Saturday, December 13, 2014

When to Throw in the Towel on a Stock

In Morgan Housel's excellent article, "If Other Industries Were Like Wall Street", he shares this satirical story: 
If we were as impatient about gardening as we are investing: Sam plants some seeds in his backyard. He checks back four hours later. Nothing. He digs them up and replants them. Four hours. Still nothing. A week later he is dismayed that he has no oak trees in his backyard. He calls oak trees a scam.
As Homer Simpson says, "It's funny 'cause it's true." 
Shoulda thrown in the towel. George Bellows' "Dempsey & Firpo"

It's equally irrational, however, to plant some seeds in the backyard, check back a decade later, see nothing sprouting from the ground, yet conclude an oak tree will eventually emerge. Something went wrong. 

At some point between the two extremes - four hours and a decade - it makes sense to throw in the towel on a stock that isn't performing and reinvest the capital elsewhere.

But how do we determine the right time? 

Here's Philip Fisher's opinion on the matter, from Developing an Investment Philosophy:
It was vital that I have some sort of quantitative check to be sure that I was right...With this in mind, I established what I called my three-year rule...
Whether I have been successful in the first year or unsuccessful can be as much a matter of luck as anything else...If I have a deep conviction about a stock that has not performed by the end of three years, I will sell it. If this same stock has performed worse rather than better than the market for a year or two, I won't like it. However, assuming that nothing has happened to change my original view of the company, I will continue to hold it for three years.  
Indeed, one of the "ground rules" of Warren Buffett's partnership was:
While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance...If any three-year or longer period produces poor results, we all should start looking for other places to have our money. 
Three years seems like the right amount of time to give the market a chance to come around to your thesis. If that hasn't happened by the three year mark, your thesis was probably wrong. 

There's something to be said for taking the "coffee can" approach -- investing in a stock and then checking back on it many decades later. Fidelity reportedly ran a study, for instance, that found the group of its clients who had the best performance were those who forgot they had accounts at Fidelity.

If given the choice of doing nothing or trading my portfolio every month, I'd choose the do nothing approach. In practice, the ideal strategy is found somewhere in the middle. 

The key is that your decision-making rules are long term in nature and are approached with a patient, business-owner's mindset. A three-year rule for throwing in the towel on a poor investment is one such rule that we'd do well to implement in our process. 

This is the last Clear Eyes Investing post of 2014. Thank you very much for reading this year. Hoping you have a wonderful holiday season!

Related posts
What I've been reading/watching this week
Stay patient, stay focused.



Saturday, December 6, 2014

Paying Up For Quality Stocks

Price is what you pay, value is what you get. - Warren Buffett
A few years back, my wife and I were shopping around for a leather couch to put in our new home. As we walked around the showroom of a furniture store and had a look at some of the price tags for the couches, however, I realized our bank account would end up being a little lighter than I expected. Real leather couches don't come cheap.

Never eager to spend large amounts of money, my attention quickly turned to the faux leather options. Much to my delight, these were much cheaper. For a fraction of the price of a real leather couch, we could get the same size and design.

And besides, I reasoned, visitors wouldn't be able to tell the difference anyway. Why spend the extra money?

It seemed like a sweet deal at the time, but things have changed.

Today, my "deep value" couch is falling apart -- literally -- and I find myself back in the market for a new couch. Had I originally paid up for a high-quality leather couch, I probably wouldn't be in my current predicament. The poor man pays twice, indeed.

My mistake was this -- I only considered the price of the faux leather couch relative to the real leather couch without considering the prices relative to their respective quality.

As investors looking to buy stocks on the cheap, we often fall into the same trap -- we erroneously think a company with a lower multiple presents a better deal than one with a high multiple. While that may hold true when we're comparing two identical assets, the rule breaks down when we're comparing assets of different quality.

While the market isn't perfectly efficient, it is generally efficient, so more times than not tomorrow's great companies won't be found using a low price/earnings screen. If you want a chance to own a few of tomorrow's great companies, then, you'll need to eliminate your aversion to paying premium multiples.

As you might deduce from my story about couch shopping, this is something I've struggled with in my own portfolio. On a number of occasions, I've had a case of sticker shock and balked at investing in promising companies only to watch those stocks push higher as their competitive advantages, pricing power, and earnings growth more than justified their premium prices.

The risk with buying premium-multiple stocks is that today's premium-multiple will be tomorrow's average-multiple and your returns will be decimated by a re-rating. Reversion to the mean is a powerful force, of course.

