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