Jeremy Siegel is the author of The Future for Investors (Crown Business, 2005). Warren Buffett commented: “Jeremy Siegel’s new facts and ideas should be studied by investors.” (Although the book was published in 2005, most of the facts and ideas still hold.)
INTRODUCTION
Siegel summarizes the main lesson from his previous book, Stocks for the Long Run:
My research showed that over extended periods of time, stock returns not only dominate the returns on fixed-income assets, but they do so with lower risk when inflation is taken into account. These findings established that stocks should be the cornerstone of all long-term investors’ portfolios.
As you extend forward in time, especially to three or four decades, the real return from stocks is roughly 6.5 to 7 percent, which will nearly always be better than any other investment, such as fixed-income or gold. Siegel has given many talks on Stocks for the Long Run, and he reports that two questions always come up:
Which stocks should I hold for the long run?
What will happen to my portfolio when the baby boomers retire and begin liquidating their portfolios?
Siegel says he wrote The Future for Investors in order to answer these questions. He studied all 500 firms that constituted the S&P 500 Index when it was first formulated in 1957. His conclusions – that the original firms in the index outperformed the newcomers (those added later to the index) – were surprising:
These results confirmed my feeling that investors overprice new stocks, many of which are in high technology industries, and ignore firms in less exciting industries that often provide investors superior returns. I coined the term the growth trap to describe the incorrect belief that the companies that lead in technological innovation and spearhead economic growth bring investors superior returns.
The more I investigated returns, the more I determined that the growth trap affected not just individual stocks, but also entire sectors of the market and even countries. The fastest-growing new firms, industries, and even foreign countries often suffered the worst return. I formulated the basic principle of investor return, which specifies that growth alone does not yield good returns, but only growth in excess of the often overly optimistic estimates that investors have built into the price of stock. It was clear that the growth trap was one of the most important barriers between investors and investment success.
As regards the aging of the baby-boom generation, Siegel argues that growth in developing countries (like China and India) will keep the global economy moving forward. Also, as citizens in developing countries become wealthier, they will buy assets that baby-boomers are selling. Siegel also holds that information technology will be central to global economic growth.
I am not going to discuss baby-boomer retirement any further in this blog post. I would only note that there is a good chance that economically significant innovation could surprise on the upside in the next few decades. See, for instance, The Second Machine Age, by Erik Brynjolfsson and Andrew McAfee (W. W. Norton, 2016). As Warren Buffett has frequently observed, the luckiest people in history are those being born now. Life in the future for most people is going to be far better than at any previous time in history.
THE GROWTH TRAP
Siegel opens the first chapter by noting the potential impact of improving technology:
The future for investors is bright. Our world today stands at the brink of the greatest burst of invention, discovery, and economic growth ever known.
Yet investors must be careful to avoid the growth trap:
The growth trap seduces investors into overpaying for the very firms and industries that drive innovation and spearhead economic expansion. This relentless pursuit of growth – through buying hot stocks, seeking exciting new technologies, or investing in the fastest-growing countries – dooms investors to poor returns. In fact, history shows that many of the best-performing investments are instead found in shrinking industries and in slower-growing countries.
Although technology has created amazing wealth and well-being, investing in new technologies is generally a poor investment strategy. Siegel explains:
How can this happen? How can these enormous economic gains made possible through the proper application of new technology translate into substantial investment losses? There’s one simple reason: in their enthusiasm to embrace the new, investors invariably pay too high a price for a piece of the action. The concept of growth is so avidly sought after that it lures investors into overpriced stocks in fast-changing and overly competitive industries, where the few big winners cannot begin to compensate for the myriad of losers.
To illustrate his point, Siegel compares Standard Oil of New Jersey (now ExxonMobil) with the new-economy juggernaut, IBM. Consider the growth rates of these companies from 1950 to 2003:
Growth Measures
IBM
Standard Oil
Advantage
Revenue/Share
12.19%
8.04%
IBM
Dividends/Share
9.19%
7.11%
IBM
Earnings/Share
10.94%
7.47%
IBM
Sector Growth
14.65%
-14.22%
IBM
IBM performed much better fundamentally than Standard Oil of New Jersey. Moreover, from 1950 to 2003, the technology sector rose from 3 percent of the market to almost 18 percent, while oil stocks shrank from 20 percent of the market to 5 percent. Therefore, it seems clear that an investor who had to choose between IBM and Standard Oil in 1950 should have chosen IBM. But this would have been the wrong decision.
Over the entire period, Standard Oil of New Jersey had an average P/E of 12.97, while IBM had an average P/E of 26.76. Also, Standard Oil had an average dividend yield of 5.19%, while IBM had an average dividend yield of 2.18%. As a result, the total returns for the two stocks were as follows:
Return Measures
IBM
Standard Oil
Advantage
Price Appreciation
11.41%
8.77%
IBM
Dividend Return
2.18%
5.19%
Standard Oil
Total Return
13.83%
14.42%
Standard Oil
Siegel explains:
IBM did very well, but investors expected it to do well, and its stock price was consistently high. Investors in Standard Oil had very modest expectations for earnings growth and kept the price of its shares low, allowing investors to accumulate more shares through the reinvestment of dividends. The extra shares proved to be Standard Oil’s margin of victory.
Here are Siegel’s broad conclusions on the S&P 500 Index:
The more than 900 new firms that have been added to the index since it was formulated in 1957 have, on average, underperformed the original 500 firms in the index.
Long-term investors would have been better off had they bought the original S&P 500 firms in 1957 and never bought any new firms added to the index. By following this buy-and-never-sell approach, investors would have outperformed almost all mutual funds and money managers over the last half century.
Dividends matter a lot. Reinvesting dividends is the critical factor giving the edge to most winning stocks in the long run… Portfolios invested in the highest-yielding stocks returned 3 percent per year more than the S&P 500 Index, while those in the lowest-yielding stocks lagged the market by almost 2 percent per year.
The return on stocks depends not on earnings growth but solely on whether this earnings growth exceeds what investors expected, and those growth expectations are embodied in the price-to-earnings, or P/E ratio. Portfolios invested in the lowest-P/E stocks in the S&P 500 Index returned almost 3 percent per year more than the S&P 500 Index, while those invested in the high-P/E stocks fell 2 percent per year behind the index.
The growth trap holds for industry sectors as well as individual firms. The fastest-growing sector, the financials, has underperformed the benchmark S&P 500 Index, while the energy sector, which has shrunk almost 80 percent since 1957, beat this benchmark index. The lowly railroads, despite shrinking from 21 percent to less than 5 percent of the industrial sector, outperformed the S&P 500 Index over the last half century.
The growth trap holds for countries as well. The fastest-growing country over the last decade has rewarded investors with the worst returns. China, the economic powerhouse of the 1990s, has painfully disappointed investors with its overpriced shares and falling stock prices.
THE TRIED AND TRUE
But how, you will ask, does one decide what [stocks are] ‘attractive’? Most analysts feel they must choose between two approaches customarily thought to be in opposition: ‘value’ and ‘growth.’… We view that as fuzzy thinking… Growth is always a component of value [and] the very term ‘value investing’ is redundant.
What was the best-performing stock from 1957 to 2003? Siegel answers that it was Philip Morris. Siegel observes:
The superb returns in Philip Morris illustrate an extremely important principle of investing: what counts is not just the growth rate of earnings but the growth of earnings relative to the market’s expectation. One reason investors had low expectations for Philip Morris’s growth was because of its potential liabilities. But its growth has continued apace. The low expectations combined with high growth and a high dividend yield provide the perfect environment for superb investor returns.
What were the top-performing S&P 500 Survivors from 1957 to 2003?
Rank
2003 Name
Accumulation of $1,000
Annual Return
1
Philip Morris
$4,626,402
19.75%
2
Abbott Labs
$1,281,335
16.51%
3
Bristol-Myers Squibb
$1,209,445
16.36%
4
Tootsie Roll Industries
$1,090,955
16.11%
5
Pfizer
$1,054,823
16.03%
6
Coca-Cola
$1,051,646
16.02%
7
Merck
$1,003,410
15.90%
8
PepsiCo
$866,068
15.54%
9
Colgate-Palmolive
$761,163
15.22%
10
Crane
$736,796
15.14%
11
H. J. Heinz
$635,988
14.78%
12
Wrigley
$603,877
14.65%
13
Fortune Brands
$580,025
14.55%
14
Kroger
$546,793
14.41%
15
Schering-Plough
$537,050
14.36%
16
Proctor & Gamble
$513,752
14.26%
17
Hershey Foods
$507,001
14.22%
18
Wyeth
$461,186
13.99%
19
Royal Dutch Petroleum
$398,837
13.64%
20
General Mills
$388,425
13.58%
S&P 500
$124,486
10.85%
Siegel points out that most of the top twenty performers have strong brands, but are not technology companies per se. Siegel discusses some of these great companies:
Number four on this list is a most unlikely winner – a small manufacturer originally named the Sweets Company of America. This company has outperformed the market by 5 percent a year since the index was formulated. The founder of this firm, an Austrian immigrant, named its product after his five-year-old daughter’s nickname, Tootsie….
The surviving company with the sixth highest return produces a product today with the exact same formula as it did over 100 years ago, much like Tootsie Roll…. Although the company keeps the formula for its drinks secret, it is no secret that Coca-Cola has been one of the best companies you could have owned over the last half century.
…Pepsi also delivered superb returns to its shareholders, coming in at number eight and beating the market by over 4 percent per year.
Two others of the twenty best-performing stocks also manufacture products virtually unchanged over the past 100 years: the William Wrigley Jr. Company and Hershey Foods. Wrigley came in at number twelve, beating the market by almost 4 percent per year, whereas Hershey came in at seventeen, beating the market by 3 percent a year.
Wrigley is the largest gum manufacturer in the world, commanding an almost 50 percent share in the global market and selling in approximately 100 countries. Hershey is currently the number-one U.S.-based publicly traded candy maker (Mars, a private firm, is number one, followed by Swiss-based Nestle).
…Heinz is another strong brand name, one that is virtually synonymous with ketchup. Each year, Heinz sells 650 million bottles of ketchup and makes 11 billion packets of ketchup and salad dressings – almost two packets for every person on earth. But Heinz is just not a ketchup producer, and it does not restrict its focus to the United States. It has the number-one or –two branded business in fifty different countries, with products such as Indonesia’s ABC soy sauce (the second-largest-selling soy sauce in the world) and Honig dry soup, the best-selling soup brand in the Netherlands.
Colgate-Palmolive also makes the list, coming in at number nine. Colgate’s products include Colgate toothpastes, Speed Stick deoderant, Irish Spring soaps, antibacterial Softsoap, and household cleaning products such as Palmolive and Ajax.
No surprise that Colgate’s rival, Procter & Gamble, makes this list as well, at number sixteen. Procter & Gamble began as a small, family-operated soap and candle company in Cincinnati, Ohio, in 1837. Today, P&G sells three hundred products, including Crest, Mr. Clean, Tide, and Tampax, to more than five billion consumers in 140 countries.
…Number twenty on the list is General Mills, another company with strong brands, which include Betty Crocker, introduced in 1921, Wheaties (the ‘Breakfast of Champions’), Cheerios, Lucky Charms, Cinnamon Toast Crunch, Hamburger Helper, and Yoplait yogurt.
What is true about all these firms is that their success came through developing strong brands not only in the United States but all over the world. A well-respected brand name gives the firm the ability to price its product above the competition and deliver more profits to investors.
…Besides the strong consumer brand firms, the pharmaceuticals had a prominent place on the list of best-performing companies. It is noteworthy that there were only six health care companies in the original S&P 500 that survive to today in their original corporate form, and all six made it onto the list of best performers. All of these firms not only sold prescription drugs but also were very successful in marketing brand-name over-the-counter treatments to consumers, very much like the brand-name consumer staples stocks that we have reviewed.
…When these six pharmaceuticals are added to the eleven name-brand consumer firms, seventeen, or 85 percent, of the twenty top-performing firms from the original S&P 500 Index, feature well-known consumer brand names.
INVESTOR EXPECTATIONS
What really matters for investors is the price paid today compared to all future free cash flows. But investors very regularly overvalue high-growth companies and undervalue low-growth or no-growth companies. This is the key reason value investing works. As Siegel writes:
Expectations are so important that without even knowing how fast a firm’s earnings actually grow, the data confirm that investors are too optimistic about fast-growing companies and too pessimistic about slow-growing companies. This is just one more confirmation of the growth trap.
Thus, if you want to do well as an investor, it is best to stick with companies trading at low multiples (low P/E, low P/B, low P/S, etc.). All of the studies have confirmed this. See: https://boolefund.com/the-ugliest-stocks-are-the-best-stocks/
Siegel did his own study, dividing S&P 500 Index companies into P/E quintiles. From 1957 to 2003, the lowest P/E quintile – bought at the beginning of each year – produced an average annual return of 14.07% (with a risk of 15.92%), while the highest P/E quintile produced an average annual return of 9.17% (with a risk of 19.39%). The S&P 500 Index averaged 11.18% (with a risk of 17.02%)
If you’re doing buy-and-hold value investing – as Warren Buffett does today – then you can pay a higher price as long as it is still reasonable and as long as the brand is strong enough to persist over time. Buffett has made it clear, however, that if he were managing a small amount of money, he would focus on microcap companies available at cheap prices. That would generate the highest returns, with 50% per year being possible in micro caps for someone like Buffett. See: https://boolefund.com/buffetts-best-microcap-cigar-butts/
Siegel discusses GARP, or growth at a reasonable price:
Advocates here compute a very similar statistic called the PEG ratio, or price-to-earnings ratio divided by the growth rate of earnings. The PEG ratio is essentially the inverse of the ratio that Peter Lynch recommended in his book, assuming you add the dividend yield to the growth rate. The lower the PEG ratio, the more attractively priced a firm is with respect to its projected earnings growth. According to Lynch’s criteria, you would be looking for firms with lower PEG ratios, preferably 0.5 or less, but certainly less than 1.
It’s important to note that earnings growth is very mean-reverting. In other words,most companies that have been growing fast do NOT continue to do so, but tend to slow down quite a bit. That’s why deep value investing – simply buying the cheapest companies (based on low P/E or low EV/EBIT), which usually have low- or no-growth – tends to produce better returns over time than GARP investing does. This is most true, on average, when you invest in cheap microcap companies.
Deep value microcap investing tends to work quite well, especially if you also use the Piotroski F-Score to screen for cheap microcap companies that also have improving fundamentals. This is the approach used by the Boole Microcap Fund. See: https://boolefund.com/cheap-solid-microcaps-far-outperform-sp-500/
One other way to do very well investing in micro caps is to try to find the ones that will grow for a long time. It’s much more difficult to use this approach successfully than it is to buy cheap microcap companies with improving fundamentals. But it is doable with enough patience and discipline. See MicroCapClub.com if you want to learn about some microcap investors who use this approach.
GROWTH IS NOT RETURN
Most investors seem to believe that the fastest-growing industries will yield the best returns. But this is simply not true. Siegel compares financials to energy companies:
Of the ten major industries, the financial sector has gained the largest share of market value since the S&P 500 Index was founded in 1957. Financial firms went from less than 1 percent of the index to over 20 percent in 2003, while the energy sector has shrunk from over 21 percent to less than 6 percent over the same period. Had you been looking for the fastest-growing sector, you would have sunk your money in financial stocks and sold your oil stocks.
But if you did so, you would have fallen into the growth trap. Since 1957, the returns on financial stocks have actually fallen behind the S&P 500 Index, while energy stocks have outperformed over the same period. For the long-term investor, the strategy of seeking out the fastest-growing sector is misguided.
Siegel continues by noting that the GICS (Global Industrial Classification Standard) breaks the U.S. and world economy down into ten sectors: materials, industrials, energy, utilities, telecommunication services, consumer discretionary, consumer staples, health care, financial, and information technology. (Recently real estate has been added as an eleventh sector.)
Just as the fastest-growing companies, as a group, underperform the slower growers in terms of investment returns, so new companies underperform the tried and true. Siegel explains what his data show:
These data confirm my basic thesis: the underperformance of new firms is not confined to one industry, such as technology, but extends to the entire market. New firms are overvalued by investors in virtually every sector of the market.
Siegel also answers the question of why energy did so well, despite shrinking from over 21 percent to less than 6 percent of the market:
Why did the energy sector perform so well? The oil firms concentrated on what they did best: extracting oil at the cheapest possible price and returning the profits to the shareholders in the form of dividends. Furthermore investors had low expectations for the growth of energy firms, so these stocks were priced modestly. The low valuations combined with the high dividends contributed to superior investor returns.
Technology firms have experienced high earnings growth. Yet investors have tended to expect even higher growth going forward than what subsequently occurs. Thus we see again that investors systematically overvalue high-growth companies, which leads to returns that trail the S&P 500 Index. Technology may be the best example of this phenomenon. Technology companies have grown very fast, but investors have generally expected too much going forward.
The financial sector is another case of high growth but disappointing (or average) returns. Much of the growth in financials has come from new companies joining the sector and being added to the index. Siegel:
The tremendous growth in financial products has spurred the growth of many new firms. This has caused a steady increase in the market share of the financial sector, but competition has kept the returns on financial stocks close to average over the whole period.
To conclude his discussion of the various sectors, Siegel writes:
The data show that three sectors emerge as long-term winners. They are health care, consumer staples, and energy. Health care and consumer staples comprise 90 percent of the twenty best-performing surviving firms of the S&P 500 Index. These two sectors have the highest proportion of firms where management is focused on bringing quality products to the market and expanding brand-name recognition on a global basis.
The energy sector has delivered above-average returns despite experiencing a significant contraction of its market share. The excellent returns in this sector are a result of two factors: the relatively low growth expectations of investors (excepting the oil and gas extractors during the late 1970s) and the high level of dividends.
TECHNOLOGY: PRODUCTIVITY CREATOR AND VALUE DESTROYER
Siegel opens the chapter by remarking:
Economic growth is not the same as profit growth. In fact, productivity growth can destroy profits and with it stock values.
Siegel continues:
Any individual or firm through its own effort can rise above the average, but every individual and firm, by definition, cannot. Similarly, if a single firm implements a productivity-improving strategy that is unavailable to its competition, its profits will rise. But if all firms have access to the same technology and implement it, then costs and prices will fall and the gains of productivity will go to the consumer.