As with any investment, it's critical to get a feel for the market's current expectations for the company and weigh them against your own. Equally important is the ability to tell the difference between a great company from an average company. If you're confident in your evaluation of both factors, you shouldn't shrink from paying up for quality stocks.

Related posts: 
What I've been reading/watching this week:
Stay patient, stay focused.



Saturday, November 29, 2014

The Difference Between a Good Company and a Great Company

Consider the largest stock holding in your portfolio. If I were to ask you to list ten reasons why you own the stock, what would you say?

You might talk about the company's strong competitive position, its attractive profit margins, its solid balance sheet, and provide additional commentary about its growth opportunities. And well you should, as these are important points to consider before making an investment.

Now, what if I asked you to list three to five reasons you're investing behind the company's management team? 

Perhaps that's not so simple to answer. I know I would struggle answering that question for some of my current portfolio holdings. 

The longer I invest, however, the more I've come to believe that what separates a good company from a great company is the people behind the business. A good horse with a mediocre jockey will win its fair share of races on talent alone, but a good horse with an elite jockey is even tougher to beat. 

Warren Buffett, for example, has stressed the importance of having a "knight" in the castle who is trying to widen the company's economic moat, the majority of Philip Fisher's "15 points" to look for in a stock are management- and employee-focused, and Ben Graham said in The Intelligent Investor that "It is fair to assume that an outstandingly successful company has unusually good management."

William Thorndike's modern classic, The Outsiders, also opened my eyes to the potential for material outperformance when you've invested in a good business run by top-notch capital allocators.

Admittedly, analyzing a company's management and corporate culture can be tricky and is far more qualitative than quantitative in nature, but therein lies an opportunity to separate yourself from other market participants.

As such, our research time would be well-spent learning more about the company's leaders and what it's like to be an employee of the company.

To illustrate, here are two companies in my portfolio and some reasons why I like the people behind each business.
WD-40 (WDFC)
  1. The company generates about $1 million in revenue per employee. This is a sign of a highly-motivated, very efficient business.
  2. WD-40 has a vibrant corporate culture. Employees are part of the "tribe," which may sound a little silly at first, but as Philip Fisher wrote in Developing an Investment Philosophy, "More successful firms usually have some unique personality traits...This is a positive not a negative sign." Companies with almost cult-like corporate cultures tend to have an uncommon ability to overcome challenges -- an intangible asset that should be considered when evaluating a company. 
  3. The company has a near-perfect score on Glassdoor, with every employee review approving of the CEO and willing to recommend the company to a friend. 
  4. Management has smartly focused on leveraging its WD-40 brand into other uses (bikes, specialist, etc.) and into new regions rather than trying to build up lesser-known brands in which it lacks a competitive advantage.
Sun Hydraulics (SNHY)
  1. Sun has a decentralized business structure, which puts decision-making power in the hands of all employees. If a customer needs something done right away, for instance, it doesn't need to go up five channels of bureaucracy to be approved.
  2. There are no formal job descriptions and employees are encouraged to learn other areas of the business. This greatly reduces "key employee risk" and if one person is out of the office for a week, the problem can still be solved.
  3. The board is only paid in stock in order to better align their interests with those of the shareholders. Very few boards do this, unfortunately, instead preferring considerable annual cash payments with some common stock as a kicker.
  4. The company has a low dividend payout ratio, but usually pays out a special dividend in particularly good years. This is an appropriate strategy given the cyclical nature of its products and is indicative of a leadership team interested in sharing rewards with shareholders.
How do you evaluate the people behind the businesses you own? Let me know in the comments section below or on Twitter @toddwenning.

Related posts:
What I've been reading/watching this week: 
Stay patient, stay focused.



Saturday, November 15, 2014

When Should You Sell a Good Stock?

With the market riding high again, you might be thinking about selling a few holdings and reinvesting the cash when stocks have fallen again.

Buy low, sell high. That's the idea, right?

