Sunday, November 24, 2013

9 Tips for Becoming a More Patient Investor

Even though the tag-line of the Clear Eyes Investing blog is, "Patience is the individual investor's greatest advantage over the market," patience is a virtue that doesn’t come naturally to me.

Maybe I played too much Nintendo as a kid or something, but my default expectation is for instant results. Whenever I’m stuck in highway traffic or waiting for a commuter train that’s running behind schedule on a frigid Chicago morning, I have to remind myself to stay calm and not get stressed, for it’s in such times that I’m prone to make stupid decisions.

Thankfully, I’m not alone in this. As Michael Mauboussin has noted in various articles, when we’re stressed, our mental time horizon shrinks and we have a tendency to make decisions that are completely focused on short-term results and we disregard long-term effects. Our brain’s reaction to stress may serve us well at times of imminent physical danger, but it can be really destructive when it comes to our financial health.

By reducing our investing stress and increasing our investing patience, I believe we can truly improve our long-term results. Indeed, hedge fund manager Joel Greenblatt recently said as much in a Morningstar interview:
"The secret to value investing is patience, and that's generally in short supply now...The world is becoming more institutionalized, there is more access to performance information, it's much easier to trade. So, patience is in short supply, and it really makes it much nicer for patient value investors…(Value investing) works over time, and it's quite irregular. But it does still work like clockwork; your clock has to be really slow." (My emphasis)
What are some ways that we can improve our ability to be patient? I’ve started a list here, but would also enjoy hearing your tips in the comments section below (or let me know on Twitter).

  1. Make a list of things that stress you out when investing: Knowing exactly what your stress triggers are will help you recognize them as they occur. One of my triggers, for example, is when a company I own makes a large acquisition that has a good chance of being value destructive. My instinct is to sell first and ask questions later, but the opposite has proven to be the better approach.
  2. Buy right and sit tight: Loss aversion is a powerful force -- and humans tend to feel the pain of a loss twice as much as the joy from a gain. In fact, some people are more sensitive to losses than others. As such, much of the investing stress that I’ve experienced myself and have heard from others comes on the selling end of an investment. Not knowing the right time to sell -- even if it will produce a gain -- can indeed be stressful. Howard Marks shared in his book, The Most Important Thing that Oaktree Capital employs the philosophy that "Well bought is half sold.” In other words, if you pay good prices for your investments, the selling should take care of itself (and be a lot less stressful).
  3. Have a 24-hour trading rule: If you’re feeling strong emotions before placing a trade -- excitement, agony, stress, etc. -- having a 24-hour trading rule can help you make calmer, more rational decisions. Take the time to consider why exactly you want to buy or sell this particular stock. You may still end up placing the trade the next day, but it will be done with more thought and less emotion.
  4. Establish longer-term performance benchmarks: Short-term investment performance has much more to do with luck than skill; therefore, it seems much more appropriate to judge our investments over a 3-5 year period rather than by a month or quarter. Granted, an investment thesis could completely fall apart within a year and action may be warranted, but aiming to give each investment a few years to play out before we sell it should reduce the need to impatiently sell based on short-term performance.
  5. Take stock quotes off your smartphone or internet homepage: There was a time not too long ago where you had to either call your (expensive) broker or wait for the daily newspaper to get the latest quote on your stock. With real-time quotes at our fingertips these days, I'd bet that those flashing green and red lights cause us to make more frequent trading decisions that we would otherwise. If you’re finding this to be the case in your own portfolio, try going without real-time quotes for a while and see if that helps.
  6. Stay diversified (to a point): Some investors will say that in order to really trounce the market, you need to have a very concentrated portfolio of just a few holdings that you really believe in. Perhaps there’s some truth to that, but there’s also something to be said for being able to sleep at night. As confident as I might be in a thesis, I also know that I’m fallible, so as a rule I don’t invest more than 10% of my portfolio in a single name. Having such a big bet on a single company would likely cause me to be impatient if my thesis wasn’t working out and make hasty trades.
  7. Read and re-read the classics: Regardless of how the market is behaving at a given time, remember that it’s happened before. The circumstances may be different, but investor behavior is the same. When in doubt about the current state of the markets, consult The Intelligent Investor, the annual Berkshire Hathaway letters, and just about any book on this list really. During the financial crisis, for example, Jack Bogle’s reflections on Wellington Fund’s 75th birthday helped me maintain my long-term approach during a very difficult time in the market.
  8. Find a “support” group: Most of the financial content on the internet is designed for short-term traders, but there are plenty of patient, long-term investors out there on various blogs (see a list of good blogs on the right), message boards, and websites that would be happy to help you work through an investment decision if you’re having trouble or have a question. Including this one!
  9. Start an investment journal: One of the best tips I received was to start an investment journal in which I wrote down my investment thesis, risks, and any emotions or concerns I felt when placing the order. This will serve to reduce “thesis drift” and help you make more rational decisions when you’re not sure what to do about a certain investment.