Siegel notes that Buffett had to deal with this type of issue when he was managing Berkshire Hathaway, a textile manufacturer. Buffett discussed plans presented to him that would improve workers’ productivity and lower costs:
Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable investments in our highly profitable candy and newspaper businesses.
Yet Buffett realized that the proposed improvements were available to all textile companies. Buffett commented in his 1985 annual report:
[T]he promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company’s investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.
Eventually, after a decade, Buffett realized he had to close the company. (He had kept it open for a decade out of concern for the employees, and because management was doing an excellent job with the hand it was dealt.) Siegel comments:
Buffett contrasts his decision to close up shop with that of another textile company that opted to take a different path, Burlington Industries. Burlington Industries spent approximately $3 billion on capital expenditures to modernize its plants and equipment and improve its productivity in the twenty years following Buffett’s purchase of Berkshire. Nevertheless, Burlington’s stock returns badly trailed the market. As Buffett states, ‘This devastating outcome for the shareholders indicates what can happen when much brain power and energy are applied to a faulty premise.’
Siegel then draws a broader conclusion about technology:
Historical economic data indicate that the fruits of technological change, no matter how great, have ultimately benefited consumers, not the owners of firms. Productivity lowers the price of goods and raises the real wages of workers. That is, productivity allows us to buy more with less.
Certainly, technological change has transitory effects on profits. There is usually a ‘first mover’ advantage. When one firm incorporates a new technology that has not yet been implemented by others, profits will increase. But as others avail themselves of this technology, competition ensures that prices will fall and profits will revert to normal.
WINNING MANAGEMENTS IN LOSING INDUSTRIES
Siegel quotes Peter Lynch:
As a place to invest, I’ll take a lousy industry over a great industry anytime. In a lousy industry, one that’s growing slowly if at all, the weak drop out and the survivors get a bigger share of the market. A company that can capture an ever-increasing share of a stagnant market is a lot better off than one that has to struggle to protect a dwindling share of an exciting market.
Many investors try to look for an industry with a bright future, and then select a company that will benefit from this growth. As we’ve already seen, this doesn’t work in general because investors systematically overvalue high-growth companies.
A deep value investment strategy looks for companies at low multiples, with terrible performance. These companies, as a group, have done much better than the market over time.
Although a deep value approach works well even if it is entirely quantitative – which is what Ben Graham, the father of value investing, often did – it can work even better if you can identify a winning management. Siegel explains:
… some of the most successful investments of the last thirty years have come from industries whose performances have been utterly horrendous.
These companies have bucked the trend. They all rose above their competitors by following a simple approach: maximize productivity and keep costs as low as possible.
Siegel gives Southwest Airlines as an example. Investors have lost more money in the airline industry than in any other. But Southwest Airlines established itself as ‘the low-fare airline.’ It accomplished this by being the low-cost airline. It offered only single-class service, with no assigned seats and no meals. It only operated city-to-city where demand was high enough. And it only used Boeing 737’s. As a result of being the low-cost and low-fare airline, the business performedwell and the stock followed.
Siegel also mentionsthe example of Nucor, which pioneered the use of ‘minimill’ technology and the recycling of scrap steel. While the steel industry as a whole underperformed the market by close to 4 percent a year for thirty years, Nucor outperformed the market by over 5 percent a year over the same time period. According to Jim Collins and others, at least 80 percent of Nucor’s success had to do with the leadership and culture of the company. At Nucor, executives actually received fewer benefits than regular workers:
All workers were eligible to receive $2,000 per year for each child for up to four years of postsecondary education, while the executives received no such benefit.
Nucor lists all of its employees – more than 9,800 – in its annual report, sorted alphabetically with no distinctions for officer titles.
There are no assigned parking spots and no company cars, boats, or planes.
All employees of the company receive the same insurance coverage and amount of vacation time.
Everybody wears the same green spark-proof jackets and hard hats on the floor (in most integrated mills, different colors designate authority).
Siegel quotes Buffett:
It is the classic example of an incentive program that works. If I were a blue-collar worker, I would like to work for Nucor.
In stark contrast, Bethlehem Steel had executives using the corporate fleet for personal reasons, like taking children to college or weekend vacations. Bethlehem also renovated a country club with corporate funds, at which shower priority was determined by executive rank, notes Siegel.
Siegel concludes his discussion of Southwest Airlines and Nucor (and Wal-Mart):
The success of these firms must make investors stop and think. The best-performing stocks are not in industries that are at the cutting edge of the technological revolution; rather, they are often in industries that are stagnant or in decline. These firms are headed by managements that find and pursue efficiencies and develop competitive niches that enable them to reach commanding positions no matter what industry they are in. Firms with these characteristics, which are often undervalued by the market, are the ones that investors should want to buy.
Another great example of a company implementing a low-cost business strategy is 3G Capital, a Brazilian investment firm. (3G was founded in 2004 by Jorge Paulo Lemann, Carlos Alberto Sicupira, and Marcel Herrmann Telles.) 3G is best known for partnering with Buffett’s Berkshire Hathaway for its acquisitions, including Burger King, Tim Hortons, and Kraft Foods. When 3G acquires a company, they typically implement deep cost cuts.
REINVESTED DIVIDENDS: THE BEAR MARKET PROTECTOR AND RETURN ACCELERATOR
Siegel explains what can happen to a dividend-paying stock during a bear market: If the stock price falls more than the dividend, then the higher dividend yield can then be used to reinvest, leading to a higher share count than otherwise. The Great Depression led to a 25-year period – October 1929 to November 1954 – during which stocks plunged and then took a long time to recover. Most investors did not do well, often because they could not or did not hold on to their shares. But investors with dividend-paying stocks who reinvested those dividends did quite well, as Siegel notes:
Instead of just getting back to even in November 1954, stockholders who reinvested their dividends (indicated as ‘total return’) realized an annual rate of return of 6 percent per year, far outstripping those who invested in either long- or short-term government bonds. In fact, $1,000 invested in stocks at the market peak turned into $4,440 when the Dow finally recovered to its old high on that November day a quarter century later. Although the price appreciation was zero, the $4,400 that resulted solely from reinvesting dividends was almost twice the accumulation in bonds and four times the accumulation in short-term treasury bills.
Siegel concludes:
There is an important lesson to be taken from this analysis. Market cycles, although difficult on investors’ psyches, generate wealth for long-term stockholders. These gains come not through timing the market but through the reinvestment of dividends.
Bear markets are not only painful episodes that investors must endure; they are also an integral reason why investors who reinvest dividends experience sharply higher returns. Stock returns are generated not by earnings and dividends alone but by the prices that investors pay for these cash flows. When pessimism grips shareholders, those who stay with dividend-paying stocks are the big winners.
The same logic applies to individual stocks. If a company is a long-term survivor (or leader), then short-term bad news causing the stock to drop will enhance your long-term returns if you’re reinvesting dividends. This is also true if you’re dollar-cost averaging.
In theory, share repurchases when the stock is low can work even better than dividends because share repurchases create tax-deferred gains. In practice, Siegel observes, management is often not as committed to a policy of share repurchases as it is to paying dividends. Once a dividend is being paid, the market usually views a reduced dividend unfavorably. Also, shareholders can track dividends more easily than share repurchases. In sum, when a stock is low, it is usually better for shareholders if they can reinvest dividends instead of relying on management to repurchase shares.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: jb@boolefund.com
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.
Ian Cassell and Sean Iddings are successful microcap investors who co-authored the book, Intelligent Fanatics Project: How Great Leaders Build Sustainable Businesses (Iddings Cassel Publishing, 2016). Ian Cassell is the founder of www.MicroCapClub.com.
If a microcap company is led by an intelligent fanatic, then it has a good chance of becoming a much larger company over time. So, for a long-term investor, it makes sense to look for an intelligent fanatic who is currently leading a microcap company. Cassel:
I want to find Reed Hastings in 2002, when Netflix (NFLX) was a $150 million market cap microcap (now worth $38 billion). I want to find Bruce Cozadd in 2009, when Jazz Pharmaceuticals (JAZZ) was a $50 million market cap microcap (now worth $9 billion).
All great companies started as small companies, and intelligent fanatics founded most great companies. So how do we find these rare intelligent fanatics early? We find them by studying known intelligent fanatics and their businesses. We look for common elements and themes, to help us in our search for the next intelligent fanatic-led business.
The term intelligent fanatic is originally from Charlie Munger. Cassel defines the term:
CEO or management team with large ideas and fanatical drive to build their moat. Willing and able to think and act unconventionally. A learning machine that adapts to constant change. Focused on acquiring the best talent. Able to create a sustainable corporate culture and incentivize their operations for continual progress. Their time horizon is in five- or ten-year increments, not quarterly, and they invest in their business accordingly. Regardless of the industry, they are able to create a moat [– i.e., a sustainable competitive advantage].
Cassel and Iddings give eight examples of intelligent fanatics:
Father of Sales and Innovation: John H. Patterson–National Cash Register
Retail Maverick: Simon Marks–Marks & Spencer
Original Warehouse Pioneer: Sol Price–Fedmart and Price Club
King of Clever Systems: Les Schwab–Les Schwab Tire Centers
Low-Cost Airline Wizard: Herb Kelleher–Southwest Airlines
Cult of Convenience: Chester Cadieux–QuikTrip
Leader of Steel: Kenneth Iverson–Nucor
Human Capital Allocators: 3G Partners–Garantia…
Cassel and Iddings conclude by summarizing the intelligent fanatic model.
FATHER OF SALES AND INNOVATION: JOHN H. PATTERSON
Patterson purchased control of National Manufacturing Company, the originator of the cash register, in 1885, five years after the company had been formed. Prospects did not appear good at all:
Everything was against a business selling cash registers at that time. There was virtually no demand for cash registers. Store owners could not justify the cost of the machine, which in today’s dollars would be roughly $1,000. Patterson’s peers mocked his purchase of such a poor business, yet Patterson had a bold vision of what the cash register market could be, and he knew it would make a significant impact.
Patterson had had a great experience with the cash register. His store in Coalton, Ohio, had immediately turned losses into profits simply by buying and installing a cash register. It is hard to imagine now but employee theft at retail operations was common, given the primitive form of record keeping in those days. Patterson knew the power of the cash register and needed to help merchants understand its value, too.
Patterson believed in staying ahead of what the current market was demanding:
We have made a policy to be just a short distance ahead, for the cash register has always had to make its market. We had to educate our first customers; we have to educate our present-day customer; and our thought has always been to keep just so far ahead that education of the buyer will always be necessary. Thus the market will be peculiarly our own–our customers will feel that we are their natural teachers and leaders.
…We are always working far ahead. If the suggestions at the tryout demonstrate that the model will be much more valuable with changes or improvements, then send them out again to be tried. And we keep up this process until every mechanical defect has been overcome and the model includes every feasible suggestion.
Few people at the time believed that the cash register would be widely adopted. But Patterson predicted at least one cash register for every four hundred citizens in a town. He was basically right.
Patterson started out working at the store on the family farm. He was frustrated by the poor recordkeeping. The employee books never reconciled.
Patterson then got a job as a toll collector at the Dayton office on the Miami and Erie Canal. There were always arguments, with the bargemen complaining about higher tolls at certain locations. Patterson solved the issue by developing a system of receipts, all of which would be sent to toll headquarters.
Patterson had extra time as a toll collector, so he started selling coal and wood out of his office. He learned that he could differentiate himself by selling quality coal delivered on time and in the right quantity. He also used the best horses, the best scales, and the best carts. He made sure everything was quality and high-class. His main challenge was that he never seemed to have enough cash since he was always reinvesting in the business, including advertising.
Eventually Patterson and his brother owned three coal mines, a store, and a chain of retail coal yards. He had trouble with his mine store in Coalton, Ohio. Revenues were high, but there were no profits and debt was growing. He discovered that some clerks were only charging for half the coal. Patterson bought two cash registers and hired new clerks. Six months later, the debt was almost zero and there were profits.
Patterson then entered a venture to take one-third of the profits for operating the Southern Coal and Iron Company. Unfortunately, this proved to be a disaster. Patterson lost three years of his life and half his investment.
Meanwhile, Patterson had purchased stock in the cash register manufacturer National Manufacturing Company. Patterson was also on the board of the company. Patterson came up with a plan to increase sales, but the controlling shareholder and CEO, George Phillips, did not agree. Patterson sold most of his stock.
But Patterson still believed in the idea of the cash register. He was able to buy shares in National Manufacturing Company from George Phillips. Patterson became the butt of Dayton jokes for buying such a bad business. Patterson even tried to give his shares back to Phillips, but Phillips wouldn’t take them even as a gift. So Patterson formed the National Cash Register Company.
Patterson started advertising directly to prospects through the mail. He then sent highly qualified salesmen to those same prospects. Patterson decided to pay his salesmen solely on commission and with no cap on how much they could make. This was unconventional at the time, but it created effective incentives. Patterson also bought expensive clothes for his salesmen, and at least one fine gown for the salesman’s wife. As a result, the salesmen became high-quality and they also wanted a better standard of living.
Moreover, Patterson systematized the sales pitches of his salesmen. This meant even salesmen with average ability could and did evolve into great salesmen. Patterson also designated specific territories for the salesmen so that the salesmen wouldn’t be competing against one another.
Patterson made sure that salesmen and also manufacturing workers were treated well. When he built new factories, he put in wall-to-wall glass windows, good ventilation systems, and dining rooms where employees could get decent meals at or below cost. Patterson also made sure his workers had the best tools. These were unusual innovations at the time.
Patterson also instituted a profit-sharing plan for all employees.
National Cash Register now had every worker aligned with common goals: to increase efficiency, cut costs, and improve profitability.
Patterson was always deeply involved in the research and development of the cash register. He often made sketches of new ideas in a memo book. He got a few of these ideas patented.
NCR’s corporate culture and strategies were so powerful that John H. Patterson produced more successful businessmen than the best university business departments of the day. More than a dozen NCR alumni went on to head large corporations, and many more went on to hold high corporate positions.
Cassel and Iddings sum it up:
Patterson was a perpetual beginner. He bought NCR without knowing much of anything about manufacturing – except that he wanted to improve every business owner’s operations. From his experiences, he took what he knew to be right and paid no attention to convention. John Patterson not only experimented with improving the cash register machine but also believed in treating employees extremely well. Many corporations see their employees as an expense line item; intelligent fanatics see employees as a valuable asset.
When things failed or facts changed, Patterson showed an ability to pivot…
…He was able to get every one of his workers to think like owners, through his profit-sharing plan. Patterson was always looking to improve production, so he made sure that every employee had a voice in improving the manufacturing operations.
RETAIL MAVERICK: SIMON MARKS
Marks & Spencer was started by Michael Marks as a small outdoor stall in Leeds. By 1923, when Michael’s son Simon was in charge, the company had grown significantly. But Simon Marks was worried that efficient American competitors were going to wage price wars and win.
So Marks went to the U.S. to study his competitors. (Walmart founder Sam Walton would do this four decades later.) When Marks returned to Britain, he delivered a comprehensive report to his board:
I learned the value of more commodious and imposing premises. I learned the value of checking lists to control stocks and sales. I learned that new accounting machines could help to reduce the time formidably, to give the necessary information in hours instead of weeks. I learned the value of counter footage and how in the chain store operation each foot of counter space had to pay wages, rent, overhead expenses, and profit. There could be no blind spots insofar as goods are concerned. This meant a much more exhaustive study of the goods we were selling and the needs of the public. It meant that the staff who were operating with me had to be reeducated and retrained.
Cassel and Iddings:
…Simon Marks had been left a company with a deteriorating moat and a growing list of competitors. He had the prescience and boldness to take a comfortable situation, a profitable, growing Marks & Spencer, and to take risks to build a long-term competitive edge. From that point on, it could have been observed that Simon Marks had only one task – to widen Marks & Spencer’s moat every day for the rest of his life and to provide investors with uncommon profits.
Simon Marks convinced manufacturers that the retailer and manufacturer, by working together without the wholesale middleman, could sell at lower prices. Marks made sure to maintain the highest quality at the lowest prices, making up for low profit margins with high volume.
Simon Marks was rare. He was able to combine an appreciation for science and technology with an industry that had never cared to utilize it, all the while maintaining ‘a continuing regard for the individual, either as a customer or employee, and with a deep responsibility for his welfare and well-being.’ Marks & Spencer’s tradition of treating employees well stretched all the way back to Michael Marks’s Penny Bazaars in the covered stalls of Northern England… To Simon Marks, a happy and contented staff was the most valuable asset of any business.
Simon Marks established many policies to better Marks & Spencer’s labor relations, leading to increased employee efficiency and productivity…
Marks introduced dining rooms to provide free or low-cost meals to employees of stores. Marks even put hair salons in stores so the female workforce could get their hair done during lunch. He also provided free or reduced-cost health insurance. Finally, he set up the Marks & Spencer Benevolent Trust to provide for the retirement of employees. These moves were ahead of their time and led to low employee turnover and high employee satisfaction.
ORIGINAL WAREHOUSE PIONEER: SOL PRICE
Sol Price founded Price Club in 1976. The company lost $750,000 during its first year. But by 1979, revenues reached $63 million, with $1.1 million in after-tax profits.
The strategy was to sell a limited number of items – 1,500 to 5,000 items versus 20,000+ offered by discounters – at a small markup from wholesale, to a small group of members (government workers and credit union customers).
Before founding Price Club, Sol Price founded and built FedMart from one location in 1954 into a company with $361 million in revenue by 1975.
…Thus, when Sol Price founded Price Club, other savvy retailers, familiar with this track record, were quick to pay close attention. These retailers made it their obligation to meet Price, to learn as much as possible, and to clone Price’s concept. They knew that the market opportunity was large and that Sol Price was an intelligent fanatic with a great idea. An astute investor could have done the same and partnered with Price early in 1980 by buying Price Club stock.
One savvy retailer who found Sol Price early in the development of Price Club was Bernard Marcus, cofounder of Home Depot. After getting fired from the home improvement company Handy Dan, Marcus met with Price, in the late 1970s. Marcus was looking for some advice from Price about a potential legal battle with his former employer. Sol Price had a similar situation at FedMart. He told Marcus to forget about a protracted legal battle and to start his own business.
