if executives have moving targets each year or lowered hurdles that have enabled management to earn a healthy bonus regardless of performance.

11. Are the other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?

This question can be rephrased as "Does the company have an economic moat?" By doing a competitive analysis of the firm against its peers, we can begin to figure out if the company is relatively advantaged and, more importantly, if that advantage is sustainable or unsustainable. (Here's a video about understanding economic moats.)

12. Does the company have a short-range or long-range outlook in regard to profits?

Long-term shareholders naturally want a management team with an eye toward building long-term value rather than just managing for short-term results. While it's true that the long-term is made up of many short-terms, you also don't want companies to consistently forgo value-enhancing projects or squeeze important suppliers/customers just because it might hurt the quarterly EPS.

13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth?

Basically, you want to find companies that are financially healthy enough to fund their growth investments with internally-generated cash or with reasonable amounts of debt. Firms that consistently need to issue equity (and dilute current shareholders' stake in the process) should be avoided.

14. Does the management talk freely to investors about its affairs when things are going well but "clam up" when troubles and disappointments occur?

Take a look through the company's reports and conference call transcripts following a particularly poor quarter or year. Is management forthcoming about mistakes they've made or is everything sugar-coated or blamed on the economy/weather/markets? If management takes ownership for the company's underperformance and thoroughly explains the steps they're taking to improve the business, you might just have a winner.

15. Does the company have a management of unquestionable integrity?

The key word here is unquestionable. A management team that has any history of dishonesty, fraud, or ignoring shareholder interests will likely repeat this behavior and you don't want to be in their way when they do. I've made this mistake fairly recently, actually, and even though the company checked off a lot of boxes on the good side of the ledger, management's lack of integrity should have outweighed all those points.

Thanks to the Internet and company filings, we have plenty of ways to analyze management track records and behavior at current and former companies. The key here is when in doubt about a management's integrity, just walk away.

More to come

Common Stocks and Uncommon Profits is a must-read for serious investors, but I wouldn't recommend it as a book that new investors should read first. It was written for experienced professional investors, has some dated company examples, and assumes the reader has a certain level of access to the company that most retail investors don't have. Most of Fisher's lessons, however, are evergreen and the book is full of great quotes that I'll list in a subsequent post.

For a list of other good investing books, click here.

Thanks for reading!


@toddwenning on Twitter

Saturday, July 13, 2013

Is Total Yield a Contrarian Indicator?

A high dividend yield has long been a useful metric for value-minded investors. Since stock prices and dividend yields have an inverse relationship, all else equal, a high dividend yield can mean a depressed share price and represent a good buying opportunity. 

The following chart showing the S&P 500's quarterly value and dividend yield illustrates this relationship:
Source: Standard & Poors (through 3/31/2013)
Indeed, the correlation between the two data sets is -53.3%. Even with the significant dividend cuts during the financial crisis, dividend yield has remained a useful buying metric over this period.

What about buybacks?

Given the rise in buyback activity in recent decades, however, some in the investing community have suggested that we reduce the emphasis on dividend yield and focus more on a "total" or "adjusted" yield that also considers buybacks.

Using the same S&P data, here's how quarterly buyback yield alone compares to the S&P 500 quarterly market value:
Source: Standard & Poors

As you can see, buyback yield has a much more positive correlation with equity values -- +60.4% by my calculation for this period. In other words, as stock prices have gone up, buyback yields have generally risen, too.

Even when we combine dividends and buybacks to come up with a "total" or "adjusted" yield, the relationship is still positive:
Source: Standard & Poors
The correlation in this case was 45.8% -- reduced a bit by the dividend yield, but still very much a positive relationship.

If anything, then, a higher total yield tends to suggest an over-valued market rather than the other way around.

Granted, this is a relatively small sample size of a few dozen quarters. Perhaps over the course of a few decades companies will begin to repurchase more of their stock when prices are depressed and make total yield more of a helpful indicator.'s to hoping at least.

Bottom line

Though I'm certainly not against buybacks and think they should be included in any equity research process, investors should be skeptical about using a high total or adjusted yield as a buying signal.