But before you hit the sell button, consider Philip Fisher's answer to the question, "Should an investor sell a good stock in the face of a potentially bad market?" 
Even if the stock of a particular company seems at or near a temporary peak and that a sizable decline may strike in the near future, I will not sell the firm's shares provided I believe that its longer term future is sufficiently attractive... 
My belief stems from some rather fundamental considerations about the nature of the investment process. Companies with truly unusual prospects for appreciation are quite hard to find for there are not too many of them. However, for someone who understands and applies sound fundamentals, I believe that a truly outstanding company can be differentiated from a run-of-the-mill company with perhaps 90 percent precision.
It is vastly more difficult to forecast what a particular stock is going to do in the next six months...For these reasons, I believe that it is hard to be correct in forecasting the short-term movement of stocks more than 60 percent of the time no matter how diligently the skill is cultivated. This may well be too optimistic an estimate. 
So, putting it in the simplest mathematical terms, both the odds and the risk/reward considerations favor holding. 
It's a point worth re-emphasizing. You have much higher odds of identifying a truly outstanding company than guessing how that company's stock will perform in the next six months. Play the odds accordingly.

Lesson learned...hopefully

I haven't always followed this advice. In April 2006, I bought shares of Core Laboratories (CLB), a high-quality and advantaged oil & gas services company, for a split-adjusted price near $26. Two years later, with oil prices near record highs, I sold the stock near $58 and patted myself on the back for a job well done.

Don't pull out your flowers and water your weeds.
(Photo taken at Kew Gardens by my wife. Nice, huh?)
I felt particularly good about my decision during the financial crisis when oil prices plunged and Core Labs fell back around $30.

Had I capitalized on my sheer luck and bought back into Core Labs after it dipped, this story might have had a happier ending, but alas I did not.

In fact, my portfolio's subsequent returns would have been markedly better had I done nothing at all. Fast forward to today and Core Labs is trading at $139 and was up to almost $200 earlier this year.

Now, it's possible that I'm looking back at this case with a serious case of hindsight bias, but my selling decision in 2008 wasn't due to a lower opinion of Core Labs' business or its management. Instead, I wanted to lock in my 123% gain after a strong run in oil prices. Not a terrible decision, of course, but not a good one either.

To see how it's supposed to work, fund manager Chuck Akre* said in an interview earlier this year that his firm has owned shares of Markel (MKL) for over 20 years and that they didn't sell during down times. During that 20+ year timeframe, according to Akre, Markel's book value per share increased 14% annualized and its stock price has grown at least at the same rate.

If you're playing at home, those kind of annualized returns will turn a $10,000 investment into just under $140,000 over 20 years.

Bottom line

While there are some good reasons to sell a stock, trading in and out of great companies in an effort to time the stock price is not one of them. Pressing the pause button on compounding can be hazardous to your wealth.

What do you think? Let me know on Twitter @toddwenning.

Related posts:
What I've been reading/watching this week:

Stay patient, stay focused.


*I own shares of Akre Focus Fund

Saturday, November 8, 2014

The Art and Science of Investing

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. - Peter Lynch, Beating the Street
The Astronomer, Vermeer
One of the traits shared by the investors I admire is an insatiable thirst for a wide range of knowledge. (Look no further than Charlie Munger on this point.) For every investing book they read, they might read two or three non-investing books if not more.

While it's absolutely critical to understand the science of investing -- accounting, valuation, analysis, etc. -- ultimately, the numbers reflected in a company's financial statement and the ones that go into our spreadsheets are by-products of human behavior. Without context, the numbers don't amount to much.

The art of investing is understanding why people do the things they do, especially the things we ourselves do. The better control we have over our own emotions and actions when other investors lack control, the better our returns should be in the long run. Further, it's important to read on a variety of topics as the market is a complex system and the more strings we can tie together, the greater our potential for identifying value-creating opportunities.

I'm curious to know what non-investing books you've read that have made a big impact on your investing strategy. You can let me know on Twitter @toddwenning or in the comments section below.

One of my recommendations is Tao Te Ching by Laozi (Lao Tzu), which has had a tremendous impact on my philosophy on patience, even if I don't always practice it as well as I should.

What I've been reading and listening to this week:
Stay patient, stay focused.



Saturday, November 1, 2014

What's Your Investing Edge?

Patience is bitter, but its fruit is sweet. - Rousseau
I recently attended the CFA Society of Chicago's annual dinner where a fellow attendee and I discussed how one of the more humbling things about going through the CFA Program, besides the difficulty of the curriculum and exams, is that you get a very real sense of the level of competition you face as an investor.

Depending on the location of your CFA test center, you could be taking the exam with over 1,000 other capable, well-educated, and motivated investment professionals, some of whom have flown in from overseas at their own expense because their country doesn't have a test center. Yep, that motivated.

You then realize the people you see are only a fraction of the global investment professionals with whom you're competing in the market every day.

We know that in order to produce different results from other investors you must have a different approach, but how to differentiate yourself amid such formidable competition isn't obvious.