Marcus borrowed many ideas from Price Club when he cofounded Home Depot. Later, Sam Walton copied as much as he could from Price Club when he founded Walmart. Walton:
I guess I’ve stolen – I actually prefer the word borrowed – as many ideas from Sol Price as from anyone else in the business.
Bernie Brotman tried to set up a deal to franchise Price Clubs in the Pacific Northwest. But Sol Price and his son, Richard Price, were reluctant to franchise Price Club. Brotman’s son, Jeff Brotman, convinced Jim Sinegal, a long-time Price Club employee, to join him and start Costco, in 1983.
Brotman and Sinegal cloned Price Club’s business model and, in running Costco, copied many of Sol Price’s strategies. A decade later, Price Club merged with Costco, and many Price Club stores are still in operation today under the Costco name.
Back in 1936, Sol Price graduated with a bachelor’s degree in philosophy. He got his law degree in 1938. Sol Price worked for Weinberger and Miller, a local law firm in San Diego. He represented many small business owners and learned a great deal about business.
Thirteen years later, Price founded FedMart after noticing a nonprofit company, Fedco, doing huge volumes. Price set up FedMart as a nonprofit, but created a separate for-profit company, Loma Supply, to manage the stores. Basically, everything was marked up 5% from cost, which was the profit Loma Supply got.
FedMart simply put items on the shelves and let the customers pick out what they wanted. This was unusual at the time, but it helped FedMart minimize costs and thus offer cheaper prices for many items.
By 1959, FedMart had grown to five stores and had $46.3 million in revenue and nearly $500,000 in profits. FedMart went public that year and raised nearly $2 million for expansion.
In 1962, Sam Walton had opened the first Walmart, John Geisse had opened the first Target, and Harry Cunningham had opened the first Kmart, all with slight variations on Sol Price’s FedMart business model.
By the early 1970s, Sol Price wasn’t enjoying managing FedMart as much. He remarked that they were good at founding the business, but not running it.
While traveling in Europe with his wife, Sol Price was carefully observing the operations of different European retailers. In particular, he noticed a hypermarket retailer in Germany named Wertkauf, run by Hugo Mann. Price sought to do a deal with Hugo Mann as a qualified partner. But Mann saw it as a way to buy FedMart. After Mann owned 64% of FedMart, Sol Price was fired from the company he built. But Price didn’t let that discourage him.
Like other intelligent fanatics, Sol Price did not sit around and mourn his defeat. At the age of 60, he formed his next venture less than a month after getting fired from FedMart. The Price Company was the name of this venture, and even though Sol Price had yet to figure out a business plan, he was ready for the next phase of his career.
…What the Prices [Sol and his son, Robert] ended up with was a business model similar to some of the concepts Sol had observed in Europe. The new venture would become a wholesale business selling merchandise to other businesses, with a membership system similar to that of the original FedMart but closer to the ‘passport’ system used by Makro, in the Netherlands, in a warehouse setting. The business would attract members with its extremely low prices.
During the first 45 days, the company lost $420,000.
Instead of doing nothing or admitting defeat, however, Sol Price figured out the problem and quickly pivoted.
Price Club had incorrectly assumed that variety and hardware stores would be large customers and that the location would be ideal for business customers. A purchasing manager, however, raised the idea of allowing members of the San Diego City Credit Union to shop at Price Club. After finding out that Price Club could operate as a retail shop, in addition to selling to businesses, the company allowed credit union members to shop at Price Club. The nonbusiness customers did not pay the $25 annual business membership fee but got a paper membership pass and paid an additional 5% on all goods. Business members paid the wholesale price. The idea worked and sales turned around, from $47,000 per week at the end of August to $151,000 for the week of November 21. The Price Club concept was now proven.
Sol Price’s idea was to have the smallest markup from cost possible and to make money on volume. This was unconventional.
Price also sought to treat his employees well, giving them the best wages and providing the best working environment. By treating employees well, he created happy employees who in turn treated customers well.
Instead of selling hundreds of thousands of different items, Sol Price thought that focusing on only a few thousand items would lead to greater efficiency and lower costs. Also, Price was able to buy in larger quantities, which helped. This approach gave customers the best deal. Customers would typically buy a larger quantity of each good, but would generally save over time by paying a lower price per unit of volume.
Sol Price also saved money by not advertising. Because his customers were happy, he relied on unsolicited testimonials for advertising. (Costco, in turn, has not only benefitted from unsolicited testimonials, but also from unsolicited media coverage.)
Jim Sinegal commented:
The thing that was most remarkable about Sol was not just that he knew what was right. Most people know the right thing to do. But he was able to be creative and had the courage to do what was right in the face of a lot of opposition. It’s not easy to stick to your guns when you have a lot of investors saying that you’re not charging customers enough and you’re paying employees too much.
Over a thirty-eight year period, including FedMart and then Price Club until the Costco merger in 1993, Sol Price generated roughly a 40% CAGR in shareholder value.
KING OF CLEVER SYSTEMS: LES SCHWAB
Les Schwab knew how to motivate his people through clever systems and incentives. Schwab realized that allowing his employees to become highly successful would help make Les Schwab Tire Centers successful.
Schwab split his profits with his first employees, fifty-fifty, which was unconventional in the 1950s. Schwab would reinvest his portion back into the business. Even early on, Schwab was already thinking about massive future growth.
As stores grew and turned into what Schwab called ‘supermarket’ tire centers, the number of employees needed to manage the operations increased, from a manager with a few helpers to six or seven individuals. Schwab, understanding the power of incentives, asked managers to appoint their best worker as an assistant manager and give him 10% of the store’s profits. Schwab and the manager each would give up 5%.
…Les Schwab was never satisfied with his systems, especially the employee incentives, and always strove to develop better programs.
…Early on, it was apparent that Les Schwab’s motivation was not to get rich but to provide opportunities for young people to become successful, as he had done in the beginning. This remained his goal for decades. Specifically, his goal was to share the wealth. The company essentially has operated with no employees, only partners. Even the hourly workers were treated like partners.
When Schwab was around fifteen years old, he lost his mother to pneumonia and then his father to alcohol. Schwab started selling newspapers. Later as a circulation manager, he devised a clever incentive scheme for the deliverers. Schwab always wanted to help others succeed, which in turn would help the business succeed.
The desire to help others succeed can be a powerful force. Les Schwab was a master at creating an atmosphere for others to succeed through clever programs. Les always told his manager to make all their people successful, because he believed that the way a company treated employees would directly affect how employees would treat the customer. Schwab also believed that the more he shared with employees, the more the business would succeed, and the more resources that would eventually be available to give others opportunities to become successful. In effect, he was compounding his giving through expansion of the business, which was funded from half of his profits.
Once in these programs, it would be hard for employees and the company as a whole not to become successful, because the incentives were so powerful. Schwab’s incentive system evolved as the business grew, and unlike most companies, those systems evolved for the better as he continued giving half his profits to employees.
Like other intelligent fanatics, Schwab believed in running a decentralized business. This required good communication and ongoing education.
LOW-COST AIRLINE WIZARD: HERB KELLEHER
The airline industry has been perhaps the worst industry ever. Since deregulation in 1978, the U.S. airline industry alone has lost $60 billion.
Southwest Airlines is nearing its forty-third consecutive year of profitability. That means it has made a profit nearly every year of its corporate life, minus the first fifteen months of start-up losses. Given such an incredible track record in a horrible industry, luck cannot be the only factor. There had to be at least one intelligent fanatic behind its success.
…In 1973, the upstart Texas airline, Southwest Airlines, with only three airplanes, turned the corner and reached profitability. This was a significant achievement, considering that the company had to overcome three and a half years of legal hurdles by two entrenched and better-financed competitors: Braniff International Airways had sixty-nine aircraft and $256 million in revenues, and Texas International had forty-five aircraft with $32 million in revenues by 1973.
As a young man, Herb ended up living with his mother after his older siblings moved out and his father passed away. Kelleher says he learned about how to treat people from his mother:
She used to sit up talking to me till three, four in the morning. She talked a lot about how you should treat people with respect. She said that positions and titles signify absolutely nothing. They’re just adornments; they don’t represent the substance of anybody… She taught me that every person and every job is worth as much as any other person or any other job.
Kelleher ended up applying these lessons at Southwest Airlines. The idea of treating employees well and customers well was central.
Kelleher did not graduate with a degree in business, but with a bachelor’s degree in English and philosophy. He was thinking of becoming a journalist. He ended up becoming a lawyer, which helped him get into business later.
When Southwest was ready to enter the market in Texas as a discount airline, its competitors were worried.
With their large resources, competitors did everything in their power to prevent Southwest from getting off the ground, and they were successful in temporarily delaying Southwest’s first flight. The incumbents filed a temporary restraining order that prohibited the aeronautics commission from issuing Southwest a certificate to fly. The case went to trial in the Austin state court, which did not support another carrier entering the market.
Southwest proceeded to appeal the lower court decision that the market could not support another carrier. The intermediate appellate court sided with the lower court and upheld the ruling. In the meantime, Southwest had yet to make a single dollar in revenues and had already spent a vast majority of the money it had raised.
The board was understandably frustrated. At this point, Kelleher said he would represent the company one last time and pay every cent of legal fees out of his own pocket. Kelleher convinced the supreme court to rule in Southwest’s favor. Meanwhile, Southwest hired Lamar Muse as CEO, who was an experienced, iconoclastic entrepreneur with an extensive network of contacts.
Herb Kelleher was appointed CEO in 1982 and ran Southwest until 2001. He led Southwest from $270 million to $5.7 billion in revenues, every year being profitable. This is a significant feat, and no other airline has been able to match that kind of record in the United States. No one could match the iron discipline that Herb Kelleher instilled in Southwest Airlines from the first day and maintained so steadfastly through the years.
Before deregulation, flying was expensive. Herb Kelleher had the idea of offering lower fares. To achieve this, Southwest did four things.
First, they operated out of less-costly and less-congested airports. Smaller airports are usually closer to downtown locations, which appealed to businesspeople.
Second, Southwest only operated the Boeing 737. This gave the company bargaining power in new airplane purchases and the ability to make suggestions in the manufacture of those plans to improve efficiency. Also, operating costs were lower because everyone only had to learn to operate one type of plane.
Third, Southwest reduced the amount of time planes were on the ground to 10 minutes (from 45 minutes to an hour).
Fourth, Southwest treats employees well and is thus able to retain qualified, hardworking employees. This cuts down on turnover costs.
Kelleher built an egalitarian culture at Southwest where each person is treated like everyone else. Also, Southwest was the first airline to share profits with employees. This makes employees think and act like owners. As well, employees are given autonomy to make their own decisions, as an owner would. Not every decision will be perfect, but inevitable mistakes are used as learning experiences.
Kelleher focused the company on being entrepreneurial even as the company grew. But simplifying did not include eliminating employees.
Southwest Airlines is the only airline – and one of the few corporations in any industry – that has been able to run for decades without ever imposing a furlough. Cost reductions are found elsewhere, and that has promoted a healthy morale within the Southwest Airlines corporate culture. Employees have job security. A happy, well-trained labor force that only needs to be trained on one aircraft promotes more-efficient and safer flights. Southwest is the only airline that has a nearly perfect safety record.
Kelleher once told the following story:
What I remember is a story about Thomas Watson. This is what we have followed at Southwest Airlines. A vice president of IBM came in and said, ‘Mr. Watson, I’ve got a tremendous idea…. And I want to set up this little division to work on it. And I need ten million dollars to get it started.’ Well, it turned out to be a total failure. And the guy came back to Mr. Watson and he said that this was the original proposal, it cost ten million, and that it was a failure. ‘Here is my letter of resignation.’ Mr. Watson said, ‘Hell, no! I just spent ten million on your education. I ain’t gonna let you leave.’ That is what we do at Southwest Airlines.
One example is Matt Buckley, a manager of cargo in 1985. He thought of a service to compete with Federal Express. Southwest let him try it. But it turned out to be a mistake. Buckley:
Despite my overpromising and underproducing, people showed support and continued to reiterate, ‘It’s okay to make mistakes; that’s how you learn.’ In most companies, I’d probably have been fired, written off, and sent out to pasture.
Kelleher believed that any worthwhile endeavor entails some risk. You have to experiment and then adjust quickly when you learn what works and what doesn’t.
Kelleher also created a culture of clear communication with employees, so that employees would understand in more depth how to minimize costs and why it was essential.
Communication with employees at Southwest is not much different from the clear communication Warren Buffett has had with shareholders and with his owned operations, through Berkshire Hathaway’s annual shareholder letters. Intelligent fanatics are teachers to every stakeholder.
CULT OF CONVENIENCE: CHESTER CADIEUX
Warren Buffett:
Back when I had 10,000 bucks, I put 2,000 of it into a Sinclair service station, which I lost, so my opportunity cost on it’s about 6 billion right now. A fairly big mistake – it makes me feel good when Berkshire goes down, because the cost of my Sinclair station goes down too.
Chester Cadieux ran into an acquaintance from school, Burt B. Holmes, who was setting up a bantam store – an early version of a convenience store. Cadieux invested $5,000 out of the total $15,000.
At the time, in 1958, there were three thousand bantam stores open. They were open longer hours than supermarkets, which led customers to be willing to pay higher prices.
Cadieux’s competitive advantage over larger rivals was his focus on employees and innovation. Both characteristics were rooted in Chester’s personal values and were apparent early in QuikTrip’s history. He would spend a large part of his time – roughly two months out of the year – in direction communication with QuikTrip employees. Chester said, ‘Without fail, each year we learned something important from a question or comment voiced by a single employee.’ Even today, QuikTrip’s current CEO and son of Chester Cadieux, Chet Cadieux, continues to spend four months of his year meeting with employees.
Cassel and Iddings:
Treat employees well and incentivize them properly, and employees will provide exceptional service to the customers. Amazing customer service leads to customer loyalty, and this is hard to replicate, especially by competitors who don’t value their employees. Exceptional employees and a quality corporate culture have allowed QuikTrip to stay ahead of competition from convenience stores, gas retailers, quick service restaurants, cafes, and hypermarkets.
Other smart convenience store operators have borrowed many ideas from Chester Cadieux. Sheetz, Inc. and Wawa, Inc. – both convenience store chains headquartered in Pennsylvania – have followed many of Cadieux’s ideas. Cadieux, in turn, has also picked up a few ideas from Sheetz and Wawa.
Sheetz, Wawa, and QuikTrip all have similar characteristics, which can be traced back to Chester Cadieux and his leadership values at QuikTrip. When three stores in the same industry, separated only by geography, utilize the same strategies, have similar core values, and achieve similar success, then there must be something to their business models. All could have been identified early, when their companies were much smaller, with qualitative due diligence.
One experience that shaped Chester Cadieux was when he was promoted to first lieutenant at age twenty-four. He was the senior intercept controller at his radar site, and he had to lead a team of 180 personnel:
…he had to deal with older, battle-hardened sergeants who did not like getting suggestions from inexperienced lieutenants. Chester said he learned ‘how to circumvent the people who liked to be difficult and, more importantly, that the number of stripes on someone’s sleeves was irrelevant.’ The whole air force experience taught him how to deal with people, as well as the importance of getting the right people on his team and keeping them.
When Cadieux partnered with Burt Holmes on their first QuikTrip convenience store, it seemed that everything went wrong. They hadn’t researched what the most attractive location would be. And Cadieux stocked the store like a supermarket. Cadieux and Holmes were slow to realize that they should have gone to Dallas and learned all they could about 7-Eleven.
QuikTrip was on the edge of bankruptcy during the first two or three years. Then the company had a lucky break when an experienced convenience store manager, Billy Neale, asked to work for QuikTrip. Cadieux:
You don’t know what you don’t know. And when you figure it out, you’d better sprint to fix it, because your competitors will make it as difficult as possible in more ways than you could ever have imagined.
Cadieux was smart enough to realize that QuikTrip survived partly by luck. But he was a learning machine, always learning as much as possible. One idea Cadieux picked up was to sell gasoline. He waited nine years until QuikTrip had the financial resources to do it. Cadieux demonstrated that he was truly thinking longer term.
QuikTrip has always adapted to the changing needs of its customers, demographics, and traffic patterns, and has constantly looked to stay ahead of competition. This meant that QuikTrip has had to reinvest large sums of capital into store updates, store closures, and new construction. From QuikTrip’s inception, in 1958, to 2008, the company closed 418 stores; in 2008, QuikTrip had only five hundred stores in operation.
QuikTrip shows its long-term focus by its hiring process. Cadieux:
Leaders are not necessarily born with the highest IQs, or the most drive to succeed, or the greatest people skills. Instead, the best leaders are adaptive – they understand the necessity of pulling bright, energetic people into their world and tapping their determination and drive. True leaders never feel comfortable staying in the same course for too long or following conventional wisdom – they inherently understand the importance of constantly breaking out of routines in order to recognize the changing needs of their customers and employees.
QuikTrip interviews about three out of every one hundred applicants and then chooses one from among those three. Only 70% of new hires make it out of training, and only 50% of those remaining make it past the first 6 months on the job. But QuikTrip’s turnover rate is roughly 13% compared to the industry average of 59%. These new hires are paid $50,000 a year. And QuikTrip offers a generous stock ownership plan. Employees also get medical benefits and a large amount of time off.
Cadieux’s main goal was to make employees successful, thereby making customers and eventually shareholders happy.
LEADER OF STEEL: F. KENNETH IVERSON
Ken Iverson blazed a new trail in steel production with the mini mill, thin-slab casting, and other innovations. He also treated his employees like partners. Both of these approaches were too unconventional and unusual for the old, slow-moving, integrated steel mills to compete with. Ken Iverson harnessed the superpower of incentives and effective corporate culture. He understood how to manage people and had a clear goal.
In its annual report in 1975, Nucor had all of its employees listed on the front cover, which showed who ran the company. Every annual report since then has listed all employees on the cover. Iverson:
I have no desire to be perfect. In fact, none of the people I’ve seen do impressive things in life are perfect… They experiment. And they often fail. But they gain something significant from every failure.
Iverson studied aeronautical engineering at Cornell through the V-12 Navy College Training Program. Iverson spent time in the Navy, and then earned a master’s degree in mechanical engineering from Purdue University. Next he worked as an assistant to the chief research physicist at International Harvester.
Iverson’s supervisor told him you can achieve more at a small company. So Iverson started working as the chief engineer at a small company called Illium Corp. Taking chances was encouraged. Iverson built a pipe machine for $5,000 and it worked, which saved the company $245,000.
