Saturday, January 31, 2015

Don't Overlook This Factor in Your Research Process

"Culture is not the most important thing. It's the only thing." - Jim Sinegal, Costco co-founder & former CEO
When was the last time you read a stock report that included a discussion of the company's culture?

I bet it's been a while.

Perhaps part of the reason for this is that investors as a group prefer to focus on the quantifiable factors that can be entered into our spreadsheets - earnings, free cash flow, return on equity, etc.. More qualitative factors like culture are often unfairly dismissed as fluff.

Another reason could be that when we hear the term we associate it with the dull and lifeless, Office Space definition of "corporate culture."

And remember, next Friday is Hawaiian shirt day
Whatever the reasons why we tend to overlook corporate culture in our research process, we're doing ourselves a disservice by ignoring it. That's because, when a vibrant and authentic culture complements a company's durable competitive advantages, it can yield great results for shareholders.

Aligned interests

An example of a company with a great culture in my own portfolio is U.K.-based insurer, Admiral Group (ADM.L), which prides itself on being a low-cost operator. Indeed, in 2013, its U.K. business's expense ratio of 15% was about half the market average. It's true that there are other, more operational factors that anchor the company's low-cost advantage, but Admiral's culture also strengthens it in a number of ways.

For one, Admiral is frequently voted one of the top employers in the U.K. and in other markets in which it operates. By making it a fun place to work, the company attracts top talent and keeps costly employee turnover well below its competitors' attrition rates. Further, each employee - regardless of pay grade - has received £3,000 of free shares each year since the company went public in 2004. All else equal, employee-owners of the business should care more about cutting expenses than employees who only collect a paycheck. No one washes the rental car, after all. 

One of my favorite anecdotes about Admiral's low-cost culture is that when it opened its first U.S. office in 2009, employees were required to do a push-up in view of the CEO's desk whenever they used the printer so as to keep paper costs to a minimum and encourage employees to first consider cheaper alternatives. 

All adds up

To some, these may seem like nice-but-ultimately-inconsequential items, but as Buffett pointed out in his 2005 letter to Berkshire shareholders, the little things that companies do each day matter over time:
If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength...On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.  
When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as "widening the moat." 
Culture matters precisely because it enables these small actions and can thus have a tremendous impact on a company's competitive position. Companies like Costco, Whole Foods, and Southwest Airlines have leveraged their unique corporate cultures to stand apart and build brand loyalty in highly competitive industries. Suffice it to say that patient investors have also done quite well with these companies.

Click to enlarge
As long-term, business-focused investors ourselves, it's well worth our time to consider culture as part of our regular research process and how it may contribute to - or, in cases of a poor culture, even detract from - the company's ability to create shareholder value for years to come.

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



Saturday, January 17, 2015

Preparing for the Next Bear Market

The opportunity to secure ourselves against defeat lies in our own hands, but the opportunity of defeating the enemy is provided by the enemy himself. - Sun Tzu
Earlier this week, a friend asked me what I thought could end this bull market. I searched for a smart answer and concluded that it was the one that investors haven't fully considered yet. Recalling my experience from the financial crisis, I said that it's always the punch you didn't see coming that knocks you out.

Keep an eye on your pic-a-nic baskets
Fearing this answer might be unsatisfactory, I floated a guess that there could be unforeseen consequences of falling oil prices.

There -- an answer more befitting an industry veteran.

The fact is, we have no idea what specific event or events will end this bull market, though it'll be obvious in hindsight, of course. Maybe someone will guess right, make leveraged bets on their thesis, make millions or billions and write a book about it, but for every one of those guys, there are legions who guessed wrong and are far worse off.

As long-term, business-focused investors, we shouldn't care much about what causes the next bear market. To borrow a phrase from Peter Lynch about macroeconomics, if you spend 13 minutes thinking about this, you've wasted 10 minutes. If anything, you're more likely to stress yourself out and make emotional trades in a quixotic mission to avoid your envisioned losses.

Rather than scramble to reposition your portfolio for the next bear market, we're much better off focusing on the things we can control. For one, look to learn more about the businesses we already own and the ones in which we've taken an interest.
  • How might a bear market impact management's current strategy?
  • If the current management team was in place during the financial crisis, how did they handle that challenge? Were they honest in their evaluation of the marketplace or did they try to put on a good face? 
  • Does management have a track record of making opportunistic acquisitions and investments (buybacks, etc.) in down markets?
  • Is the company's balance sheet prepared to handle a few lean years? 
  • Is the dividend well covered by both earnings and free cash flow?
By asking ourselves these types of questions now while the market is still strong, we'll be better prepared for when Mr. Market grows despondent again and offers us opportunities to invest in quality businesses at attractive prices. Indeed, it's only when Mr. Market makes such offers that we're able to sow the seeds of long-term market outperformance.

Related posts
What I've been reading/listening to this week
  • What Reese's peanut butter cups can teach us about investing -- Sova Group
  • The most under-appreciated investment skill is patience -- Time
  • Is investing really a zero sum game? -- Monevator
  • What makes for an exceptional company? -- CFO
  • Peter Lynch speech from 1994 -- YouTube
  • Understanding global capital allocation practices -- Michael Mauboussin 
  • A dozen things I've learned from Tom Murphy -- 25iq
The book I'm currently reading:
Stay patient, stay focused.



Saturday, January 10, 2015

The Benefits of a Focused Investing Approach

When I was working in London a few years ago, I would often hear about a well-regarded investing book called The Zulu Principle by Jim Slater. As an American investor, I'd never come across the book and was curious to figure out what it was all about.