This passage from the 1996 Berkshire Hathaway letter provides two solid options (my emphasis added):
Most investors, both institutional and individual, will find that the best way  to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.
    Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering.  Intelligent investing is not complex, though that is far from saying that it is easy.  What an investor needs is the ability to correctly evaluate selected businesses. Note that word "selected":  You don't have to be an expert on every company, or even many.  You only have to be able to evaluate companies within your circle of competence.  The size of that circle is not very important; knowing its boundaries, however, is vital.
To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets.  You may, in fact, be better off knowing nothing of these.  That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects.  In our view, though, investment students need only two well-taught courses - How to Value a Business, and How to Think About Market Prices. 
    Your goal as an investor should simply be to purchase, at a rational  price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock.  You must also resist the temptation to stray from your guidelines:  If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value.  
In other words, you can concede that you don't have an advantage over the market and build a diversified portfolio using low-cost index funds (which is a fine option), or you can aim to outperform by investing in businesses you understand, paying a good price for them, and holding them for the long-term. (Also see: A Simple Formula For Investing Success)

You could also do a little of both, of course, which is often called the "core and explore" or "core and satellite" approach.

The common thread, whichever strategy you choose, is patience and emotional self-control. As we've said here before, individual investors can't sustainably out-trade the institutions and that patience is the individual investor's greatest advantage over the market. We need to stick to our strengths.

Our efforts as individual investors would be put to better use if we focused on learning to analyze businesses and control our emotions -- buying when others are selling, doing nothing when others are trying to force returns, etc. -- rather than trying to outfox other investors in the short-term.

Though this is hard to do, I think it's the best way we can differentiate ourselves in the incredibly competitive marketplace of investors. To borrow a phrase from A League of Their Own, "It's supposed to be hard. If it wasn't hard, everyone would do it. The what makes it great."

What I've been reading & watching this week
Stay patient, stay focused.


@toddwenning on Twitter

Saturday, October 25, 2014

How I Got Started in Investing

Working hard is important. But there is something that matters even more, believing in yourself. Think of it this way; every great wizard in history has started out as nothing more than what we are now, students. If they can do it, why not us? -- Harry Potter
The title of the first page I opened to was, "What is a stock?"

I had no idea.

It was the summer of 2003, I'd just graduated from college and was reading through a Series 6 license study guide that Vanguard sent me a few weeks before my start date. All the financial lingo I came across as I flipped through the study guide was intimidating to say the least. 

"I might have made a mistake," I thought. I might be out of my league with this job.

I was a history major in college, and even though I minored in economics, I had no clue about finance and investments. To illustrate, a neighbor who heard I was hired by Vanguard said to me, "Oh, we own some of their mutual funds. It's a really good company."

I nodded along with her, but I confess that I still wasn't entirely sure what a mutual fund was. I needed to learn a lot. In a hurry.

The telephone game

Before taking the job at Vanguard, I was deciding between a career in law or in teaching -- the typical paths for history majors.

Investing, however, was something I knew I needed to learn about and I figured I'd try working in the industry for a year or two before going to law school. At the very least, I'd leave the industry knowing what to do with my money, so I applied to a few financial firms near Philadelphia.

Vanguard was hiring entry-level registered representatives and they liked that I had experience managing a call center during college. My break was that I knew how to talk on a phone. The finance stuff, they must have figured, they could teach me. 

(With hindsight, I realize how lucky I was to start my investing career at a firm that preached things like focusing on the long term, insisting on low costs, and staying the course. If I'd started my career at a commission-based firm or one with front-loaded funds, things might be different.)

Into the fire

It was a steep learning curve. After a few weeks of training, I was on the phone speaking with 40 or more clients a day about mutual funds, placing trades, and walking through IRA transfer forms. While it wasn't exactly the job I'd envisioned as an idealistic recent graduate, speaking with such a broad group of individual investors was great training.

After a year on the mutual fund side, I moved over to brokerage and was introduced to equity investors. My first day on that job, someone called and asked for the current quote for Microsoft. I asked him, "What's the ticker?" Click. Guy hung up. That's how green I was with stocks. 

Working in brokerage was my first real meeting with Mr. Market and the emotions that drive short-term stock swings. The busiest day I had in brokerage, for example, was not on some good economic news or during tax season -- it was when Howard Stern announced he was joining Sirius Satellite Radio. No one cared about price, they just wanted to buy. 