Iverson had a few other jobs. He helped Nuclear Corporation of America find a good acquisition – Vulcraft Corporation. After the acquisition, Vulcraft made Iverson vice president. The company tripled its sales and profits over the ensuing three years, while the rest of Nuclear was on the verge of bankruptcy. When Nuclear’s president resigned, Iverson became president of Nuclear.
Nuclear Corporation changed its name to Nucor. Iverson cut costs. Although few could have predicted it, Nucor was about to take over the steel industry. Iverson:
At minimum, pay systems should drive specific behaviors that make your business competitive. So much of what other businesses admire in Nucor – our teamwork, extraordinary productivity, low costs, applied innovation, high morale, low turnover – is rooted in how we pay our people. More than that, our pay and benefit programs tie each employee’s fate to the fate of our business. What’s good for the company is good – in hard dollar terms – for the employee.
The basic incentive structure had already been in place at Vulcraft. Iverson had the sense not to change it, but rather to improve it constantly. Iverson:
As I remember it, the first time a production bonus was over one hundred percent, I thought that I had created a monster. In a lot of companies, I imagine many of the managers would have said, ‘Whoops, we didn’t set that up right. We’d better change it.’ Not us. We’ve modified it some over the years. But we’ve stayed with that basic concept ever since.
Nucor paid its employees much more than what competitors paid. But Nucor’s employees produced much, much more. As a result, net costs were lower for Nucor. In 1996, Nucor’s total cost was less than $40 per ton of steel produced versus at least $80 per ton of steel produced for large integrated U.S. steel producers.
Nucor workers were paid a lower base salary – 65% to 70% of the average – but had opportunities to get large bonuses if they produced a great deal.
Officer bonuses (8% to 24%) were tied to the return on equity.
Nonproduction headquarter staff, engineers, secretaries, and so on, as well as department managers, could earn 25% to 82% of base pay based on their division’s return on assets employed. So, if a division did not meet required returns, those employees received nothing, but they received a significant amount if they did. There were a few years when all employees received no bonuses and a few years when employees maxed out their bonuses.
An egalitarian incentive structure leads all employees to feel equal, regardless of base pay grade or the layer of management an employee is part of. Maintenance workers want producers to be successful and vice versa.
All production workers, including managers, wear hard hats of the same color. Everyone is made to feel they are working for the common cause. Nucor has only had one year of losses, in 2009, over a fifty-year period. This is extraordinary for the highly cyclical steel industry.
Iverson, like Herb Kelleher, believed that experimentation – trial and error – was essential to continued innovation. Iverson:
About fifty percent of the things we try really do not work out, but you can’t move ahead and develop new technology and develop a business unless you are willing to take risks and adopt technologies as they occur.
HUMAN CAPITAL ALLOCATORS: 3G PARTNERS
3G Partners refers to the team of Jorge Paulo Lemann, Carlos Alberto “Beto” Sicupira, and Marcel Hermann Telles. They have developed the ability to buy underperforming companies and dramatically improve productivity.
When the 3G partners took control of Brahma, buying a 40% stake in 1989, it was the number two beer company in Brazil and was quickly losing ground to number one, Antarctica. The previously complacent management and company culture generated low productivity – approximately 1,200 hectoliters of beverage produced per employee. There was little emphasis on profitability or achieving more efficient operations. During Marcel Telles’s tenure, productivity per employee multiplied seven times, to 8,700 hectoliters per employee. Efficiency and profitability were top priorities of the 3G partners, and the business eventually held the title of the most efficient and profitable brewer in the world. Through efficiency of operations and a focus on profitability, Brahma maintained a 20% return on capital, a 32% compound annual growth rate in pretax earnings, and a 17% CAGR in revenues over the decade from 1990 to 1999… Shareholder value creation stood at an astounding 42% CAGR over that period.
…Subsequent shareholder returns generated at what eventually became Anheuser-Busch InBev (AB InBev) have been spectacular, driven by operational excellence.
Jorge Paulo Lemann – who, like Sicupira and Telles, was born in Rio de Janeiro – started playing tennis when he was seven. His goal was to become a great tennis player. He was semi-pro for a year after college. Lemann:
In tennis you win and lose. I’ve learned that sometimes you lose. And if you lose, you have to learn from the experience and ask yourself, ‘What did I do wrong? What can I do better? How am I going to win next time?’
Tennis was very important and gave me the discipline to train, practice, and analyze… In tennis you have to take advantage of opportunities.
So my attitude in business was always to make an effort, to train, to be present, to have focus. Occasionally an opportunity passed and you have to grab those opportunities.
In 1967, Lemann started working for Libra, a brokerage. Lemann owned 13% of the company and wanted to create a meritocratic culture. But others disagreed with him.
In 1971, Lemann founded Garantia, a brokerage. He aimed to create a meritocratic culture like the one at Goldman Sachs. Lemann would seek out top talent and then base their compensation on performance. Marcel Telles and Beto Sicupira joined in 1972 and 1973, respectively.
Neither Marcel Telles nor Beto Sicupira started off working in the financial markets or high up at Garantia. Both men started at the absolute bottom of Garantia, just like any other employee…
Jorge Paulo Lemann initially had a 25% interest in Garantia, but over the first seven years increased it to 50%, slowly buying out the other initial investors. However, Lemann also wanted to provide incentives to his best workers, so he began selling his stake to new partners. By the time Garantia was sold, Lemann owned less than 30% of the company.
Garantia transformed itself into an investment bank. It was producing a gusher of cash. The partners decided to invest in underperforming companies and then introduce the successful, meritocratic culture at Garantia. In 1982, they invested in Lojas Americanas.
Buying control of outside businesses gave Lemann the ability to promote his best talent into those businesses. Beto Sicupira was appointed CEO and went about turning the company around. The first and most interesting tactic Beto utilized was to reach out to the best retailers in the United States, sending them all letters and asking to meet them and learn about their companies; neither Beto nor his partners had any retailing experience. Most retailers did not respond to this query, but one person did: Sam Walton of Walmart.
The 3G partners met in person with the intelligent fanatic Sam Walton and learned about his business. Beto was utilizing one of the most important aspects of the 3G management system: benchmarking from the best in the industry. The 3G partners soaked up everything from Walton, and because the young Brazilians were a lot like him, Sam Walton became a mentor and friend to all of them.
In 1989, Lemann noticed an interesting pattern:
I was looking at Latin America and thinking, Who was the richest guy in Venezuela? A brewer (the Mendoza family that owns Polar). The richest guy in Colombia? A brewer (the Santo Domingo Group, the owner of Bavaria). The richest in Argentina? A brewer (the Bembergs, owners of Quilmes). These guys can’t all be geniuses… It’s the business that must be good.
3G always set high goals. When they achieved one ambitious goal, then they would set the next one. They were never satisfied. When 3G took over Brahma, the first goal was to be the best brewer in Brazil. The next goal was to be the best brewer in the world.
3G has always had a truly long-term vision:
Marcel Telles spent considerable time building Brahma, with a longer-term vision. The company spent a decade improving the efficiency of its operations and infusing it with the Garantia culture. When the culture was in place, a large talent pipeline was developed, so that the company could acquire its largest rival, Antarctica. By taking their time in building the culture of the company, management was ensuring that the culture could sustain itself well beyond the 3G partners’ tenure. This long-term vision remains intact and can be observed in a statement from AB InBev’s 2014 annual report: ‘We are driven by our passion to create a company that can stand the test of time and create value for our shareholders, not only for the next ten or twenty years but for the next one hundred years. Our mind-set is truly long term.’
3G’s philosophy of innovation was similar to a venture capitalist approach. Ten people would be given a small amount of capital to try different things. A few months later, two out of ten would have good ideas and so they would get more funding.
Here are the first five commandments (out of eighteen) that Lemann created at Garantia:
A big and challenging dream makes everyone row in the same direction.
A company’s biggest asset is good people working as a team, growing in proportion to their talent, and being recognized for that. Employee compensation has to be aligned with shareholders’ interests.
Profits are what attract investors, people, and opportunities, and keep the wheels spinning.
Focus is of the essence. It’s impossible to be excellent at everything, so concentrate on the few things that really matter.
Everything has to have an owner with authority and accountability. Debate is good, but in the end, someone has to decide.
Garantia had an incentive system similar to that created by other intelligent fanatics. Base salary was below market average. But high goals were set for productivity and costs. And if those goals are achieved, bonuses can amount to many times the base salaries.
The main metric that employees are tested against is economic value added – employee performance in relation to the cost of capital. The company’s goal is to achieve 15% economic value added, so the better the company performs as a whole, the larger is the bonus pool to be divided among employees. And, in a meritocratic culture, the employees with the best results are awarded the highest bonuses.
Top performers also are given a chance to purchase stock in the company at a 10% discount.
The 3G partners believe that a competitive atmosphere in a business attracts high-caliber people who thrive on challenging one another. Carlos Brito said, ‘That’s why it’s important to hire people better than you. They push you to be better.’
Our final advantage is the hard-to-duplicate culture that permeates Berkshire. And in businesses, culture counts.
One study found the following common elements among outperformers:
What elements of those cultures enabled the top companies to adapt and to sustain performance? The common answers were the quality of the leadership, the maintenance of an entrepreneurial environment, prudent risk taking, innovation, flexibility, and open communication throughout the company hierarchy. The top-performing companies maintained a small-company feel and had a long-term horizon. On the other hand, the lower-performing companies were slower to adapt to change. Interviewees described these companies as bureaucratic, with very short-term horizons.
Cassel and Iddings discuss common leadership attributes of intelligent fanatics:
Leading by Example
Intelligent fanatics create a higher cause that all employees have the chance to become invested in, and they provide an environment in which it is natural for employees to become heavily invested in the company’s mission.
…At Southwest, for example, the company created an employee-first and family-like culture where fun, love, humor, and creativity were, and continue to be, core values. Herb Kelleher was the perfect role model for those values. He expressed sincere appreciation for employees and remembered their names, and he showed his humor by dressing up for corporate gatherings and even by settling a dispute with another company through an arm wrestling contest.
Unblemished by Industry Dogma
Industries are full of unwritten truths and established ways of thinking. Industry veterans often get accustomed to a certain way of doing or thinking about things and have trouble approaching problems from a different perspective. This is the consistency and commitment bias Charlie Munger has talked about in his speech ‘The Psychology of Human Misjudgment.’ Succumbing to the old guard prevents growth and innovation.
…All of our intelligent fanatic CEOs were either absolute beginners, with no industry experience, or had minimal experience. Their inexperience allowed them to be open to trying something new, to challenge the old guard. The CEOs developed new ways of operating that established companies could not compete with. Our intelligent fanatics show us that having industry experience can be a detriment.
Teaching by Example
Jim Sinegal learned from Sol Price that ‘if you’re not spending ninety percent of your time teaching, you’re not doing your job.’
Founder Ownership Creates Long-Term Focus
The only way to succeed in dominating a market for decades is to have a long-term focus. Intelligent fanatics have what investor Tom Russo calls the capacity to suffer short-term pain for long-term gain…. As Jeff Bezos put it, ‘If we have a good quarter, it’s because of work we did three, four, five years ago. It’s not because we did a good job this quarter.’ They build the infrastructure to support a larger business, which normally takes significant up-front investment that will lower profitability in the short term.
Keep It Simple
Jorge Paulo Lemann:
All the successful people I ever met were fanatics about focus. Sam Walton, who built Walmart, thought only about stores day and night. He visited store after store. Even Warren Buffett, who today is my partner, is a man super focused on his formula. He acquires different businesses but always within the same formula, and that’s what works. Today our formula is to buy companies with a good name and to come up with our management system. But we can only do this when we have people available to go to the company. We cannot do what the American private equity firms do. They buy any company, send someone there, and constitute a team. We only know how to do this with our team, people within our culture. Then, focus is also essential.
Superpower of Incentives
Intelligent fanatics are able to create systems of financial incentive that attract high-quality talent, and they provide a culture and higher cause that immerses employees in their work. They are able to easily communicate the why and the purpose of the company so that employees themselves can own the vision.
…All of this book’s intelligent fanatic CEOs unleashed their employees’ fullest potential by getting them to think and act as owners. They did this two ways: they provided a financial incentive, aligning employees with the actual owners, and they gave employees intrinsic motivation to think like owners. In every case, CEOs communicated the importance of each and every employee to the organization and provided incentives that were simple to understand.
Experimentation
Intelligent fanatics and their employees are unstoppable in their pursuit of staying ahead of the curve. They test out many ideas, like a scientist experimenting to find the next breakthrough. In the words of the head of Amazon Web Services (AWS), Andy Jassy, ‘We think of (these investments) as planting seeds for very large trees that will be fruitful over time.’
Not every idea will work out as planned. Jeff Bezos, the founder and CEO of Amazon, said, ‘A few big successes compensate for dozens and dozens of things that did not work.’ Bezos has been experimenting for years and often has been unsuccessful…
Productive Paranoia
Jim Collins describes successful leaders as being ‘paranoid, neurotic freaks.’ Although paranoia can be debilitating for most people, intelligent fanatics use their paranoia to prepare for financial or competitive disruptions. They also are able to promote this productive paranoia within their company culture, so the company can maintain itself by innovating and preparing for the worst.
Decentralized Organizations
Intelligent fanatics focus a lot of their mental energy on defeating bureaucracies before they form.
…Intelligent fanatics win against internal bureaucracies by maintaining the leanness that helped their companies succeed in the first place… Southwest was able to operate with 20% fewer employees per aircraft and still be faster than its competitors. It took Nucor significantly few workers to produce a ton of steel, allowing them to significantly undercut their competitors’ prices.
Dominated a Small Market Before Expanding
Intelligent fanatics pull back on the reins in the beginning so they can learn their lessons while they are small. Intelligent fanatic CEOs create a well-oiled machine before pushing the accelerator to the floor.
Courage and Perseverance in the Face of Adversity
Almost all successful people went through incredible hardship, obstacles, and challenges. The power to endure is the winner’s quality. The difference between intelligent fanatics and others is perseverance…
Take, for instance, John Patterson losing more than half his money in the Southern Coal and Iron Company, or Sol Price getting kicked out of FedMart by Hugo Mann. Herb Kelleher had to fight four years of legal battles to get Southwest Airlines’ first plane off the ground. Another intelligent fanatic, Sam Walton, got kicked out of his first highly successful Ben Franklin store due to a small clause in his building’s lease and had to start over. Most people would give up, but intelligent fanatics are different. They have the uncanny ability to quickly pick themselves up from a large mistake and move on. They possess the courage to fight harder than ever before…
CULTURE: THE ONLY TRUE SUSTAINABLE COMPETITIVE ADVANTAGE
Intelligent fanatics demonstrate the qualities all employees should emulate, both within the organization and outside, with customers. This allows employees to do their jobs effectively, by giving them autonomy. All employees have to do is adjust their internal compass to the company’s true north to solve a problem. Customers are happier, employees are happier, and if you make those two groups happy, then shareholders are happier.
…Over time, the best employees rise to the top and can quickly fill the holes left as other employees retire or move on. Employees are made to feel like partners, so the success of the organization is very important to them. Partners are more open to sharing new ideas or to offering criticism, because their net worth is tied to the long-term success of the company.
Companies with a culture of highly talented, driven people continually challenge themselves to offer best-in-class service and products. Great companies are shape-shifters and can maneuver quickly as they grow and as the markets in which they compete change.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: jb@boolefund.com
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.
Howard Marks is one of the great value investors. The Most Important Thing is a book Marks created based on his memos to clients. Marks noticed that in his meetings with clients, he would often say, “The most important thing is X,” and then a bit later say, “The most important thing is Y,” and so on. So the book, The Most Important Thing, has many “most important things,” all of which truly are important according to Marks.
Outstanding books are often worth reading at least four or five times. The Most Important Thing is clearly outstanding, and is filled with investment wisdom. As a result, this blog post is longer than usual. It’s worth spending time to absorb the wisdom of Howard Marks.
INTRODUCTION
Marks writes:
Where does an investment philosophy come from? The one thing I’m sure of is that no one arrives on the doorstep of an investment career with his or her philosophy fully formed. A philosophy has to be the sum of many ideas accumulated over a long period of time from a variety of sources. One cannot develop an effective philosophy without having been exposed to life’s lessons. In my life I’ve been quite fortunate in terms of both rich experiences and powerful lessons.
Marks adds:
Good times teach only bad lessons: that investing is easy, that you know its secrets, and that you needn’t worry about risk. The most valuable lessons are learned in tough times.
SECOND-LEVEL THINKING
Marks first points out how variable the investing landscape is:
No rule always works. The environment isn’t controllable, and circumstances rarely repeat exactly. Psychology plays a major role in markets, and because it’s highly variable, cause-and-effect relationships aren’t reliable.
The goal for an investor is to do better than the market over time. Otherwise, the best option for most investors is simply to buy and hold low-cost broad market index funds. Doing better than the market requires an identifiable edge:
Since other investors may be smart, well-informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess. You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others… which by definition means your thinking has to be different.
Marks gives some examples of second-level thinking:
First-level thinking says, ‘It’s a good company; let’s buy the stock.’ Second-level thinking says, ‘It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.’
First-level thinking says, ‘The outlook calls for low growth and rising inflation. Let’s dump our stocks.’ Second-level thinking says, ‘The outlook stinks, but everyone else is selling in panic. Buy!’
First-level thinking says, ‘I think the company’s earnings will fall; sell.’ Second-level thinking says, ‘I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.’
Marks explains that first-level thinking is generally simplistic. By contrast, second-level thinking requires thinking of the full range of possible future outcomes, along with estimating probabilities for each possible outcome. Second-level thinking means understanding what the consensus thinks, why one has a different view, and the likelihood that one’s contrarian view is correct. Marks observes that second-level thinking is far more difficult than first-level thinking, thus few investors truly engage in second-level thinking. First-level thinkers cannot expect to outperform the market. Marks:
To outperform the average investor, you have to be able to outthink the consensus. Are you capable of doing so? What makes you think so?
Marks again:
The upshot is simple: to achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate. That’s not easy.