Above all else, the "Zulu Principle" is about focusing as an investor. Indeed, the name itself came to Slater after his wife read a four page article on the Zulu tribe in Readers Digest and he concluded that, from that short article alone, his wife knew much more than he did about the Zulus. Taking it a step further, he reckoned that if she then went to the library and read more about the Zulus, she'd probably know more than anyone in town. If she lived in South Africa to study the Zulus for six months, she'd know more than anyone else in Britain.

In other words, by focusing on a niche, one can more easily become a leading expert on the subject than if they tried to understand everything. This is consistent with Buffett's advice to only invest in companies within your circle of competence.

While Slater discusses a number of investing approaches in the book, he believes that individual investors should spend most of their time researching smaller companies where there are fewer institutional investors to compete with and where an information edge is more likely to be obtained.

One of the things I particularly like about Slater's approach is that his investing process is simple, consistent, and repeatable.

Here are some of the criteria that he looks for in a new investment. The first five he considers mandatory while the latter six he considers to be added "protection."
  1. A positive growth rate in earnings per share in at least four of the last five years.
  2. A low price/earnings ratio relative to its growth rate. Look for a PEG ratio under 0.75, ideally under 0.66.
  3. An optimistic chairman's statement. If management's commentary about the coming year is negative or cautious, don't buy.
  4. Strong liquidity, low borrowings and high cash flow.
  5. A substantial competitive advantage.
  6. Something new. Does the company have a new product or service that the market may not fully appreciate yet? 
  7. A small market capitalization. Are large investors overlooking or unable to buy this stock? 
  8. High relative strength of the shares. Only buy a growth stock within 15% of its 52-week high.
  9. A more than nominal dividend yield. 
  10. A reasonable asset position. 
  11. Management should have a significant shareholding. 
That's a pretty good list if you're looking to invest in smaller growth companies. Of these 11 criteria, the most difficult to be consistently right on is #2. Slater recommends using broker forecasts (which may themselves be biased) to determine the "G" in the PEG ratio, but with smaller companies that have less analyst coverage, you'll need to do more of the work yourself.

If starting from scratch, I'd calculate the company's "sustainable growth rate" (discussed here) to determine what growth rate the company is capable of achieving. Also read through conference call transcripts and any investor presentations to see if management has an earnings growth target.

Slater also recommends a focused portfolio of 10-12 stocks with a maximum 15% invested in any one stock. By owning fewer stocks, it stands to reason that you'll become more expert in those companies than others in the market.

While U.S. investors may struggle with some of the U.K.-focused terminology and some dated company examples in the book, The Zulu Principle is definitely worth a read. I've added it to my recommended reading list.

Finally, here are a few good quotes from the book:
  • "Elephants don't gallop."
  • "Investment is essentially the arbitrage of ignorance."
  • "Do not go bottom-fishing - you can drown that way."
  • "If you are intent upon turning a stampede, you have to wait until the cattle are tiring; otherwise you can be trampled underfoot."
Hard to believe, but this is the 100th Clear Eyes Investing post. Thank you very much for reading! 

What I've been reading/watching this week:
Book I'm currently reading:
Stay patient, stay focused.



Thursday, January 1, 2015

Some Investing Advice for My Son

My wife and I recently welcomed our son into the world and, like any new parent, I've been thinking about all the things I'll need to teach him as he grows up -- how to ride a bike, how to read, and, of course, how to invest.

So with a few minutes to spare between diaper changes, I jotted down a few points for him to consider down the road if he ever wants to start managing his own money.

1. Learn from the masters, but think for yourself. By all means, read Warren Buffett, Peter Lynch, Ben Graham, and the writings of other successful investors, but remember that what worked for them may not work for you. Incorporate lessons from other investors with your own experience and develop a style that you're comfortable with.

2. Be an investor in businesses, not a trader of tickers. Invest in companies in which you want to be a long-term owner of the business. You have much better odds of identifying a good company than guessing where a stock's price will be in the next few months.

3. You can only grow the money that you keep. Minimize the costs of investing (commissions, fees, and taxes) by maintaining a long-term focus and not trading too often.

4. Stay emotionally balanced. Don't let the short-term movements of your stock prices determine your mood. You're never as good or as bad of an investor as you think -- just focus on becoming a better investor each day and the long-term returns will take care of themselves.

5. Keep it simple. Complex financial products and companies with hard-to-understand operations aren't worth your time and are probably over-priced anyway. Stick to what makes sense to you and aim to simplify your process.

6. Be insatiably curious. Read anything and everything. Some of the most valuable investing lessons you'll learn won't come from investing books. Philosophy, science, art, fiction, history, etc. all have something to offer, so always look to broaden your horizons. You'll be amazed at what you can tie back into your investing approach.

7. Only make investment decisions when you're calm and relaxed. When you're stressed, your mental time horizon shrinks and you struggle to see the big picture. Go for a walk, take some deep breaths, shoot some basketball in the driveway -- whatever it takes to regain the right perspective.

8. Invest for a greater purpose. Help yourself and help others. Investing isn't an end in itself, but is a means to an end. Use any money you don't need to be a blessing to others.

9. Be patient. The benefits of compounding interest are fully realized with time and time is on your side as an individual investor. Aim to hold your stock investments for at least three years, but ideally longer than that.

10. If you want to focus on nobler pursuits, invest using index funds. If you don't want to invest in individual companies, make sure that you're at least earning the market rate of return with your long-term savings. Invest in some low-cost total market funds, add money to them each month, and then see lesson #9.

What investing lessons have you shared with your own kids, nieces, nephews, etc.? Let me know in the comments section below or on Twitter @toddwenning.

What I've been reading/watching this week (short list this week):
Book I'm currently reading
Happy New Year!

Stay patient, stay focused.