Lessons learned

My first two years in the industry were a tremendous learning experience and those early lessons have stuck with me in the nine years since. Here are some of them:
  1. Few people have a strong understanding about investing and many people are intimidated by it.
  2. Learning how to invest is not easy and requires a lot of time, interest, and dedication.
  3. Most people are aware of the first two points and want someone they can trust to help them achieve their goals so they can focus on other things. 
  4. Investing and money management is an emotional business. The account balance isn't just a number -- it represents someone's life savings and is a by-product of their labor. The financial professional's job should be to help the person manage those emotions and make prudent investment decisions.
  5. There's always something you don't know about investing. It's a never-ending education.
Getting started in investing can be overwhelming, but it's important to remember that everyone has to start somewhere and no one is born a natural investor. The critical thing is to stay confident and never stop learning

What I've been reading & watching
Stay patient, stay focused.



Friday, September 5, 2014

An Important Dividend Cut Case Study

Back in March, I explained why I sold my position in Tesco for a 22% loss.

Looks like it was the right move. As of this writing, the stock is down another 25% from my selling price. Worse, the company recently reduced its interim dividend by 75%.

Double whammy

By no means was I the first to highlight trouble at Tesco and plenty of observers have offered reasons for the company's decline. My focus here will be on the dividend.

Frankly, I'm still a bit stunned at how Tesco's turned out and think its dividend cut serves an important case study for dividend investors to review.

Consider that in fiscal year 2011 (year-end February 2011) Tesco increased its dividend by 10.8% -- marking an impressive 27 consecutive years of dividend increases. Well-respected long-term investors like Neil Woodford and Warren Buffett held considerable positions in Tesco and its UK market share was over 30%. All seemed to be right.

The board and management also appear to have been very confident in the future of the business, otherwise they wouldn't have increased the dividend at such a high rate in fiscal 2011.

With the exception of a financial crisis-scenario, rarely does a company have such a sharp reversal in dividend policy. Yet that's exactly what happened at Tesco. 

In fiscal year 2012, the dividend grew just 2.1%. The next year, it was held flat and stayed at that rate until it was finally cut in August 2014.

Source: Company filings
The company's dividend health, as measured by the Dividend Compass, was also deteriorating.

While some warning signs were present, the combination of Tesco's distinguished dividend track record, its real estate holdings, and its leading share of the UK grocery market remained for some compelling reasons to hold and hope for a dividend turnaround.

Yet the numbers didn't lie. Tesco's dividend health slowly worsened, the dividend yield steadily increased to more than twice the UK market average (usually a good sign that something's wrong), and it was only a matter of time before the board needed to make some tough decisions. 

Lessons learned

The first takeaway from Tesco's dividend cut is a reminder that no dividend is risk-less or sacrosanct. In the UK market, Tesco was a core holding in many dividend portfolios (including mine for a while) and up until a few years ago its payout was about as much of a sure thing as one could expect. Yet in a matter of three years Tesco went from dividend aristocrat to dividend plebian. If worse comes to worse, the board can always cut the company's dividend.

Second, it's critical to not "buy and forget" your investments. I know some well-intentioned dividend strategies advocate this approach and while I certainly appreciate the value of patience and keeping trading costs to a minimum, what happened with Tesco serves as an example of why some level of maintenance research is needed if you hope to avoid dividend cuts.

The combination of a permanent capital loss and a dividend cut can have a material impact on your longer-term income returns and you'll have less capital to reinvest in another dividend-paying stock. If you can catch a dividend cut early, you have much higher odds of preserving more of your capital.

Third, no matter how strong the company's dividend track record, if the numbers don't add up, it pays to be skeptical. Admittedly, I held onto Tesco a little too long thinking that it would simply take some time for the company to right the ship. When in doubt, preserve capital.

Fourth, while most dividend-focused portfolios are diversified, the Tesco share price decline and dividend cut is a reminder that it's important not to rely on any one stock (or one sector) to generate a large percentage of your dividend income.  

Finally, even if you're a patient investor, it's important to establish some selling rules. For example, one rule might be that if a company's dividend growth trajectory radically changes for the worse or is altogether halted, it's time to sell. In such a situation, it's highly likely that company leaders have changed their opinion about the company's ability to generate higher levels of cash flow.

What do you think? Let me know on Twitter @toddwenning

What I've been reading this week
Stay patient, stay focused.