UNDERSTANDING MARKET EFFICIENCY
Marks holds a view of market efficiency similar to that of Buffett: The market is usually efficient, but it is far from always efficient. Marks says that the market reflects the consensus view, but the consensus is not always right:
In January 2000, Yahoo sold at $237. In April 2001 it was $11. Anyone who argues that the market was right both times has his or her head in the clouds; it has to have been wrong on at least one of those occasions. But that doesn’t mean many investors were able to detect and act on the market’s error.
Marks summarizes his view:
The bottom line for me is that, although the more efficient markets often misvalue assets, it’s not easy for any one person – working with the same information as everyone else and subject to the same psychological influences – to consistently hold views that are different from the consensus and closer to being correct. That’s what makes the mainstream markets awfully hard to beat – even if they aren’t always right.
Marks makes an important point about riskier investments:
Once in a while we experience periods when everything goes well and riskier investments deliver the higher returns they seem to promise. Those halcyon periods lull people into believing that to get higher returns, all they have to do is make riskier investments. But they ignore something that is easily forgotten in good times: this can’t be true, because if riskier investments could be counted on to produce higher returns, they wouldn’t be riskier.
Marks notes that inefficient prices imply that for each investor who buys at a cheap price, another investor must sell at that cheap price. Inefficiency essentially implies that each investment that beats the market implies another investment that trails the market by an equal amount.
Generally it is exceedingly difficult to beat the market. To highlight this fact, Marks asks a series of questions:
Why should a bargain exist despite the presence of thousands of investors who stand ready and willing to bid up the price of anything that is too cheap?
If the return appears so generous in proportion to the risk, might you be overlooking some hidden risk?
Why would the seller of the asset be willing to part with it at a price from which it will give you an excessive return?
Do you really know more about the asset than the seller does?
If it’s such a great proposition, why hasn’t someone else snapped it up?
Market inefficiency alone, argues Marks, is not a sufficient condition for outperformance:
All that means is that prices aren’t always fair and mistakes are occurring: some assets are priced too low and some too high. You still have to be more insightful than others in order to regularly buy more of the former than the latter. Many of the best bargains at any point in time are found among the things other investors can’t or won’t do.
Marks ends this section by saying that a key turning point in his career was when he concluded that he should focus on relatively inefficient markets. (Note: micro-cap stocks is one area that is relatively inefficient, which is why I created the Boole Microcap Fund.)
A few notes about deep value (contrarian value) investing:
In order to buy a stock that is very cheap in relation to its intrinsic value, some other investor must be willing to sell the stock at such an irrationally low price. Sometimes such sales happen due to forced selling. The rest of the time, the seller must be making a mistake in order for the value investor to make a market-beating investment.
Many deep value approaches are fully quantitative, however. (Deep value is also called contrarian value.) The quantitative deep value investor is not necessarily making an exceedingly detailed judgment on each individual deep value stock – a judgment which would imply that the value investor is correct in this particular case, and that the seller is wrong. Rather, the quantitative deep value investor forms a portfolio of the statistically cheapest 20 or more stocks. All of the studies have shown that a basket of quantitatively cheap stocks does better than the market over time, and is less risky (especially during down markets).
A concentrated deep value approach, by contrast, typically involves the effort to select the most promising and the cheapest stocks available. Warren Buffett and Charlie Munger both followed this approach when they were managing smaller amounts of capital. They would typically have between 3 and 8 positions making up nearly the entire portfolio. (Joel Greenblatt also used this approach when he was managing smaller amounts. Greenblatt produced a ten-year record of 50.0% gross per year using a concentrated value approach focused on special situations. See Greenblatt’s book, You Can Be a Stock Market Genius.)
VALUE
Marks begins by saying that “buy low; sell high” is one of the oldest rules in investing. But since selling will occur in the future, how can one figure out a price today that will be lower than some future price? What’s needed is an ability to accurately assess the intrinsic value of the asset. The intrinsic value of a stock can be derived from the price that an informed buyer would pay for the entire company, based on the net asset value or the earnings power of the company. Writes Marks:
The quest in value investing is for cheapness. Value investors typically look at financial metrics such as earnings, cash flow, dividends, hard assets and enterprise value and emphasize buying cheap on these bases. The primary goal of value investors, then, is to quantify the company’s current value and buy its securities when they can do so cheaply.
Marks also notes that successful value investing requires an estimate of current net asset value, or the current earnings power, that is unrecognized by the consensus. Successful growth investing, by contrast, requires an estimate of future earnings that is higher than what the consensus currently thinks. Often the rewards for successful growth investing are higher, but a successful value investing approach is much more repeatable and achievable.
Buying assets below fair value, however, does not mean those assets will outperform right away. Thus value investing requires having a firmly held view, because quite often after buying, cheap assets will continue to underperform the market. Marks elaborates:
If you liked it at 60, you should like it more at 50… and much more at 40 and 30. But it’s not that easy. No one’s comfortable with losses, and eventually any human will wonder, ‘Maybe it’s not me who’s right. Maybe it’s the market.’…”
Thus, successful value investing requires not only the consistent ability to identify assets available at cheap prices; it also requires the ability to ignore various signals (many of which are subconscious) flashing the message that one is wrong. As Marks writes:
Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out. Thus, there are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that view strongly enough to be able to hang in and buy even as price declines suggest that you’re wrong. Oh yes, there’s a third: you have to be right.
THE RELATIONSHIP BETWEEN PRICE AND VALUE
Many investors make the mistake of thinking that a good company is automatically a good investment, while a bad company is automatically a bad investment. But what really matters for the value investor is the relationship between price and value:
For a value investor, price has to be the starting point. It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheaply enough.
In the 1960’s, there was a group of stocks called the Nifty Fifty – companies that were viewed as being so good that all one had to do was buy at any price and then hold for the long term. But it turned out not to be true for many stocks in the basket. Moreover, the early 1970’s led to huge declines:
Within a few years, those price/earnings ratios of 80 or 90 had fallen to 8 or 9, meaning investors in America’s best companies had lost 90 percent of their money. People may have bought into great companies, but they paid the wrong price.
Marks explains the policy at his firm Oaktree:
‘Well bought is half sold.’
By this we mean we don’t spend a lot of time thinking about what price we’re going to be able to sell a holding for, or to whom, or though what mechanism. If you’ve bought it cheap, eventually those questions will answer themselves. If your estimate of intrinsic value is correct, over time an asset’s price should converge with its value.
Marks, similar to Warren Buffett and Charlie Munger, holds that psychology plays a central role in value investing:
Whereas the key to ascertaining value is skilled financial analysis, the key to understanding the price/value relationship – and the outlook for it – lies largely in insight into other investor’s minds. Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.
The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up.
A successful value investor must build systems or rules for self-protection because all investors – all humans – suffer from psychological biases, which often operate subconsciously. For more on cognitive biases, see the following two blog posts:
Of all the possible routes to investment profit, buying cheap is clearly the most reliable. Even that, however, isn’t sure to work. You can be wrong about the current value. Or events can come along that reduce value. Or deterioration in attitudes or markets can make something sell even further below its value. Or the convergence of price and intrinsic value can take more time than you have…
Trying to buy below value isn’t infallible, but it’s the best chance we have.
UNDERSTANDING RISK
As Buffett frequently observes, the future is always uncertain. Prices far below probable intrinsic value usually only exist when the future is highly uncertain. When there is not much uncertainty, asset prices will be much higher than otherwise. So high uncertainty about the future is the friend of the value investor.
On the other hand, in general, assets that promise higher returns always entail higher risk. If a potentially higher-returning asset was obviously as low risk as a U.S. Treasury, then investors would rush to buy the higher-returning asset, thereby pushing up its price to the point where it would promise returns on par with a U.S. Treasury.
A successful value investor has to determine whether the potential return on an ostensibly cheap asset is worth the risk. High risk is not necessarily bad as long as it is properly controlled and as long as the potential return is high enough. But if the risk is too high, then it’s not the type of repeatable bet that can produce long-term success for a value investor. Repeatedly taking too much risk – by sizing positions too large relative to risk-reward – virtually guarantees long-term failure.
Consider the Kelly criterion. If the probability of success and the returns from a potential investment can be quantified, then the Kelly criterion tells one exactly how much to bet in order to maximize the long-term compound returns from a long series of such bets. Betting any other amount than what the Kelly criterion says will inevitably lead to less than the maximum potential returns. Most importantly, betting more than what the Kelly criterion says guaranteeszero or negative long-term returns. Repeatedly overbetting guarantees long-term failure. For more about the Kelly criterion, see: https://boolefund.com/the-dhandho-investor/
This is why Howard Marks, Warren Buffett, Charlie Munger, and other great value investors often point out that minimizing big mistakes is more important for long-term investing success than hitting home runs. Buffett and Munger apply the same logic to life itself: avoiding big mistakes is more important than trying to hit home runs. Buffett: “You have to do very few things right in life so long as you don’t do too many things wrong.”
Again, Marks points out, while riskier investments promise higher returns, those higher returns are not guaranteed, otherwise riskier investments wouldn’t be riskier! The probability distribution of potential returns is wider for riskier investments, typically including some large potential losses. A certain percentage of future outcomes will be zero or negative for riskier investments.
Marks agrees with Buffett and Munger that the best definition of risk is the potential to experience loss.
Of course, as John Templeton, Ray Dalio, and other great investors observe, even the best investors are typically only right two-thirds of the time, while they are wrong one-third of the time. Thus, following a successful long-term value investing framework where one consistently and carefully pays cheap prices for assets still entails being wrong roughly one-third of the time. Being wrong often means that the lower probability future negative scenarios do in fact occur a certain percentage of the time. Back luck does happen a certain percentage of the time. (Mistakes in analysis or psychology also happen.)
It’s important to bet big when the odds are heavily in one’s favor. But one should be psychologically prepared to be wrong roughly one-third of the time, whether due to bad luck or to mistakes. The overall portfolio should be able to withstand at least a 33% error rate.
More Notes on Deep Value
Investors are systematically too pessimistic about companies that have been doing poorly, and systematically too optimistic about companies that have been doing well. This is why a deep value (contrarian value) approach, if applied systematically, is very likely to produce market-beating returns over a long enough period of time.
Marks explains:
Dull, ignored, possibly tarnished and beaten-down securities – often bargains exactly because they haven’t been performing well – are often ones value investors favor for high returns…. Much of the time, the greatest risk in these low-luster bargains lies in the possibility of underperforming in heated bull markets. That’s something the risk-conscious value investor is willing to live with.
Measuring Risk-Adjusted Returns
Marks mentions the Sharpe ratio – or excess return compared to the standard deviation of the return. While not perfect, the Sharpe ratio is a solid measure of risk-adjusted return for many public market securities.
It’s important to point out again that risk can no more be objectively measured after an investment than it can be objectively measured before the investment. Marks:
The point is that even after an investment has been closed out, it’s impossible to tell how much risk it entailed. Certainly the fact that an investment worked doesn’t mean it wasn’t risky, and vice versa. With regard to a successful investment, where do you look to learn whether the favorable outcome was inescapable or just one of a hundred possibilities (many of them unpleasant)? And ditto for a loser: how do we ascertain whether it was a reasonable but ill-fated venture, or just a wild stab that deserved to be punished?
Did the investor do a good job of assessing the risk entailed? That’s another good questions that’s hard to answer. Need a model? Think of the weatherman. He says there’s a 70 percent chance of rain tomorrow. It rains; was he right or wrong? Or it doesn’t rain; was he right or wrong? It’s impossible to assess the accuracy of probability estimates other than 0 and 100 except over a very large number of trials.
Marks believes (as do Buffett, Munger, and other top value investors) that there is some merit to the expected value framework whereby one attempts to identify possible future scenarios and the probabilities of their occurrence:
If we have a sense for the future, we’ll be able to say which outcome is most likely, what other outcomes also have a good chance of occurring, how broad the range of possible outcomes is and thus what the ‘expected result’ is. The expected result is calculated by weighing each outcome by its probability of occurring; it’s a figure that says a lot – but not everything – about the likely future.
Again, though, having a reasonable estimate of the future probability distribution is not enough. One must also make sure that one’s portfolio can withstand a run of bad luck; and one must recognize when one has experienced a run of good luck. Marks quotes his friend Bruce Newberg (with whom he has played cards and dice):
There’s a big difference between probability and outcome. Probable things fail to happen – and improbable things happen – all the time.
This is one of the most important lessons to know about investing, asserts Marks.
Marks defines investment performance:
… investment performance is what happens when a set of developments – geopolitical, macro-economic, company-level, technical and psychological – collide with an extant portfolio. Many futures are possible, to paraphrase Dimson, but only one future occurs. The future you get may be beneficial to your portfolio or harmful, and that may be attributable to your foresight, prudence or luck. The performance of your portfolio under the one scenario that unfolds says nothing about how it would have fared under the many ‘alternative histories’ that were possible.
A portfolio can be set up to withstand 99 percent of all scenarios but succumb because it’s the remaining 1 percent that materializes. Based on the outcome, it may seem to have been risky, whereas the investor might have been quite cautious.
Another portfolio may be structured so that it will do very well in half the scenarios and very poorly in the other half. But if the desired environment materializes and it prospers, onlookers can conclude that it was a low-risk portfolio.
The success of a third portfolio can be entirely contingent on one oddball development, but if it occurs, wild aggression can be mistaken for conservatism and foresight.
Marks again:
Risk can be judged only by sophisticated, experienced second-level thinkers.
The past seems very definite: for every evolving set of possible scenarios, only one scenario happened at each point along the way. But that does not at all mean that the scenarios that actually occurred were the only scenarios that could have occurred.
Furthermore, most people assume that the future will be like the past, especially the more recent past. As Ray Dalio says, the biggest mistake most investors make is to assume that the recent past will continue into the future.
Marks also reminds us that the “worst-case” assumed by most investors is typically not negative enough. Marks relates a funny story his father told about a gambler who bet everything on a race with only one horse in it. How could he lose?
Halfway around the track, the horse jumped over the fence and ran away. Invariably things can get worse than people expect.
Taking more risk usually leads to higher returns, but not always.
And when risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk’s all about.
RECOGNIZING RISK
The main source of risk, argues Marks, is high prices. When stock prices move higher, for instance, most investors feel more optimistic and less concerned about downside risk. But value investors have the opposite point of view: risk is typically very low when stock prices are very low, while risk tends to increase significantly when stock prices have increased significantly.
Most investors are not value investors:
So a prime element in risk creation is a belief that risk is low, perhaps even gone altogether. That belief drives up prices and leads to the embrace of risky actions despite the lowness of prospective returns.
Marks emphasizes that recognizing risk – which comes primarily from high prices – has nothing to do with predicting the future, which cannot be done with any sort of consistency when it comes to the overall stock market or the economy.
Marks also highlights, again, how the psychology of eager buyers – who are unworried about risk – is precisely what creates greater levels of risk as they drive prices higher:
Thus, the market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. I call this the ‘perversity of risk.’
In a nutshell:
When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price.
And, of course, as demonstrated by the experience of Nifty Fifty investors, when everyone believes something embodies no risk they usually bid it up to the point where it’s enormously risky. No risk is feared, and thus no reward for risk bearing – no ‘risk premium’ – is demanded or provided. That can make the thing that’s most esteemed the riskiest.
Marks again:
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…
CONTROLLING RISK
Outstanding investors, in my opinion, are distinguished at least as much for their ability to control risk as they are for generating return.
Great investors generate high returns with moderate risk, or moderate returns with low risk. If they generate high returns with “high risk,” but they do so consistently for many years, then perhaps the high risk “either wasn’t really high or was exceptionally well-managed.” Mark says that great investors such as Buffett or Peter Lynch tend to have very few losing years over a relatively long period of time.
It’s important, notes Marks, to see that risk leads to loss only when lower probability negative scenarios occur:
… loss is what happens when risk meets adversity. Risk is the potential for loss if things go wrong. As long as things go well, loss does not arise. Risk gives rise to loss only when negative events occur in the environment.
We must remember that when the environment is salutary, that is only one of the environments that could have materialized that day (or that year). (This is Nassim Nicholas Taleb’s idea of alternative histories…) The fact that the environment wasn’t negative does not mean that it couldn’t have been. Thus, the fact that the environment wasn’t negative doesn’t mean risk control wasn’t desirable, even though – as things turned out – it wasn’t needed at that time.
The absence of losses does not mean that there was no risk. Only a skilled investor can look at a portfolio during good times and tell how much risk has been taken.
Bottom line: risk control is invisible in good times but still essential, since good times can so easily turn into bad times.
Marks says that an investment manager adds value by generating higher than market returns for a given level of risk. Achieving the same return as the market, but with less risk, is adding value. Achieving better than market returns without undue risk is also adding value.
Many value investors, such as Marks and Buffett, somewhat underperform during up markets, but far outperform during down markets. The net result over a long period of time is market-beating performance with very little incremental risk. But it does take some time in order to see the value-added.
Controlling the risk in your portfolio is a very important and worthwhile pursuit. The fruits, however, come only in the form of losses that don’t happen. Such what-if calculations are difficult in placid times.
Marks:
On the other hand, the intelligent acceptance of recognized risk for profit underlies some of the wisest, most profitable investments – even though (or perhaps due to the fact that) most investors dismiss them as dangerous speculations.
Marks’ firm Oaktree invests in high yield bonds. High yield bonds can be good investments over time if the prices are low enough:
I’ve said for years that risky assets can make for good investments if they’re cheap enough. The essential element is knowing when that’s the case. That’s it: the intelligent bearing of risk for profit, the best test for which is a record of repeated success over a long period of time.
Risk bearing per se is neither wise nor unwise, says Marks. Investing in the more aggressive niches with risk properly controlled is ideal. But controlling risk always entails being prepared for bad scenarios.
Extreme volatility and loss surface only infrequently. And as time passes without that happening, it appears more and more likely that it’ll never happen – that assumptions regarding risk were too conservative. Thus, it becomes tempting to relax rules and increase leverage. And often this is done just before the risk finally rears its head…
Marks quotes Nassim Taleb:
Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six. After a few dozen tries, one forgets about the existence of the bullet, under a numbing false sense of security… Second, unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality… One is thus capable of unwittingly playing Russian roulette – and calling it by some alternative ‘low risk’ name.
A good example, which Marks does mention, is large financial institutions in 2004-2007. Virtually no one thought that home prices could decline on a nationwide scale, since they had never done so before.
