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!