Monday, September 1, 2014

Playing the Loser's Game

In a 1975 article in the Financial Analysts Journal entitled “The Loser’s Game”, Charles D. Ellis wrote:
Gifted, determined, ambitious professionals have come into investment management in such large numbers during the past 30 years that it may no longer be feasible for any of them to profit from the errors of all the others sufficiently often and by sufficient magnitude to beat the market averages.
Ellis concluded that the influx of smart and motivated people into the industry led to money management becoming a “loser’s game” -- a game in which you'd be crazy to compete and one that you should perhaps consider surrendering to (i.e. buy an index fund). Ellis recently reiterated this opinion in a recent article for the Financial Analysts Journal

Time to throw in the towel?

It's natural to read these comments and get discouraged about buying individual stocks, but Ellis's 1975 article offers a few excellent tips on how to not play the loser's game. 

1. Be sure you are playing your own game.

The individual investor’s advantage is not in trading. The hedge funds, mutual funds, and professional traders of the world simply have better data, more advanced trading platforms, and more financial incentive to focus on the short-term. The weekend investor doesn’t stand a chance versus this type of firepower, so trading is a game where the odds are stacked against the individual investor.

Staying patient, keeping a long-term mindset, and exploiting your advantages as an individual investor alters the playing field and improves your odds of success.

2. Keep it simple.

The less complicated your investment strategy, the better. As Ellis recommends, "Try to do a few things well." By focusing your efforts on one strategy -- whether it is based on dividends, small caps, deep value, etc -- and consistently sticking with it, you can more effectively tune out distractions and make better decisions. As a result, you'll keep trading costs down and give yourself the best opportunity to realize your return objectives. 

3. Concentrate on your defenses.

Ellis advocates improving your selling strategy because the market’s focus on buying makes it difficult to gain an edge on that side of the equation. It’s a fair point. 

To figure out how we might improve our selling strategy, let's consider the market's selling strategy.

While each investment firm has its own selling strategy, we know that the average mutual fund turnover ratio in recent years implies that, on average, stocks owned by funds have been held for just over one year.

Our key strength as individual investors lies in our ability to be patient, so our selling strategy should start with the idea of holding for at least three years and ideally five years or longer. Obviously if one of your stocks shoots well above your fair value estimate, it might be time to sell or trim the position, but on average we should look to hold for longer periods of time.

4. Don’t take it personally.

According to Ellis, the market turned into a loser's game precisely because investors’ "efforts to beat the market are no longer the most important part of the solution; they are the most important part of the problem." Resist the temptation to try harder for better returns. In fact, do just the opposite. This doesn’t mean you should pick stocks at random and buy and hold forever. Do your homework, of course, but be deliberate and patient, too. Let the market go through its phases of euphoria and despair and stay your course. Don't try to force returns.

Bottom line

Trying to beat the market in the short-run is a loser’s game if you make it your primary investment objective, so don’t play it. Instead, redefine the game. Establish your own objectives, stick to your strengths, and stay patient and when you look back at your returns five years from now, I think you'll like what you see. If you happen to beat the market, all the better.

For more on the "loser's game", a new multi-part video series by Sensible Investing addresses the topic and has a lined up a number of good interviewees. Here's the trailer.

What do you think? Let me know on Twitter @toddwenning

I've updated my Dividend Compass spreadsheet to fix a few bugs. You can download the updated version here

What I've been reading this week:

Stay patient, stay focused. 



A version of this post was published on April 14, 2012. It has been updated.

Saturday, August 23, 2014

Book Review of The Outsiders

I finally got around to reading William Thorndike's The Outsiders -- a sure classic that I've added to the "must read" section of my recommended books on investing.

Looking through my Kindle copy of the book, I have 70 highlights and bookmarks, so going through all of them here would be a bit onerous to both read and write.

Instead, I want to focus on the core principles of eight CEOs that Thorndike lays out in the introduction.

With a nod to Buffett's Graham and Doddsville, which analyzes a group of investors who consistently beat the market by following the principles of Benjamin Graham and David Dodd, Thorndike calls his group of CEOs "Singletonville" after former former Teledyne CEO Henry Singleton.

While each CEO was dealt different sets of cards, they all played their hands incredibly well by understanding the following principles and putting them into action:
  • Capital allocation is a CEO's most important job.
  • What counts in the long run is the increase in per share value, not overall growth or size.
  • Cash flow, not reported earnings, is what determines long-term value.
  • Decentralized organizations release entrepreneurial energy and keep both costs and "rancor" down.
  • Independent thinking is essential to long-term success, and interactions with outside advisers (Wall Street, the press, etc.) can be distracting and time-consuming.
  • Sometimes the best investment opportunity is your own stock.
  • With acquisitions, patience is a is occasional boldness.
Right away, you'll notice that most CEOs don't embody these principles. In fact, if you invert each principle, you're closer to how most CEOs approach their jobs (with perhaps the exception of the sixth principle).