Of course, it’s also possible to be too conservative. You can’t run a business on the basis of worst-case assumptions. You wouldn’t be able to do anything. And anyway, a ‘worst-case assumption’ is really a misnomer; there’s no such thing, short of a total loss. Now, we know the quants shouldn’t have assumed there couldn’t be a nationwide decline in home prices. But once you grant that such a decline can happen… what should you prepare for? Two percent? Ten? Fifty?
Marks continues:
If every portfolio was required to be able to withstand declines on the scale we’ve witnessed this year [2008], it’s possible no leverage would ever be used. Is that a reasonable reaction?
Even if we realize that unusual, unlikely things can happen, in order to act we make reasoned decisions and knowingly accept that risk when well paid to do so. Once in a while, a ‘black swan’ will materialize. But if in the future we always said, ‘We can’t do such-and-such, because the outcome could be worse than we’ve ever seen before,’ we’d be frozen in inaction.
…
… It’s by bearing risk when we’re well paid to do so – and especially by taking risks toward which others are averse in the extreme – that we strive to add value for our clients.
BEING ATTENTIVE TO CYCLES
Rule number one: most things will prove to be cyclical.
Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.
Marks explains:
… processes in fields like history and economics involve people, and when people are involved, the results are variable and cyclical. The main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical.
Objective factors do play a large part in cycles, of course – factors such as quantitative relationships, world events, environmental changes, technological developments and corporate decisions. But it’s the application of psychology to these things that causes investors to overreact or underreact, and thus determines the amplitude of the cyclical fluctuations.
Marks continues:
Economies will wax and wane as consumers spend more or less, responding emotionally to economic factors or exogenous events, geopolitical or naturally occurring. Companies will anticipate a rosy future during the up cycle and thus overexpand facilities and inventories; these will become burdensome when the economy turns down. Providers of capital will be too generous when the economy’s doing well, abetting overexpansion with cheap money, and then they’ll pull the reins too tight when things cease to look as good.
Investors will overvalue companies when they’re doing well and undervalue them when things get difficult.
AWARENESS OF THE PENDULUM
Marks holds that there are two risks in investing:
the risk of losing money and the risk of missing opportunity.
Most investors consistently do the wrong things at the wrong time: when prices are high, most investors rush to buy; when prices are low, most investors rush to sell. Thus, the value investor can profit over time by following Warren Buffett’s advice:
Be fearful when others are greedy. Be greedy when others are fearful.
Marks:
Stocks are cheapest when everything looks grim. The depressing outlook keeps them there, and only a few astute and daring bargain hunters are willing to take new positions.
COMBATING NEGATIVE INFLUENCES
Marks writes as follows:
Many people possess the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology. To say this another way, many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently. The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological. Investor psychology includes many separate elements, which we will look at in this chapter, but the key thing to remember is that they consistently lead to incorrect decisions. Much of this falls under the heading of ‘human nature.’
Cognitive Biases
As humans, we all have psychological tendencies or cognitive biases that were mostly helpful to us during much of our evolutionary history, but that often lead us to make bad judgments in many areas of modern life.
Marks writes about the following psychological tendencies:
Greed
Fear
Self-deception
Conformity to the crowd
Envy
Ego or overconfidence
Capitulation
How might these psychological tendencies have been useful in our evolutionary history?
When food was often scarce, being greedy by hoarding food (whether at the individual or community level) made sense. When a movement in the grass occasionally meant the presence of a dangerous predator, immediate fear (this fear is triggered by the amygdala even before the conscious mind is aware of it) was essential for survival. When hunting for food was dangerous, often with low odds of success, self-deception – accompanied by various naturally occurring chemicals – helped hunters to persevere over long periods of time, regardless of high danger and often regardless of injury. (Chemical reactions could often cause an injured hunter not to feel the pain much.) If everyone in one’s hunting group, or in one’s community, was running away as fast as possible, following the crowd was usually the most rational response. If a starving hunter saw another person with a huge pile of food, envy would trigger a strong desire to possess such a large pile of food, whether by trying to take it or by going on a hunting expedition with a heightened level of determination. When hunting a dangerous prey, with low odds of success, ego or overconfidence would cause the hunter to be convinced that he would succeed. From the point of view of the community, having self-deceiving and overconfident hunters was a net benefit because the hunters would persevere despite often low odds of success, and despite inevitable injuries and deaths among individual hunters.
How do these psychological tendencies cause people to make errors in modern activities such as investing?
Greed causes people to follow the crowd by paying high prices for stocks in the hope that there will be even higher prices in the future. Fear causes people to sell or to avoid ugly stocks – stocks trading at low multiples because the businesses in question are facing major difficulties.
As humans, we have an amazingly strong tendency towards self-deception:
The first principle is that you must not fool yourself, and you are the easiest person to fool. – Richard Feynman
Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true. – Demosthenes, as quoted by Charlie Munger
There have been many times in history when self-deception was probably crucial for the survival of a given individual or community. I’ve mentioned hunters pursuing dangerous prey. A much more recent example might be Winston Churchill, who was firmly convinced – even when virtually all the evidence was against it – that England would defeat Germany in World War II. Churchill’s absolute belief helped sustain England long enough for both good luck and aid to arrive: the Germans ended up overextended in Russia, and huge numbers of American troops (along with mass amounts of equipment) arrived in England.
Like other psychological tendencies, self-deception not only was important in evolutionary history, but it still often plays a constructive role. Yet when it comes to investing, self-deception is clearly harmful, especially as the time horizon is extended so that luck evens out.
Conformity to the crowd is another psychological tendency that many (if not most) investors seem to display. Marks notes the famous experiment by Solomon Asch. The subject is shown lines of obviously different lengths. But in the same room with the subject are shills, who unbeknownst to the subject have already been instructed to say that two lines of obviously different lengths actually have the same length. So the subject of the experiment has to decide between the obvious evidence of his eyes – the two lines are clearly different lengths – and the opinion of the crowd. A significant number (36.8 percent) ignored their own eyes and went with the crowd, saying that the two lines had equal length, despite the obvious fact that they didn’t.
(The experiment involved a control group in which there were no shills. Almost every subject – over 99 percent – gave the correct answer under these circumstances.)
Greed, conformity, and envy together operate powerfully on the brain of many investors:
Time and time again, the combination of pressure to conform and the desire to get rich causes people to drop their independence and skepticism, overcome their innate risk aversion and believe things that don’t make sense.
A good example from history is the tulip mania in Holland, during which otherwise rational people ended up paying exorbitant sums for colorful tulip bulbs. The South Sea Bubble is another example, during which even the extremely intelligent Isaac Newton, after selling out early for a solid profit, could not resist buying in again as prices seemed headed for the stratosphere. Newton and many others lost huge sums when prices inevitably returned to earth.
Envy has a very powerful and often negative effect on most human brains. And as Charlie Munger always points out, envy is particularly stupid because it’s a sin that, unlike many other sins, is not any fun at all. There are many people who could easily learn to be very happy – grateful for blessings, grateful for the wonders of life itself, etc. – who become miserable because they fixate on other people who have more of something, or who are doing better in some way. Envy is fundamentally irrational and stupid, but it is powerful enough to consume many people. Buffett: “It’s not greed that drives the world, but envy.” Envy and jealousy have for a very long time caused the downfall of human beings. This certainly holds true in investing.
Ego is another powerful psychological tendency humans have. As with the other potential pitfalls, many of the best investors – from Warren Buffett to Ray Dalio – are fundamentally humble. Overconfidence (closely related to ego) is a very strong bias that humans have, and if it is not overcome by learning humility and objectivity, it will kill any investor eventually. Marks writes:
In contrast, thoughtful investors can toil in obscurity, achieving solid gains in the good years and losing less than others in the bad years. They avoid sharing in the riskiest behavior because they’re so aware of how much they don’t know and because they have their egos in check. This, in my opinion, is the greatest formula for long-term wealth creation – but it doesn’t provide much ego gratification in the short run. It’s just not that glamorous to follow a path that emphasizes humility, prudence, and risk control. Of course, investing shouldn’t be about glamour, but often it is.
Capitulation is a final phenomenon that Marks emphasizes. In general, people become overly negative about a stock that is deeply out of favor because the business in question is going through hard times. Moreover, when overly negative investors are filled with fear and when they see everyone selling in a panic, they themselves often sell near the very bottom. Often these investors know analytically that the stock is cheap, but their emotions (fear of loss, conformity to the crowd, etc.) are too strong, so they disbelieve their own sound logic. The rational, contrarian, long-term value investor does just the opposite: he or she buys near the point of maximum pessimism (to use John Templeton’s phrase).
Similarly, most investors become overly optimistic when a stock is near its all-time highs. They see many other investors who have done well with the sky-high stock, and so they tend to buy at a price that is near the all-time highs. Again, many of these investors – like Isaac Newton – know analytically that buying a stock when it is near its all-time highs is often not a good idea. But greed, envy, self-deception, crowd conformity, etc. (fear of missing out, dream of a sure thing), overwhelm their own sound logic. By contrast, the rational, long-term value investor does the opposite: he or she sells near the point of maximum optimism.
Marks gives a marvelous example from the tech bubble of 1998-2000:
From the perspective of psychology, what was happening with IPOs is particularly fascinating. It went something like this: The guy next to you in the office tells you about an IPO he’s buying. You ask what the company does. He says he doesn’t know, but his broker told him its going to double on the day of issue. So you say that’s ridiculous. A week later he tells you it didn’t double… it tripled. And he still doesn’t know what it does. After a few more of these, it gets hard to resist. You know it doesn’t make sense, but you want protection against continuing to feel like an idiot. So, in a prime example of capitulation, you put in for a few hundred shares of the next IPO… and the bonfire grows still higher on the buying from new converts like you.
CONTRARIANISM
To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.– Sir John Templeton
Superior value investors buy when others are selling, and sell when others are buying. Value investing is simple in concept, but it is very difficult in practice.
Of course, it’s not enough just to be contrarian. Your facts and your reasoning also have to be right:
You’re neither right nor wrong because the crowd disagrees with you. You’re right because your data and reasoning are right – and that’s the only thing that makes you right. And if your facts and reasoning are right, you don’t have to worry about anybody else.– Warren Buffett
Or, as Seth Klarman puts it:
Value investing is at its core the marriage of a contrarian streak with a calculator.
Only by being right about the facts and the reasoning can a long-term value investor hold (or add to) a position when everyone else continues to sell. Getting the facts and reasoning right still involves being wrong roughly one-third of the time, often due to bad luck but also sometimes due to mistakes in analysis or psychology. But getting the facts and reasoning right leads to ‘being right’ roughly two-third of the time.
‘Being right’ usually means a robust process correctly followed – both analytically and psychologically – and the absence of bad luck. But sometimes good luck plays a role. Either way, a robust process correctly followed should produce positive results (on both an absolute and relative basis) over most rolling five-year periods, and over nearly all rolling ten-year periods.
It’s never easy to consistently follow a careful, contrarian value investing approach. Marks quotes David Swensen:
Investment success requires sticking with positions made uncomfortable by their variance with popular opinion… Only with the confidence created by a strong decision-making process can investors sell speculative excess and buy despair-driven value.
… Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom.
Marks puts it in his own words:
The most profitable investment actions are by definition contrarian: you’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and the price is high). These actions are lonely and… uncomfortable.
Marks writes about the paradoxical nature of investing:
The thing I find most interesting about investing is how paradoxical it is: how often the things that seem most obvious – on which everyone agrees – turn out not to be true.
The best bargains are typically only available when pessimism and uncertainty are high. Many investors say, ‘We’re not going to try to catch a falling knife; it’s too dangerous… We’re going to wait until the dust settles and the uncertainty is resolved.’ But waiting until uncertainty gets resolved usually means missing the best bargains, as Marks says:
The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left. When buying something has become comfortable again, its price will no longer be so low that it’s a great bargain. Thus, a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.
It’s our job as contrarians to catch falling knives, hopefully with care and skill. That’s why the concept of intrinsic value is so important. If we hold a view of value that enables us to buy when everyone else is selling – and if our view turns out to be right – that’s the route to the greatest rewards earned with the least risk.
FINDING BARGAINS
It cannot be too often repeated:
A high-quality asset can constitute a good or bad buy, and a low-quality asset can constitute a good or bad buy. The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, gets most investors into trouble.
What is the process by which some assets become cheap relative to intrinsic value? Marks explains:
Unlike assets that become the subject of manias, potential bargains usually display some objective defect. An asset class may have weaknesses, a company may be a laggard in its industry, a balance sheet may be over-levered, or a security may afford its holders inadequate structural protection.
Since the efficient-market process of setting fair prices requires the involvement of people who are analytical and objective, bargains usually are based on irrationality or incomplete understanding. Thus, bargains are often created when investors either fail to consider an asset fairly, or fail to look beneath the surface to understand it thoroughly, or fail to overcome some non-value-based tradition, bias or stricture.
Unlike market darlings, the orphan asset is ignored or scorned. To the extent it’s mentioned at all by the media and at cocktail parties, it’s in unflattering terms.
Usually its price has been falling, making the first-level thinker as, ‘Who would want to own that?’ (It bears repeating that most investors extrapolate past performance, expecting the continuation of trends rather than the far-more-dependable regression to the mean. First-level thinkers tend to view price weakness as worrisome, not as a sign that the asset has gotten cheaper.)
As a result, a bargain asset tends to be one that’s highly unpopular. Capital stays away from it or flees, and no one can think of a reason to own it.
Where is the best place to look for underpriced assets? Marks observes that a good place to start is among things that are:
little known and not fully understood;
fundamentally questionable on the surface;
controversial, unseemly or scary;
deemed inappropriate for ‘respectable’ portfolios;
unappreciated, unpopular and unloved;
trailing a record of poor returns; and
recently the subject of disinvestment, not accumulation.
Marks:
To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality. That means the best opportunities are usually found among things most others won’t do. After all, if everyone feels good about something and is glad to join in, it won’t be bargain-priced.
Marks started a fund for high yield bonds – junk bonds – in 1978. One rating agency described high yield bonds as “generally lacking the characteristics of a desirable investment.” Marks points out the obvious: “if nobody owns something, demand for it (and thus the price) can only go up and…. by going from taboo to even just tolerated, it can perform quite well.”
In 1987, Marks formed a fund to invest in distressed debt:
Who would invest in companies that already had demonstrated their lack of financial viability and the weakness of their management? How could anyone invest responsibly in companies in free fall? Of course, given the way investors behave, whatever asset is considered worst at a given point in time has a good likelihood of being the cheapest. Investment bargains needn’t have anything to do with high quality. In fact, things tend to be cheaper if low quality has scared people away.
PATIENT OPPORTUNISM
Marks makes the same point that Warren Buffett and Charlie Munger often make: Most of the time, by far the best thing to do is absolutely nothing. Finding one good idea a year is enough to get outstanding returns over time. Writes Marks:
So here’s a tip: You’ll do better if you wait for investments to come to you rather than go chasing after them. You tend to get better buys if you select from the list of things sellers are motivated to sell rather than start with a fixed notion as to what you want to own. An opportunist buys things because they’re offered at bargain prices. There’s nothing special about buying when prices aren’t low.
Marks took five courses in Japanese studies as an undergraduate business major in order to fulfill his requirement for a minor. He learned the Japanese value of mujo:
… mujo means cycles will rise and fall, things will come and go, and our environment will change in ways beyond our control. Thus we must recognize, accept, cope and respond. Isn’t that the essence of investing?
… What’s past is past and can’t be undone. It has led to the circumstances we now face. All we can do is recognize our circumstances for what they are and make the best decisions we can, given the givens.
Marks quotes Buffett, who notes that there are no called strikes in investing:
Investing is the greatest business in the world because you never have to swing. You stand at the plate; the pitcher throws you General Motors at 47! U.S. steel at 39! And nobody calls a strike on you. There’s no penalty except opportunity. All day you wait for the pitch you like; then, when the fielders are asleep, you step up and hit it.
It’s dumb to invest when the opportunities are not there. But when the overall market is high, there are still a few ways to do well as a long-term value investor. If one is able to ignore short-term volatility and focus on the next five to ten years, then one can invest in undervalued stocks.
If one’s assets under management are small enough, then there can be certain parts of the market where one can still find excellent bargains. An example would be micro-cap stocks, since very few professional investors look there. (This is the focus of the Boole Microcap Fund.)
We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know. – John Kenneth Galbraith
Marks, like Buffett, Munger, and most other top value investors, thinks that financial forecasting simply cannot be done with any sort of consistency. But Marks has two caveats:
The more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage. With hard work and skill, we can consistently know more than the next person about individual companies and securities, but that’s much less likely with regard to markets and economies. Thus, I suggest people try to ‘know the knowable.’
An exception comes in the form of my suggestion, on which I elaborate in the next chapter, that investors should make an effort to figure out where they stand at a moment in time in terms of cycles and pendulums. That won’t render the future twists and turns knowable, but it can help one prepare for likely developments.
Marks has tracked (in a limited way) many macro predictions, including U.S. interest rates, the U.S. stock market, and the yen/dollar exchange rate. He found quite clearly that most forecasts were not correct.
I can elaborate on two examples that I spent much time on (when I should have stayed focused on finding individual companies available at cheap prices):
the U.S. stock market
the yen/dollar exchange
A secular bear market for U.S. stocks began (arguably) in the year 2000, when the 10-year Graham-Shiller P/E – also called the CAPE (cyclically adjusted P/E) – was over 30, its highest level in U.S. history. The long-term average CAPE is around 16. Based on over one hundred years of history, the pattern for U.S. stocks in a secular bear market would be relatively flat or lower until the CAPE approached 10. However, ever since Greenspan started running the Fed in the 1980’s, the Fed has usually had a policy of stimulating the economy and stocks by lowering rates or keeping rates as low as possible. This has caused U.S. stocks to be much higher than otherwise. For instance, with rates today staying near zero, U.S. stocks could easily be twice as high as or three times as high as “normal” indefinitely, assuming the Fed decides to keep rates low for many more years. As Buffett has noted, near-zero rates for many decades would eventually mean price/earnings ratios on stocks of 100.
In any case, in the year 2012 to 2013, some of the smartest market historians (including Russell Napier, author of Anatomy of the Bear) started predicting that the S&P 500 Index would fall towards a CAPE of 10 or lower, which is how every previous U.S. secular bear market concluded. It didn’t happen in 2012, or in 2013, or in 2014, or in 2015, or in 2016, or in 2017, or in 2018, or in 2019. (Also, the stock market decline in early 2020 was a temporary response to the coronavirus.) Eventually the U.S. stock market will experience another major bear market. But by the time that happens, it may start from a level over 4,000 or 4,500 in the next year or two, and it may not decline below 2000, which is actually far above the level from which the smartest forecasters (such as Russell Napier) said the decline would begin.