Other good reads this week
Quote of the week
It is our belief that shareholders should demand of their managements either a normal payout of earnings -- on the order of, say, two-thirds -- or else a clear-cut demonstration that the reinvested profits have produced a satisfactory increase in per-share earnings. ~Benjamin Graham, The Intelligent Investor (ch. 19)

Have a great weekend!


@toddwenning on Twitter

Tuesday, July 9, 2013

A Closer Look at Peter Lynch's "Principles"

Even though I've been a big fan of Peter Lynch's classic One Up on Wall Street for many years, I'd for some reason never thought to follow up with his next book, Beating the Street.

I'm glad I finally did. Whereas "One Up" focuses mainly on the retail investor's strategy of "buying what you know", this book is more of a review of his years running Fidelity Magellan and it spends more time on the investing processes he used to produce some of the best long-term returns in mutual fund history.

The one drawback to the book for the reader in 2013 is that some of the case studies are a bit dated and it could use updated commentaries. Still, it's the investing research process that's particularly compelling and that is fairly evergreen.

Throughout the book Lynch peppers in 21 "Peter's Principles", or quick lessons from his investing career. I've outlined them here and added some commentary.

#1 When the operas outnumber the football games three to zero, you know there is something wrong with your life.

Lynch knew his work-life balance was skewed when he found he didn't have enough time to enjoy his family and things that he loved. Not an investing lesson, per se, but a good reminder that professional success isn't everything.

#2 Gentlemen who prefer bonds don't know what they're missing.

At the time the book was published in the early '90s, bonds were very popular and Lynch lists reason after reason why investors with a long time horizon should prefer stocks to bonds in just about every market scenario (with one exception below). Indeed, Lynch reminds investors that fixed income is exactly that:
Whereas companies routinely reward their shareholders with higher dividends, no company in the history of finance, going back as far as the Medicis, has rewarded its bondholders by raising the interest rate on a bond...The most a bondholder can expect is to get his or her principal back, after its value has been shrunk by inflation.
#3 Never invest in any idea you can't illustrate with a crayon.

One of Lynch's gems. Before you buy a stock, try drawing a diagram of how cash comes in and cash goes out. It's not always as easy as it seems. If it's a struggle, best pass on the idea.

#4 You can't see the future through a rearview mirror.

The market is forward-looking. What happened in the news or in the market last year, last month, or even yesterday has little bearing on a stock's price a year from now. As such, try to keep the right perspective on things like historical performance and backtests.

#5 There's no point paying Yo-Yo Ma to play a radio. 

Lynch makes the point in the book that investors can build a portfolio of Treasuries more cheaply than by paying fund managers to do the same thing. There's no point in paying someone top-dollar to do something you can do yourself.

#6 As long as you're picking a fund, you might as well pick a good one.

Pretty self-explanatory. I'd only add that when researching a fund, focus on the team's investing process and less on recent performance.

#7 The extravagance of any corporate office is directly proportional to management's reluctance to reward its shareholders.

Every dollar spent on office luxuries not needed to effectively run the business is a dollar less that could go in your pocket as a dividend or reinvested in the business. If you can visit the company's offices to determine the level of extravagance, great -- if not, try using Google Maps street-level view to get a sense of the location and perhaps a view of the building itself. Golden statues and ostentatious fountains...bad sign.

#8 When yields on long-term government bonds exceed the dividend yield of the S&P 500 by 6 percentage points or more, sell your stocks and buy bonds.

As unlikely as this scenario may seem today, it could happen down the road. Lynch's point is that if long-term Treasuries are yielding far above the dividend yield on stocks, it's likely a sign that stocks are overbought (and yields have fallen) and bonds are probably providing more attractive intermediate-term returns. In any case, we have a really long way to go to reach a 6% gap today.

#9 Not all common stocks are equally common. 

Lynch was often criticized for owning so many stocks at Magellan that the fund was a "closet" index fund with an expensive price tag. His point here is that as long as the stocks he owns have a strong investment thesis, it shouldn't matter if he owns 10, 100, or 1,000 of them.

#10 Never look back when you're driving on the autobahn.