Even though Buffett's been writing about the importance of management's capital allocation decisions for decades, it's a topic that's been undercovered for much too long.

The reason it has flown under the radar, I believe, is that analyzing management is largely qualitative in nature and doesn't lend itself well to screening tools and Excel spreadsheets.

Measuring management

Indeed, it's generally only after the fact that a CEO's impact can be measured and appreciated. Thorndike writes, for instance, that "You really only need to know three things to evaluate a CEO's greatness: the compound annual return to shareholders during his or her tenure and the return over the same period for peer companies and for the broader market (usually measured by the S&P 500)."

The key for investors, of course, is to identify these CEOs before they dramatically outperform the market and their peers.

And here is where understanding the capital allocation processes practiced by the CEOs in Thorndike's book come in handy. If you come across a CEO or management team with an approach that includes some of the principles mentioned above, you might be onto something.

The next step is to read the company's annual reports, understand how executives are incentivized, and reverse engineer management's capital allocation decisions to determine why and how management arrived at its decision to acquire a certain company, divest an asset, or repurchase its stock.

Just because a company may not be led by a member of Singletonville doesn't mean the company isn't worth owning. Elite capital allocators are few and far between; decent-to-good capital allocators, while still rare, are more common. Provided those decent-to-good capital allocators are running a company with durable competitive advantages, that can still be an attractive business to own at the right price.

Finally, the princples outlined by Thorndike in Outsiders can also help you avoid investing behind CEOs that are decidedly poor capital allocators, and ultimately that might be just as important as finding the elite CEOs.

What I've been reading this week

Stay patient, stay focused.


@toddwenning on Twitter

Wednesday, August 20, 2014

Buybacks Aren't Doing Much For Shareholders Right Now

"If everyone is doing (buybacks), there must be something wrong with them." 
- Henry Singleton, former Teledyne CEO (profiled in The Outsiders)

With the exception of 2009, gross buybacks have outpaced dividends paid by U.S. companies each year since 1997. As such, it's absolutely critical that investors -- even dividend investors -- take buybacks into consideration when evaluating companies.

But as Michael Mauboussin points out in a recent study on capital allocation, unlike dividends, which treat all shareholders equally:
In a buyback, selling shareholders benefit at the expense of ongoing shareholders if the stock is overvalued, and ongoing shareholders benefit at the expense of selling shareholders if the stock is undervalued. All shareholders are treated uniformly only if the stock price is at fair value.
In other words, when a company repurchases its shares at a discount to fair value, it's a good use of shareholder capital and ongoing shareholders make out quite well. However, relatively few management teams consistently buyback stock at opportunistic prices.

Indeed, the number of S&P 500 companies repurchasing shares and the amount spent on buybacks tends to follow the market.

While there are undoubtedly some companies making smart and opportunistic buyback decisions today, when the majority of companies are also buying back stock, it's not likely that companies on average are adding much long-term shareholder value with share repurchases.

Jim Chanos, in an interview with Barry Ritholtz, echoed these sentiments:
And when corporations embarked on massive buybacks across all industries and all companies, in effect these CEOs are buying the stock market. So what they’re telling you then, is unequivocally that they think that either they’re happy to earn the stock market rate of return or maybe something hopefully better. Or their rate of return on the margin of any new capital project is much much lower, in fact half or less of what is stated. And that does not bode well for the future of profits, or for the quality of earnings reported as current profits.
Any investor can earn the market rate of return on their own using low-cost index funds. We certainly don't need companies doing it on our behalf. If companies can't find projects (including their own stocks) that generate long-term value, that cash should be returned to shareholders via dividends. Let the shareholders decide how to reinvest the cash as they see fit.

Let me know what you think in the comments below or on Twitter @toddwenning

Stay patient, stay focused.



Friday, August 8, 2014

This is the Opposite of Real Investing

Innovation in finance is designed largely to benefit those who create the complex new products, rather than those who own them. - Jack Bogle 
Earlier this week, I came across an article about "math nerds taking over Wall Street" and thought it must have been republished from 2006 when quantitative strategies were in their heyday

Nope. A few years after the financial crisis broke their old can't-miss algorithims, the quants have returned with a new set of proprietary trading formulas that will work until they don't anymore. 