Robert Shiller, the Nobel Prize-winning economist who perfected the CAPE (Shiller P/E), said in 1996 that U.S. stocks were high. But if an investor had gone to cash in 1996, they wouldn’t have had any chance of being ahead of the stock market until 2008 to 2009, more than 10 years later during the biggest financial crisis since the Great Depression.
When the CAPE is high, as it is today, the long-term investor should still have a large position in U.S. stocks. But the long-term investor should expect fairly low ten-year returns, a few percent per annum, and they also should some investments outside of U.S. stocks. Shiller also has observed that certain sectors in the U.S. economy can be cheap (low CAPE). Many oil-related stocks, for example, are very probably quite cheap today (mid 2021) relative to their long-term normalized earnings power.
The main point here, though, is that forecasting the next bear market or the next recession with any precision is generally impossible. Another example would be the Economic Cycle Research Institute (https://www.businesscycle.com/), which predicted a U.S. recession around 2011-2012 based on its previously quite successful set of leading economic indicators. But they were wrong, and they later admitted that the Fed printing so much money not only may have kept the U.S. barely out of recession, but also may have led to distortions in the economic data, making ECRI’s set of leading economic indicators no longer as reliable.
As for the yen/dollar exchange, the story begins in a familiar way: some of the smartest macro folks around predicted (in 2010 and later) that shorting the yen vs. the U.S. dollar would be the “trade of the decade,” and that the yen/dollar exchange would exceed 200. But it’s not 2021, and the yen/dollar exchange rate has come nowhere near 200.
The “trade of the decade argument” was the following: the debt-to-GDP in Japan has reached stratospheric levels, , government deficits have continued to widen, and the Japanese population is actually shrinking. Since long-term GDP growth is a function of population growth plus innovation, it should become mathematically impossible for the Japanese government to pay back its debt without a significant devaluation of their currency. If the BOJ could devalue the yen by 67% – which would imply a yen/dollar exchange rate of well over 200 – then Japan could repay the government debt in seriously devalued currency. In this scenario – a yen devaluation of 67% – Japan effectively would only have to repay 33% of the government debt. Currency devaluation – inflating away the debts – is what most major economies throughout history have done.
The bottom line as regards the yen is the following: Either Japan must devalue the Yen by 67% – implying a yen/dollar exchange rate of well over 200 – or Japan will inevitably reach the point where it is quite simply impossible for it to repay a large portion of the government debt. That’s the argument. There could be other solutions, however. The human economy is likely to be much larger in the future, and there may be some way to help the Japanese government with its debts. After all, the situation wouldn’t seem so insurmountable if Japan could grow its population. But this might happen in some indirect way if the human economy becomes more open in the future, perhaps involving the creation of a new universal currency.
In any case, for the past five to ten years, and even longer, it has been argued that either the yen/dollar would eventually exceed 200 (thus inflating away as much as 67% of the debt), or the Japanese government would inevitably default on JGB’s (Japanese government bonds). In either case, the yen should collapse relative to the U.S. dollar, meaning a yen/dollar of well over 200. This has been described as “the trade of the decade,” but it may not happen for several decades.
In the end, one could have spent decades trying to short the Yen or trying to short JGB’s, without much to show for it. Or one could have spent those decades doing value investing: finding and buying cheap stocks, year in and year out. Decades later, value investing would almost certainly have produced a far better result, and with a relatively low level of risk.
The same logic applies to market timing, or trying to profit on the basis of predicting bull markets, bear markets, recessions, etc. For the huge majority of investors, they would get much better profits, at relatively low risk, by following a value investing approach (whether by investing in a value fund, or by applying the value approach directly to stocks) or simply investing in low-cost broad market index funds.
In Sum
In sum, financial forecasting cannot be done with any sort of consistency. Every year, there are many people making financial forecasts, and so purely as a matter of chance, a few will be correct in a given year. But the ones correct this year are almost never the ones correct the next time around, because what they’re trying to predict can’t be predicted with any consistency. Marks writes thus:
I am not going to try to prove my contention that the future is unknowable. You can’t prove a negative, and that certainly includes this one. However, I have yet to meet anyone who consistently knows what lies ahead macro-wise…
One way to get to be right sometimes is to always be bullish or always be bearish; if you hold a fixed view long enough, you may be right sooner or later. And if you’re always an outlier, you’re likely to eventually be applauded for an extremely unconventional forecast that correctly foresaw what no one else did. But that doesn’t mean your forecasts are regularly of any value…
It’s possible to be right about the macro-future once in a while, but not on a regular basis. It doesn’t do any good to possess a survey of sixty-four forecasts that includes a few that are accurate; you have to know which ones they are. And if the accurate forecasts each six months are made by different economists, it’s hard to believe there’s much value in the collective forecasts.
Marks gives one more example: How many predicted the crisis of 2007-2008? Of those who did predict it – there was bound to be some from pure chance alone – how many of those then predicted the recovery starting in 2009 and continuing until early 2020? The answer is “very few.” The reason, observes Marks, is that those who got 2007-2008 right “did so at least in part because of a tendency toward negative views.” They probably were negative well before 2007-2008, and more importantly, they probably stayed negative afterwards, during which the U.S. stock market increased (from the low) more than 400% as the U.S. economy expanded from 2009 to early 2020.
Marks has a description for investors who believe in the value of forecasts. They belong to the “I know” school, and it’s easy to identify them:
They think knowledge of the future direction of economies, interest rates, markets and widely followed mainstream stocks is essential for investment success.
They’re confident it can be achieved.
They know they can do it.
They’re aware that lots of other people are trying to do it too, but they figure either (a) everyone can be successful at the same time, or (b) only a few can be, but they’re among them.
They’re comfortable investing based on their opinions regarding the future.
They’re also glad to share their views with others, even though correct forecasts should be of such great value that no one would give them away gratis.
They rarely look back to rigorously assess their record as forecasters.
Marks contrasts the confident “I know” folks with the guarded “I don’t know” folks. The latter believe you can’t predict the macro-future, and thus the proper goal for investing is to do the best possible job analyzing individual securities. Marks points out that if you belong to the “I don’t know” school, eventually everyone will stop asking you where you think the market’s going.
You’ll never get to enjoy that one-in-a-thousand moment when your forecast comes true and the Wall Street Journal runs your picture. On the other hand, you’ll be spared all those times when forecasts miss the mark, as well as the losses that can result from investing based on overrated knowledge of the future.
Marks continues by noting that no one likes investing on the assumption that the future is unknowable. But if the future IS largely unknowable, then it’s far better as an investor to acknowledge that fact than to pretend otherwise.
Furthermore, says Marks, the biggest problems for investors tend to happen when investors forget the difference between probability and outcome (i.e., the limits of foreknowledge):
when they believe the shape of the probability distribution is knowable with certainty (and that they know it),
when they assume the most likely outcome is the one that will happen,
when they assume the expected result accurately represents the actual result, or
perhaps most important, when they ignore the possibility of improbable outcomes.
Marks sums it up:
Overestimating what you’re capable of knowing or doing can be extremely dangerous – in brain surgery, transocean racing or investing. Acknowledging the boundaries of what you can know – and working within those limits rather than venturing beyond – can give you a great advantage.
HAVING A SENSE FOR WHERE WE STAND
Marks believes that market cycles – inevitable ups and downs – cannot be predicted as to extent and (especially) as to timing, but have a profound influence on us as investors. The only thing we can predict is that market cycles are inevitable.
Marks holds that as investors, we can have a rough idea of market cycles. We can’t predict what will happen exactly or when. But we can at least develop valuable insight into various future events.
So look around, and ask yourself: Are investors optimistic or pessimistic? Do the media talking heads say the markets should be piled into or avoided? Are novel investment schemes readily accepted or dismissed out of hand? Are securities offerings and fund openings being treated as opportunities to get rich or possible pitfalls? Has the credit cycle rendered capital readily available or impossible to obtain? Are price/earnings ratios high or low in the context of history, and are yield spreads tight or generous? All of these things are important, and yet none of them entails forecasting. We can make excellent investment decisions on the basis of present observations, with no need to make guesses about the future.
Marks likens the process of assessing the current cycle with “taking the temperature” of the market. Again, one can never precisely time market turning points, but one can at least become aware of when markets are becoming overheated, or when they’ve become unusually cheap.
It may be more difficult today to take the market’s temperature because of the policy of near-zero (or negative) interest rates in many of the world’s major economies. This obviously distorts all asset prices. As Buffett remarked recently, if U.S. rates were going to stay near zero for many decades into the future, U.S. stocks would eventually be much higher than they are today. Zero rates indefinitely would easily mean price/earnings ratios of 100 (or even 200).
Stanley Druckenmiller, one of the most successful macro investors, has consistently said that the stock market is driven in large part not by earnings, but by central bank liquidity.
In any case, timing the next major bear market is virtually impossible, as acknowledged by the majority of great investors such as Howard Marks, Warren Buffett, Charlie Munger, Seth Klarman, Bill Ackman, and others.
What Marks, Buffett, and Munger stress is to focus on finding cheap stocks. Pay cheap enough prices so that, on average, one can make a profit over the next five years or ten years. At some point – no one knows precisely when – the U.S. stock market is likely to drop roughly 30-50%. One must be psychologically prepared for this. And one’s portfolio must also be prepared for this.
If one is able to buy enough cheap stocks, while maintaining a focus on the next five years or ten years, and if one is psychologically prepared for a big drop at some point, which always happens periodically, then one will be in good position.
Note: Cheap stocks (whether oil-related or otherwise) typically have lower correlation than usual with the broader stock market. Even if the broader market declines, some cheap stocks may do much better on both a relative and absolute basis.
Finally, some percentage in cash may seem like a wise position to have in the event of a major (or minor) bear market. The tricky part, again, is what percentage to have in cash and when. Many excellent value investors have had 50% or more in cash since 2012 or 2013. Since 2012, the market has more than doubled. So cash has been a significant drag on the performance of investors who have had large cash positions.
For these reasons, many great value investors – including Marks, Buffett, Munger, and many others – simply never try to time the market. Many of these value investors essentially stay fully invested in the cheapest stocks they can find. Over a very long period of time, many studies have shown that hedges, short positions, and cash lower the volatility of the portfolio, but also lower the long-term returns. Given how many smart people have been hedging since 2012, the eight or so years up until early 2020 have provided yet another clear example of why market timing is impossible to do with any consistency.
Henry Singleton, described by both Buffett and Munger as being the best capital allocator (among CEO’s) in U.S. history, compounded business value at Teledyne at incredible rates for decades by buying stocks (including Teledyne) when they were cheap. Singleton’s amazing track record included the 1970’s, when the broader U.S. stock market went virtually nowhere. Singleton was a genius (100 points away from being a chess grandmaster). On the subject of market timing, Singleton has said:
I don’t believe all this nonsense about market timing. Just buy very good value and when the market is ready that value will be recognized.
APPRECIATING THE ROLE OF LUCK
Luck – chance or randomness – influences investment outcomes. Marks considers Nassim Taleb’s Fooled by Randomness to be essential reading for investors. Writes Marks:
Randomness (or luck) plays a huge part in life’s results, and outcomes that hinge on random events should be viewed as different from those that do not.
Marks quotes Taleb:
If we have heard of [history’s great generals and inventors], it is simply because they took considerable risks, along with thousands of others, and happened to win. They were intelligent, courageous, noble (at times), had the highest possible obtainable culture in their day – but so did thousands of others who live in the musty footnotes of history.
A central concept from Taleb is that of “alternative histories.” What actually has happened in history is merely a small subset of all the things that could have happened, at least as far as we know. As long as there is a component of indeterminacy in human behavior (not to mention the rest of reality), one must usually assume that many “alternative histories” were possible. From the practical point of view of investing, given a future that is currently unknowable in many respects, one must develop a reasonable set of scenarios along with estimated probabilities for each scenario. And, when judging the quality of past decisions, one must think carefully about various possible (“alternative”) histories, of which what actually happened appears to be a small subset.
Thus, the fact that a stratagem or action worked – under the circumstances that unfolded – doesn’t necessarily prove that the decision behind it was wise.
Marks says he agrees with all of Taleb’s important points:
Investors are right (and wrong) all the time for the ‘wrong reason.’ Someone buys a stock because he or she expects a certain development; it doesn’t occur; the market takes the stock up anyway; the investor looks good (and invariably accepts credit).
The correctness of a decision can’t be judged from the outcome. Neverthelss, that’s how people assess it. A good decision is one that’s optimal at the time it’s made, when the future is by definition unknown. Thus, correct decisions are often unsuccessful, and vice versa.
Randomness alone can produce just about any outcome in the short run. In portfolios that are allowed to reflect them fully, market movements can easily swamp the skillfulness of the manager (or lack thereof). But certainly market movements cannot be credited to the manager (unless he or she is the rare market timer who’s capable of getting it right repeatedly).
For these reasons, investors often receive credit they don’t deserve. One good coup can be enough to build a reputation, but clearly a coup can arise out of randomness alone. Few of these “geniuses” are right more than once or twice in a row.
Thus, it’s essential to have a large number of observations – lots of years of data – before judging a given manager’s ability.
Over the long run, the rational investor learns, refines, and sticks with a robust investment process that reliably produces good results. In the short run, when a good process sometimes leads to bad outcomes (often due to bad luck but sometimes due to a mistake), one must simply be stoic and patient.
Marks continues:
The actions of the ‘I know’ school are based on a view of a single future that is knowable and conquerable. My ‘I don’t know’ school thinks of future events in terms of a probability distribution. That’s a big difference. In the latter case, we may have an idea which one outcome is most likely to occur, but we also know there are many other possibilities, and those other outcomes may have a collective likelihood much higher than the one we consider most likely.
Marks concludes:
We should spend our time trying to find value among the knowable – industries, companies and securities – rather than base our decisions on what we expect from the less-knowable macro world of economies and broad market performance.
Given that we don’t know exactly which future will obtain, we have to get value on our side by having a strongly held, analytically derived opinion of it and buying for less when opportunities to do so present themselves.
We have to practice defensive investing, since many of the outcomes are likely to go against us. It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones.
To improve our chances of success, we have to emphasize acting contrary to the herd when it’s at extremes, being aggressive when the market is low and cautious when it’s high.
Given the highly indeterminate nature of outcomes, we must view strategies and their results – both good and bad – with suspicion until proved over a large number of trials.
INVESTING DEFENSIVELY
Unlike professional tennis, where a successful outcome depends on which player hits the most winners, successful investing generally depends on minimizing mistakes more than it does on finding winners.
… investing is full of bad bounces and unanticipated developments, and the dimensions of the court and the height of the net change all the time. The workings of economies and markets are highly imprecise and variable, and the thinking and behavior of the other players constantly alter the environment. Even if you do everything right, other investors can ignore your favorite stock; management can squander the company’s opportunities; government can change the rules; or nature can serve up a catastrophe.
Marks argues that successful investing is a balance between offense and defense, and that this balance often differs for each individual investor. What’s important is to stick with an investment process that works over the long term:
… Few people (if any) have the ability to switch tactics to match market conditions on a timely basis. So investors should commit to an approach – hopefully one that will serve them through a variety of scenarios. They can be aggressive, hoping they’ll make a lot on the winners and not give it back on the losers. They can emphasize defense, hoping to keep up in good times and excel by losing less than others in bad times. Or they can balance offense and defense, largely giving up on tactical timing but aiming to win through superior security selection in both up and down markets.
And by the way, there’s no right choice between offense and defense. Lots of possible routes can bring you to success, and your decision should be a function of your personality and leanings, the extent of your belief in your ability, and the peculiarities of the markets you work in and the clients you work for.
Marks argues that defense can be viewed as aiming for higher returns, but through the avoidance of mistakes and through consistency, rather than through home runs and occasional flashes of brilliancy.
Avoiding losses first involves buying assets at cheap prices (well below intrinsic value). Another element to avoiding losses is to ensure that one’s portfolio can survive a bear market. If the five-year or ten-year returns appear to be high enough, an investor still may choose to play more offense than defense, even when he or she knows that a bear market is likely within five years or less. But one must be fully prepared – psychologically and in one’s portfolio – for many already very cheap stocks to get cut in half or worse during a bear market.
Again, some investors can accept higher volatility in exchange for higher long-term returns. One must know oneself. One must know one’s clients. One must really think through all the possible scenarios, because things can get much worse than one can imagine during bear markets. And bear markets are inevitable.
There is always a trade-off between potential return and potential downside. Choosing to aim for higher long-term returns means accepting higher downside volatility over shorter periods of time.
But it’s important to keep in mind that many investors fail not due to lack of home runs, but due to having too many strikeouts. Overbetting is thus a common cause of failure for long-term investors. We know from the Kelly criterion that overbetting guarantees zero or negative long-term returns. Therefore, it’s wise for most investors to aim for consistency – a high batting average based on many singles and doubles – rather than to aim for the maximum number of home runs.
Put differently, it is easier for most investors to minimize losses than it is to hit a lot of home runs. Thus, most investors are much more likely to achieve long-term success by minimizing losses and mistakes, than by hitting a lot of home runs.
Investing defensively can cause you to miss out on things that are hot and get hotter, and it can leave you with your bat on your shoulder in trip after trip to the plate. You may hit fewer home runs than another investor… but you’re also likely to have fewer strikeouts and fewer inning-ending double plays.
Defensive investing sounds very erudite, but I can simplify it: Invest scared! Worry about the possibility of loss. Worry that there’s something you don’t know. Worry that you can make high-quality decisions but still be hit by bad luck or surprise events. Investing scared will prevent hubris; will keep your guard up and your mental adrenaline flowing; will make you insist on adequate margin of safety; and will increase the chances that your portfolio is prepared for things going wrong. And if nothing does go wrong, surely the winners will take care of themselves.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.
The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees. The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: jb@boolefund.com
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.
It’s crucial in investing to have the proper balance of confidence and humility. Overconfidence is very deep-seated in human nature. Nearly all of us tend to believe that we’re above average across a variety of dimensions, such as looks, smarts, academic ability, business aptitude, driving skill, and even luck (!).