Saturday, November 23, 2013

Investing is an Expectations Game

A thing long expected takes the form of the unexpected when at last it comes. - Mark Twain
In such a low-interest rate environment, why would the market allow companies to trade with 8%+ free cash flow yields -- even after considering a reasonable equity risk premium?

The answer lies in market expectations. For firms with very low free cash flow yields, the market is expecting robust free cash flow growth in the coming years; conversely, for firms with high free cash flow yields, the market might be expecting some free cash flow contraction.

In this graphic, you could justifiably substitute "expectations" for "price".

Naturally, higher market expectations also carry greater risk for market disappointment, and vice versa. As we're evaluating companies for potential investment, this is an important relationship to bear in mind.

To illustrate, I considered the free cash flow yields of some of the largest S&P 500 stocks:

As the list illustrates, the market has relatively lower expectations for Apple than it does Home Depot and lower expectations for Wal-Mart than it does Tesla. This doesn't necessarily mean that Apple is a better investment than Tesla at the moment, but it does mean that, in terms of market expectations, Tesla has much less room to make a mistake than Apple does.

While some stocks with high market expectations -- the Teslas, Amazons, etc. -- could end up being great investments by doing even better than the market currently expects, I think that investors will do have better results, on average, by investing in companies with low market expectations.

Yes, those companies could also do worse than the market expects and fall further in price, but if we conclude that a company's competitive advantages remain intact, the financials are sound, and that they're led by capable management, then there are fairly decent odds that the market's low expectations are wrong.

Whether we're looking for long or short candidates, as investors we want to find where the market's expectations are meaningfully different from our own. Before you begin researching a new company or re-evaluating a current holding, then, it's helpful to determine the company's free cash flow yield to see where it sits on the market expectations spectrum and how your own expectations might differ.

Please note: I recently updated the blog's URL to from Existing bookmarks should work fine, but please let me know if you have any trouble accessing the site. 

Good reads this week:
Quote of the week: 
This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them. - Howard Marks, "Everyone Knows"
Happy Thanksgiving!


(long CSCO)

Saturday, November 16, 2013

Buy Stocks for Their Substance, Not Their Stories

“No, no! The adventures first, explanations take such a dreadful time.”  - Lewis Carrol, Alice in Wonderland
At an investor conference a few weeks back, I had the pleasure of hearing a dozen or so companies tell their stories to rooms filled with potential investors. No matter how long you've been investing, there are always companies you haven't learned about yet and others with new stories to tell. That's one of the great things about this business -- it provides lifetime learning opportunities.

As I was sitting in the various rooms listening to the presentations, I couldn't help but think how powerful stories are in the investing world. After all, no one is eager to brag to their friends about the investment they just made in a company that treats sewage. It's far more fun to tell friends about a company whose new gadget will replace the need for burning fossil fuels, or some such thing.

Indeed, storytelling has always been a fundamental part of the human experience. Yet as investors, it's important that we learn to separate story from substance before we invest our hard-earned money in a company.

The first investment pitch? Note the bulls...
What I mean by this is that before we invest in a company we've read about in a magazine, newspaper, newsletter, etc., we need good answers to the following questions:

  1. Why am I excited about this particular company? With any investment idea, there's always something that gets us interested. Perhaps it's the fact that the company is tapping into a major trend like 3D printing or that it's got a product that's sure to make the world a better place. Perhaps it's led by a CEO with a silver tongue. The key is to identify what exactly it is that got you interested, separate it from the larger narrative, and begin to draw your own conclusions about it. For example, you might say to yourself, "This company's product has huge potential, but five of their peers have come up with a similar product," or, "Looking at the CEO's track record, I've found that he gave a similarly optimistic pitch five years ago and the stock has underperformed the market."
  2. Who doesn't already know this story? There are really good odds that you're not the first investor to hear about the company's story and, even if the story has substance, you most certainly don't want to be one of the last investors to hear about it. Have a look around the internet to see if there are other investors discussing the same story. If that's the case, you're too late. 
  3. What happens when the story changes? Blame it on the fact that I'm a history major, but when I'm researching a promising company, I always go back at least ten years and read the chairman and CEO letters in the annual reports to better understand why the company is where it is today. By doing this exercise, one thing you'll quickly pick up is that the narrative changes over time. Companies acquire and divest businesses, growth markets become mature markets, and so on. Try to determine management's record of delivering on expectations -- do they frequently over-promise to boost short-term investor interest only to under-deliver and disappoint in the long-term? If so, that's not a company worthy of your investment.
  4. Do the numbers check out? Companies with durable competitive advantages should have numbers that reflect their position. How do the companies' margins, returns on capital, and free cash flow figures stack up against their peers? Also, keep a look out for potential pot-holes like a highly-leveraged balance sheet or off-balance sheet liabilities -- things that normally aren't a part of a company's sales pitch. 
  5. What's management doing with its own money? Its amazing how few executives, who are more than willing to buy the company's stock with shareholder money, are unwilling to do the same with their own. If management really believes in its story and current valuation, they'll put some of their own money to work, too.
Here's the key thing to remember after you hear an exciting company story -- don't invest right after hearing the pitch. Wait at least 24 hours and let the emotion dissipate before proceeding with your research. By doing so, you'll save yourself a lot of trouble and make better decisions. 

Good reads this week
Music of the week

Pearl Jam's "Getaway"

Thanks for reading!



Sunday, November 10, 2013

When Companies Aren't Committed to Dividends

Prior to 1982, when large-scale share repurchases became viable after Congress enacted rule 10b-18, nearly all shareholder distributions were returned via cash dividends. 

As such, companies with longer operating histories tend to have a tradition of paying dividends and their shareholders have naturally come to expect them to continue.

If given the chance, however, I suspect some of them would elect for a diminished dividend program in favor of buybacks, which offer substantially more financial flexibility and tend to benefit management and short-term investors.

Consider the following chart, which shows the rolling three-year percentage of U.S. shareholder distributions made via cash dividends versus buybacks.

Source: Birinyi Associates and FRB Z.1. (1985-87), S&P (2011-6/2013), author estimates 
What's particularly notable is that this trend developed despite equal tax rates on dividends and long-term capital gains since 2003, an increasing number of retiring baby boomers seeking income over growth, and strong demand for higher-yielding stocks in a low rate environment. 

All of these factors should have encouraged a larger share of shareholder distributions going to cash dividends, but that's not happening. Some companies are clearly not comfortable with making a larger commitment to their dividend program. 

We can discuss the reasons this might be the case in the comments section below, but you might be rightly wondering at this point, "Why does this even matter?"

As you're building a dividend portfolio, you want to stock it with companies that want to pay dividends. You don't want to own companies that feel burdened by their current payout, as these are the companies most likely to cut their payouts if given the opportunity.

Here are five red flags that a company may not be comfortable with its dividend policy:

  1. Token dividend increases: If a company's raising its dividend by a small amount each year (less than 4% growth), it might mean that it is cautious about its prospects, or it could mean that the company is simply raising its payout by a token amount to maintain a tradition of raising payouts. In either case, this is not an encouraging track.
  2. High leverage and high payout ratio: Firms with high financial leverage that are also paying out the majority of free cash flow as dividends might be concerned about their ability to maintain the current payout. In the event of an economic downturn or a shock to their competitive environment, the dividend could come under fire. Keep an eye out for "token" dividend increases from such companies. 
  3. Excessive stock options in management compensation: The expected value of stock options decreases with the payment of dividends, so if the company's executive compensation program is heavily-weighted toward stock options, management may have a disincentive to paying higher levels of dividends. 
  4. Short-term focused ownership: If a friend or colleague offered you an opportunity to buy a small equity stake in a local business, one of the questions you'd surely ask is, "Who are the other owners?" You'd want to know how the other equity holders think about the business, are their interests aligned with yours, etc., yet it's amazing how infrequently this question is asked before investors purchase stocks. Take a look at the list of the company's largest shareholders (outlined in annual filings), check out the fund managers' websites, and try to determine if they're long-term and/or dividend-focused. If you see a bunch of hedge fund owners, you might want to walk away from the stock.
  5. An increasing preference for buybacks: Though buybacks properly employed can support dividend growth, you want to see a balance between dividends and buybacks over time. If the company is shifting from a balanced approach toward more preference for buybacks, it's a warning sign that the company is losing enthusiasm for its dividend program. 
As long-term, patient, dividend-focused investors, we want to own companies whose interests are aligned with our own. Recognizing the early signs of companies that are less committed to their dividend programs can help us better build our portfolios around the right companies.