No one ever said Wall Street had a long memory. 

The article highlights a quantitative software program that "uses historical data and analysis to predict price movements in various assets." 

This line made me think of Buffett's commentary in the 2008 Berkshire letter:
Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas. (my emphasis)
I don't mean to come down too hard on the quants -- they're clearly bright people and there's apparently demand for what they're doing, but their approach is the complete opposite of what we should be trying to do as investors.

Seeking patterns where none exist. (Pi)
Any time you would spend seeking patterns in the newspaper quotes page or developing automatic trading formulas would be much better spent pursuing another type of formula, like the one Buffett outlined in the 1994 Berkshire letter:
We believe that our formula - the purchase at sensible prices of businesses that have good underlying economics and are run by honest and able people - is certain to produce reasonable success. 
This simple formula isn't easy to implement, of course, but it beats using a complex formula that is easy to implement.

What do you think? Let me know on Twitter @toddwenning.

What I've been reading this week:
Cartoon of the week:

Stay patient, stay focused.



Saturday, July 26, 2014

6 Signs of a Good Investment Process

In my baseball-playing days, I was on the mound in a big playoff game, and at a key moment in the game I threw what seemed to be a good pitch, only to watch as the ball sailed over the fence for a home run. It might still be traveling somewhere over North Jersey, it was hit so hard.

Walking back to the dugout after the inning was over, I was furious with myself for throwing the pitch. What was I thinking? What did I forget to do? What could I have done better? All natural questions to ask when you've experienced a bad outcome. 

In the dugout, I asked our catcher what he thought went wrong. He said, "Nothing at all. It was exactly what I called for and it was in the right spot. You've gotta tip your hat to the hitter -- he just took a great swing."

Nine out of ten times that pitch would have either led to a strike or an out. Instead, that time around the ball was hit out of the park. The process was right, the outcome was bad. If I could do it again, I would have thrown the same pitch...just perhaps a few more inches outside. 

This story from my glory days was on my mind this week as I was re-reading Michael Mauboussin's More Than You Know (which I highly recommend if you haven't already read it). 

The first chapter of the book is called "Be the House: Process and Outcome in Investing" and addresses the importance of process when making investing decisions. Here's an important quote from the chapter:
Results - the bottom line - are what what ultimately matter. And results are typically easier to assess and more objective than evaluating process.  
But investors often make the critical mistake of assuming that good outcomes are the result of a good process and that bad outcomes imply a bad process. In contrast, the best long-term performers in any probabilistic field...all emphasize process over outcome
When the market is strong, it's easy to fall into a false sense of confidence about your investment process because you're receiving almost daily positive reinforcement from rising stock prices. The opposite is true when the market is down -- you could have a good process experiencing bad short-term outcomes.

It's important to remember that there's a lot of randomness and luck involved in short-term market outcomes and they aren't indicative of investing skill.

What really matters is whether or not your investment process can survive short-term periods of positive and negative reinforcement and deliver longer-term results. In a probabilistic field like investing, a good process will produce good results over time and over a large sample.

How do you know if your process is any good? Each investor will have his or her own process, but in my experience I've found six common traits of a good investment process:
  1. Stoic: It can endure both good and bad short-term outcomes without getting emotionally swayed in either direction.
  2. Consistent: It doesn't adjust to current market sentiment and sticks to core competencies. 
  3. Self-critical: The process is periodically reviewed, includes both pre-mortem and post-mortem analysis on decisions, and is refined as needed. 
  4. Business-focused: Rather than rely on heuristics like "only buy stocks with P/Es below 15," a good investment process focuses on understanding things like the underlying business's competitive advantages (if any) and determining whether or not management has integrity and if they are good capital allocators.
  5. Repeatable: A process gets more valuable with each application -- insights are gained, deficiencies are noticed, etc. 
  6. Simple: The less complex, the better. If you can hand off your process to another investor without creating significant confusion, you're on the right track.
What do you think? Let me know in the comments section below or on Twitter @toddwenning

What I've been reading this week...
  • 5 investing lessons from Markel's Tom Gayner -- David Hanson
  • Cloning Neil Woodford's new dividend fund -- Monevator
  • Common sense investing guidelines -- Ben Carlson
  • A small cap CEO who reads Buffett and Graham -- MinnPost
  • Beware when a CEO leaves for no apparent reason -- MoneyWeek