This is probably literal advice, as Lynch shares his story about being nearly run over by a Mercedes on the autobahn. A bit of a head-scratcher for inclusion in the list of principles, I must say.

#11 The best stock to buy may be the one you already own.

This is something that I myself struggle with now and again. The "thrill of the chase" is a powerful force for investors and we're always looking for the next exciting opportunity, but you've already bought the stocks in your portfolio for a reason -- and if those reasons are still good, why not buy more (at the right price)? After all, these should be stocks you already know well and you won't need to start from scratch and invest many hours researching the next stock. This isn't always the right strategy, but it's one to keep in mind.

#12 A sure cure for taking a stock for granted is a big drop in the price.

Even the highest quality companies can have nasty surprises. Don't set any investment on auto-pilot; aim to check-in every quarter or at least twice a year to make sure your thesis is still intact.

#13 Never bet on a comeback while they're playing "Taps."

It's important to look for unloved and under-appreciated stocks, but some stocks have fallen for good reason. If you're going to make a strong bet against market sentiment, have a reasonable thesis and don't buy a beaten-up stock simply because it's beaten-up. It could get even worse...

#14 If you like the store, chances are you'll love the stock.

This is a degree. Before buying the stock of a company whose stores I like, though, I want to make sure that the market hasn't already priced-in other consumers feeling the same way. I much prefer buying my favorite retailers in the event of an indiscriminate market sell-off.

#15 When insiders are buying, it's a good sign -- unless they happen to be New England bankers. 

Lynch talks about New England bankers buying their own stocks all the way down, but in most cases insider buying is a positive signal. Ideally, you want to see executives using personal cash in the open market (not so much exercising stock options) and purchasing a meaningful amount. Executives are naturally optimistic about their companies' prospects, but it's much less common for them to put their own money up behind this sentiment. When they do, take note.

#16 In business, competition is never as healthy as total domination. 

Popular stocks tend to be those with high-growth potential, but Lynch rightly points out that these companies often attract significant competition. Slower-growth companies, on the other hand, can be much better buys if they also happen to command a large share of the market, have significant pricing power, etc.

#17 All else being equal, invest in the company with the fewest color photographs in the annual report.

Somewhat similar to #7, companies that feel the need to put on a good face for shareholders by using fancy pictures and interactive features in their annual reports might be trying to cover up deteriorating operations. (Enron's 1999 annual report, for example, was colorful.) Not always the case, of course, but something to bear in mind.

#18 When even the analysts are bored, it's time to start buying.

Industries that have lagged market rallies or posted underwhelming growth for a year or two may be overlooked by investors currently focused on recent winners.

#19 Unless you're a short seller or a poet looking for a wealthy spouse, it never pays to be pessimistic.

Bears will be right once every few years and pessimists often have elaborate and alluring theses, but as Josh Brown has noted, "Count the perma bears on the Forbes 400 list or the amount of pessimists who run companies in the Fortune 500. You will find none." When it comes to being a long-term investor, it pays to be optimistic -- especially if you can remain optimistic when others are becoming more pessimistic. Granted this is easy to say, harder to do.

#20 Corporations, like people, change their names for one of two reasons: either they've gotten married, or they've been involved in some fiasco that they hope the public will forget.

Be wary of companies that have changed their name. It's probably the same pig...only with a new shade of lipstick.

#21 Whatever the queen is selling, buy it. 

Look for opportunities to buy recently-privatized businesses. These opportunities are more likely to be found  today in emerging markets.

A few more good quotes...

Shareholders play a major role in a fund's success or failure. If they are steadfast and refuse to panic in the scary situations, the fund manager won't have to liquidate stocks at unfavorable prices in order to pay them back.

Cyclicals are like blackjack: stay in the game too long and it's bound to take back all your profit.

Stockpicking is both an art and a science, but too much of either is a dangerous thing...If you could tell the future from a balance sheet, then mathematicians and accountants would be the richest people in the world by now.

When a company buys back shares that once paid a dividend and borrows the money to do it, it enjoys a double advantage. The interest on the loan is tax-deductable, and the company is reducing its outlay for dividend checks, which it had to pay in after-tax dollars.

Have you read Beating the Street? If so, what did you think?