Good reads this week:
Art of the Week:

My friend Anna's still life "Occhioverde"

Thanks for reading!



Sunday, November 3, 2013

Use the Market's Short-Termism to Your Advantage

Here's a general criticism that I often hear about investing in companies with economic moats:
Companies with economic moats always look expensive and they trade with premium multiples to the market. How can we invest with a suitable margin-of-safety and generate superior returns if we're consistently buying expensive stocks? 
It's a fair criticism. Indeed, companies that can consistently out-earn their costs of capital should trade with premium multiples and frequently do. In bull markets such as this one, quality doesn't come cheap and good moat-buying opportunities seem far and few between.

But here's the key thing to remember -- economic moats affect value in the long-term while the market's focus is on short-term results.

Why does this matter? Because if we're patient investors -- and if you're reading this blog, you're probably in this camp -- we only need to wait for the market to overreact to some short-term news (a bad quarter, etc.) that doesn't impact the company's competitive position and then look to capitalize on the opportunity. In other words, use the market's short-termism to our long-term advantage.

Opportunities to buy quality companies at good prices do present themselves over the course of the business cycle -- and purchasing premium companies at market average prices is a strategy I'll gladly endorse.



Saturday, November 2, 2013

Make the Most of Your Investing Mistakes

Like most people, I don't like being wrong. Trouble is, I'm wrong quite often.

To err is human, after all, and I've come to accept the fact that I'll make incorrect choices in the course of everyday life, such as the time I was about the head outside wearing both a corduroy jacket and corduroy trousers before my wife mercifully stopped me and corrected my obvious fashion misjudgment.  

When it comes to investing matters, however, I have yet to similarly come to terms with making incorrect choices. I tend to dwell on the mistakes I've made in my portfolio far more than I enjoy the successful moves I've made. A dent to my pride can be repaired, but a permanent loss of capital cannot.

The key to managing investment mistakes, as I've come to learn the hard way, is to admit them quickly, correct the mistake, and use the expensive lesson to improve your investment process.

  • Admit them quickly: This is the hardest part. Your research and thesis turned out to be wrong, but it's easier to be stubborn and rationalize the mistake. In my own experience, I've found that writing down my thesis before purchasing a stock has helped me own up to my mistake and not succumb to "thesis drift." 
  • Correct the mistake: Investors who've made a mistake often compound the mistake by either waiting for the market to correct it for them -- the classic, "I'll just hold on until the price gets back to my purchase price" -- or doubling-down on a broken thesis hoping the lower cost basis will fix things with time. In this situation, it's best to close your position and reallocate your capital to a better idea. (I should note here that if your thesis remains intact but the stock price has simply fallen a bit due to short-term concerns, that's not necessarily a mistake on your part and it may in fact be wise to hold or double down).
  • Improve your investment process: Do a post-mortem on your mistake. Determine where you went wrong with your research and/or thesis and apply the lessons to your process going forward. In fact, I recommend including a pre-mortem in your investment process and think about what could go wrong before you buy the stock. For instance, ask yourself, "If the stock falls by 50%, what happened?"
Investing is, by nature, a humbling endeavor and we can't always be right. In this business you're a legend if you're consistently right 6 out of 10 times, which still leaves 4 mistakes out of 10 to address. Acting as if the mistakes never happened doesn't do anyone any good. Instead, by learning to make the most of our investing mistakes -- while ultimately seeking to minimize their frequency -- I believe we can greatly improve our long-term results. 

Good reads this week

Going for Long-Term Growth - Interactive Investor
The First Law of Thermodynamics and Investing Risk - Monevator
The Intersection of High Quality and Cheap Valuation - Fidelity

Quote of the week

"Life is not always a matter of holding good cards, but sometimes playing a poor hand well." – Jack London

Thanks for reading!