Overconfidence is often harmless and it even helps in some areas. But when it comes to investing, if we’re overconfident about what we know and can do, eventually our results will suffer.
(Image by Wilma64)
The simple truth is that the vast majority of us should invest in broad market low-cost index funds. Buffett has maintained this argument for a long time: https://boolefund.com/warren-buffett-jack-bogle/
The great thing about investing in index funds is that you can outperform most investors, net of costs, over the course of several decades. This is purely a function of costs. A Vanguard S&P 500 index fund costs 2-3% less per year than the average actively managed fund. This means that, after a few decades, you’ll be ahead at least 80% (or more) of all active investors.
You can do better than a broad market index fund if you invest in a solid quantitative value fund. Such a fund can do at least 1-2% better per year, on average and net of costs, than a broad market index fund.
But you can do even better””at least 8% better per year than the S&P 500 index””by investing in a quantitative value fund focused on microcap stocks.
At the Boole Microcap Fund, our mission is to help you do at least 8% better per year, on average, than an S&P 500 index fund. We achieve this by implementing a quantitative deep value approach focused on cheap micro caps with improving fundamentals. See: https://boolefund.com/best-performers-microcap-stocks/
I recently re-read Common Stocks and Common Sense (Wiley, 2016), by Edgar Wachenheim III. It’s a wonderful book. Wachenheim is one of the best value investors. He and his team at Greenhaven Associates have produced 19% annual returns for over 25 years.
Wachenheim emphasizes that, due to certain behavioral attributes, he has outperformed many other investors who are as smart or smarter. As Warren Buffett has said:
Success in investing doesn’t correlate with IQ once you’re above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.
That’s not to say IQ isn’t important. Most of the finest investors are extremely smart. Wachenheim was a Baker Scholar at Harvard Business School, meaning that he was in the top 5% of his class.
The point is that””due to behavioral factors such as patience, discipline, and rationality””top investors outperform many other investors who are as smart or smarter. Buffett again:
We don’t have to be smarter than the rest; we have to be more disciplined than the rest.
Buffett himself has always been extraordinarily patient and disciplined. There have been several times in Buffett’s career when he went for years on end without making a single investment.
Wachenheim highlights three behavioral factors that have helped him outperform others of equal or greater talent.
The bulk of Wachenheim’s book””chapters 3 through 13″”is case studies of specific investments. Wachenheim includes a good amount of fascinating business history, some of which is mentioned here.
Outline for this blog post:
Approach to Investing
Being a Contrarian
Probable Scenarios
Controlling Emotions
IBM
Interstate Bakeries
U.S. Home Corporation
Centex
Union Pacific
American International Group
Lowe’s
Whirlpool
Boeing
Southwest Airlines
Goldman Sachs
(Photo by Lsaloni)
APPROACH TO INVESTING
From 1960 through 2009 in the United States, common stocks have returned about 9 to 10 percent annually (on average).
The U.S. economy grew at roughly a 6 percent annual rate””3 percent from real growth (unit growth) and 3 percent from inflation (price increases). Corporate revenues””and earnings””have increased at approximately the same 6 percent annual rate. Share repurchases and acquisitions have added 1 percent a year, while dividends have averaged 2.5 percent a year. That’s how, on the whole, U.S. stocks have returned 9 to 10 percent annually, notes Wachenheim.
Even if the economy grows more slowly in the future, Wachenheim argues that U.S. investors should still expect 9 to 10 percent per year. In the case of slower growth, corporations will not need to reinvest as much of their cash flows. That extra cash can be used for dividends, acquisitions, and share repurchases.
Following Warren Buffett and Charlie Munger, Wachenheim defines risk as the potential for permanent loss. Risk is not volatility.
Stocks do fluctuate up and down. But every time the market has declined, it has ultimately recovered and gone on to new highs. The financial crisis in 2008-2009 is an excellent example of large””but temporary””downward volatility:
The financial crisis during the fall of 2008 and the winter of 2009 is an extreme (and outlier) example of volatility. During the six months between the end of August 2008 and end of February 2009, the [S&P] 500 Index fell by 42 percent from 1,282.83 to 735.09. Yet by early 2011 the S&P 500 had recovered to the 1,280 level, and by August 2014 it had appreciated to the 2000 level. An investor who purchased the S&P 500 Index on August 31, 2008, and then sold the Index six years later, lived through the worst financial crisis and recession since the Great Depression, but still earned a 56 percent profit on his investment before including dividends””and 69 percent including the dividends that he would have received during the six-year period. Earlier, I mentioned that over a 50-year period, the stock market provided an average annual return of 9 to 10 percent. During the six-year period August 2008 through August 2014, the stock market provided an average annual return of 11.1 percent””above the range of normalcy in spite of the abnormal horrors and consequences of the financial crisis and resulting deep recession.
(Photo by Terry Mason)
Wachenheim notes that volatility is the friend of the long-term investor. The more volatility there is, the more opportunity to buy at low prices and sell at high prices.
Because the stock market increases on average 9 to 10 percent per year and always recovers from declines, hedging is a waste of money over the long term:
While many investors believe that they should continually reduce their risks to a possible decline in the stock market, I disagree. Every time the stock market has declined, it eventually has more than fully recovered. Hedging the stock market by shorting stocks, or by buying puts on the S&P 500 Index, or any other method usually is expensive, and, in the long run, is a waste of money.
Wachenheim describes his investment strategy as buying deeply undervalued stocks of strong and growing companies that are likely to appreciate significantly due to positive developments not yet discounted by stock prices.
Positive developments can include:
a cyclical upturn in an industry
an exciting new product or service
the sale of a company to another company
the replacement of a poor management with a good one
a major cost reduction program
a substantial share repurchase program
If the positive developments do not occur, Wachenheim still expects the investment to earn a reasonable return, perhaps close to the average market return of 9 to 10 percent annually. Also, Wachenheim and his associates view undervaluation, growth, and strength as providing a margin of safety””protection against permanent loss.
Wachenheim emphasizes that at Greenhaven, they are value investors not growth investors. A growth stock investor focuses on the growth rate of a company. If a company is growing at 15 percent a year and can maintain that rate for many years, then most of the returns for a growth stock investor will come from future growth. Thus, a growth stock investor can pay a high P/E ratio today if growth persists long enough.
Wachenheim disagrees with growth investing as a strategy:
…I have a problem with growth-stock investing. Companies tend not to grow at high rates forever. Businesses change with time. Markets mature. Competition can increase. Good managements can retire and be replaced with poor ones. Indeed, the market is littered with once highly profitable growth stocks that have become less profitable cyclic stocks as a result of losing their competitive edge. Kodak is one example. Xerox is another. IBM is a third. And there are hundreds of others. When growth stocks permanently falter, the price of their shares can fall sharply as their P/E ratios contract and, sometimes, as their earnings fall””and investors in the shares can suffer serious permanent loss.
Many investors claim that they will be able to sell before a growth stock seriously declines. But very often it’s difficult to determine whether a company is suffering from a temporary or permanent decline.
Wachenheim observes that he’s known many highly intelligent investors””who have similar experiences to him and sensible strategies””but who, nonetheless, haven’t been able to generate results much in excess of the S&P 500 Index. Wachenheim says that a key point of his book is that there are three behavioral attributes that a successful investor needs:
In particular, I believe that a successful investor must be adept at making contrarian decisions that are counter to the conventional wisdom, must be confident enough to reach conclusions based on probabilistic future developments as opposed to extrapolations of recent trends, and must be able to control his emotions during periods of stress and difficulties. These three behavioral attributes are so important that they merit further analysis.
BEING A CONTRARIAN
(Photo by Marijus Auruskevicius)
Most investors are not contrarians because they nearly always follow the crowd:
Because at any one time the price of a stock is determined by the opinion of the majority of investors, a stock that appears undervalued to us appears appropriately valued to most other investors. Therefore, by taking the position that the stock is undervalued, we are taking a contrarian position””a position that is unpopular and often is very lonely. Our experience is that while many investors claim they are contrarians, in practice most find it difficult to buck the conventional wisdom and invest counter to the prevailing opinions and sentiments of other investors, Wall Street analysts, and the media. Most individuals and most investors simply end up being followers, not leaders.
In fact, I believe that the inability of most individuals to invest counter to prevailing sentiments is habitual and, most likely, a genetic trait. I cannot prove this scientifically, but I have witnessed many intelligent and experienced investors who shunned undervalued stocks that were under clouds, favored fully valued stocks that were in vogue, and repeated this pattern year after year even though it must have become apparent to them that the pattern led to mediocre results at best.
Wachenheim mentions a fellow investor he knows””Danny. He notes that Danny has a high IQ, attended an Ivy League university, and has 40 years of experience in the investment business. Wachenheim often describes to Danny a particular stock that is depressed for reasons that are likely temporary. Danny will express his agreement, but he never ends up buying before the problem is fixed.
In follow-up conversations, Danny frequently states that he’s waiting for the uncertainty to be resolved. Value investor Seth Klarman explains why it’s usually better to invest before the uncertainty is resolved:
Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain. Yet high uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.
PROBABLE SCENARIOS
(Image by Alain Lacroix)
Many (if not most) investors tend to extrapolate recent trends into the future. This usually leads to underperforming the market. See:
The successful investor, by contrast, is a contrarian who can reasonably estimate future scenarios and their probabilities of occurrence:
Investment decisions seldom are clear. The information an investor receives about the fundamentals of a company usually is incomplete and often is conflicting. Every company has present or potential problems as well as present or future strengths. One cannot be sure about the future demand for a company’s products or services, about the success of any new products or services introduced by competitors, about future inflationary cost increases, or about dozens of other relevant variables. So investment outcomes are uncertain. However, when making decisions, an investor often can assess the probabilities of certain outcomes occurring and then make his decisions based on the probabilities. Investing is probabilistic.
Because investing is probabilitistic, mistakes are unavoidable. A good value investor typically will have at least 33% of his or her ideas not work, whether due to an error, bad luck, or an unforeseeable event. You have to maintain equanimity despite inevitable mistakes:
If I carefully analyze a security and if my analysis is based on sufficiently large quantities of accurate information, I always will be making a correct decision. Granted, the outcome of the decision might not be as I had wanted, but I know that decisions always are probabilistic and that subsequent unpredictable changes or events can alter outcomes. Thus, I do my best to make decisions that make sense given everything I know, and I do not worry about the outcomes. An analogy might be my putting game in golf. Before putting, I carefully try to assess the contours and speed of the green. I take a few practice strokes. I aim the putter to the desired line. I then putt and hope for the best. Sometimes the ball goes in the hole…
CONTROLLING EMOTION
(Photo by Jacek Dudzinski)
Wachenheim:
I have observed that when the stock market or an individual stock is weak, there is a tendency for many investors to have an emotional response to the poor performance and to lose perspective and patience. The loss of perspective and patience often is reinforced by negative reports from Wall Street and from the media, who tend to overemphasize the significance of the cause of the weakness. We have an expression that aiplanes take off and land every day by the tens of thousands, but the only ones you read about in the newspapers are the ones that crash. Bad news sells. To the extent that negative news triggers further selling pressures on stocks and further emotional responses, the negativism tends to feed on itself. Surrounded by negative news, investors tend to make irrational and expensive decisions that are based more on emotions than on fundamentals. This leads to the frequent sale of stocks when the news is bad and vice versa. Of course, the investor usually sells stocks after they already have materially decreased in price. Thus, trading the market based on emotional reactions to short-term news usually is expensive””and sometimes very expensive.
Wachenheim agrees with Seth Klarman that, to a large extent, many investors simply cannot help making emotional investment decisions. It’s part of human nature. People overreact to recent news.
I have continually seen intelligent and experienced investors repeatedly lose control of their emotions and repeatedly make ill-advised decisions during periods of stress.
That said, it’s possible (for some, at least) to learn to control your emotions. Whenever there is news, you can learn to step back and look at your investment thesis. Usually the investment thesis remains intact.
IBM
(IBM Watson by Clockready, Wikimedia Commons)
When Greenhaven purchases a stock, it focuses on what the company will be worth in two or three years. The market is more inefficient over that time frame due to the shorter term focus of many investors.
In 1993, Wachenheim estimated that IBM would earn $1.65 in 1995. Any estimate of earnings two or three years out is just a best guess based on incomplete information:
“¦having projections to work with was better than not having any projections at all, and my experience is that a surprisingly large percentage of our earnings and valuation projections eventually are achieved, although often we are far off on the timing.
The positive development Wachenheim expected was that IBM would announce a concrete plan to significantly reduce its costs. On July 28, 1993, the CEO Lou Gerstner announced such a plan. When IBM’s shares moved up from $11½ to $16, Wachenheim sold his firm’s shares since he thought the market price was now incorporating the expected positive development.
Selling IBM at $16 was a big mistake based on subsequent developments. The company generated large amounts of cash, part of which it used to buy back shares. By 1996, IBM was on track to earn $2.50 per share. So Wachenheim decided to repurchase shares in IBM at $24½. Although he was wrong to sell at $16, he was right to see his error and rebuy at $24½. When IBM ended up doing better than expected, the shares moved to $48 in late 1997, at which point Wachenheim sold.
Over the years, I have learned that we can do well in the stock market if we do enough things right and if we avoid large permanent losses, but that it is impossible to do nearly everything right. To err is human””and I make plenty of errors. My judgment to sell IBM’s shares in 1993 at $16 was an expensive mistake. I try not to fret over mistakes. If I did fret, the investment process would be less enjoyable and more stressful. In my opinion, investors do best when they are relaxed and are having fun.
Finding good ideas takes time. Greenhaven rejects the vast majority of its potential ideas. Good ideas are rare.
INTERSTATE BAKERIES
(Photo of a bakery by Mohylek, Wikimedia Commons)
Wachenheim discovered that Howard Berkowitz bought 12 percent of the outstanding shares of Interstate Bakeries, became chairman of the board, and named a new CEO. Wachenheim believed that Howard Berkowitz was an experienced and astute investor. In 1967, Berkowitz was a founding partner of Steinhardt, Fine, Berkowitz & Co., one of the earliest and most successful hedge funds. Wachenheim started analyzing Interstate in 1985 when the stock was at about $15:
Because of my keen desire to survive by minimizing risks of permanent loss, the balance sheet then becomes a good place to start efforts to understand a company. When studying a balance sheet, I look for signs of financial and accounting strengths. Debt-to-equity ratios, liquidity, depreciation rates, accounting practices, pension and health care liabilities, and ‘hidden’ assets and liabilities all are among common considerations, with their relative importance depending on the situation. If I find fault with a company’s balance sheet, especially with the level of debt relative to the assets or cash flows, I will abort our analysis, unless there is a compelling reason to do otherwise.
Wachenheim looks at management after he is done analyzing the balance sheet. He admits that he is humble about his ability to assess management. Also, good or bad results are sometimes due in part to chance.
Next Wachenheim examines the business fundamentals:
We try to understand the key forces at work, including (but not limited to) quality of products and services, reputation, competition and protection from future competition, technological and other possible changes, cost structure, growth opportunities, pricing power, dependence on the economy, degree of governmental regulation, capital intensity, and return on capital. Because we believe that information reduces uncertainty, we try to gather as much information as possible. We read and think””and we sometimes speak to customers, competitors, and suppliers. While we do interview the managements of the companies we analyze, we are wary that their opinions and projections will be biased.
Wachenheim reveals that the actual process of analyzing a company is far messier than you might think based on the above descriptions:
We constantly are faced with incomplete information, conflicting information, negatives that have to be weighed against positives, and important variables (such as technological change or economic growth) that are difficult to assess and predict. While some of our analysis is quantitative (such as a company’s debt-to-equity ratio or a product’s share of market), much of it is judgmental. And we need to decide when to cease our analysis and make decisions. In addition, we constantly need to be open to new information that may cause us to alter previous opinions or decisions.
Wachenheim indicates a couple of lessons learned. First, it can often pay off when you follow a capable and highly incentivized business person into a situation. Wachenheim made his bet on Interstate based on his confidence in Howard Berkowitz. Interstate’s shares were not particularly cheap.
Years later, Interstate went bankrupt because they took on too much debt. This is a very important lesson. For any business, there will be problems. Working through difficulties often takes much longer than expected. Thus, having low or no debt is essential.
U.S. HOME CORPORATION
(Photo by Dwight Burdette, Wikimedia Commons)
Wachenheim describes his use of screens:
I frequently use Bloomberg’s data banks to run screens. I screen for companies that are selling for low price-to-earnings (PE) ratios, low prices to revenues, low price-to-book values, or low prices relative to other relevant metrics. Usually the screens produce a number of stocks that merit additional analyses, but almost always the additional analyses conclude that there are valid reasons for the apparent undervaluations.
Wachenheim came across U.S. Home in mid-1994 based on a discount to book value screen. The shares appeared cheap at 0.63 times book and 6.8 times earnings:
Very low multiples of book and earnings are adrenaline flows for value investors. I eagerly decided to investigate further.
Later, although U.S. Home was cheap and produced good earnings, the stock price remained depressed. But there was a bright side because U.S. Home led to another homebuilder idea…
CENTEX CORPORATION
(Photo by Steven Pavlov, Wikimedia Commons)
After doing research and constructing a financial model of Centex Corporation, Wachenheim had a startling realization: the shares would be worth about $63 a few years in the future, and the current price was $12. Finally, a good investment idea:
“¦my research efforts usually are tedious and frustrating. I have hundreds of thoughts and I study hundreds of companies, but good investment ideas are few and far between. Maybe only 1 percent or so of the companies we study ends up being part of our portfolios””making it much harder for a stock to enter our portfolio than for a student to enter Harvard. However, when I do find an exciting idea, excitement fills the air””a blaze of light that more than compensates for the hours and hours of tedium and frustration.
Greenhaven typically aims for 30 percent annual returns on each investment:
Because we make mistakes, to achieve 15 to 20 percent average returns, we usually do not purchase a security unless we believe that it has the potential to provide a 30 percent or so annual return. Thus, we have very high expectations for each investment.
In late 2005, Wachenheim grew concerned that home prices had gotten very high and might decline. Many experts, including Ben Bernanke, argued that because home prices had never declined in U.S. history, they were unlikely to decline. Wachenheim disagreed:
It is dangerous to project past trends into the future. It is akin to steering a car by looking through the rearview mirror”¦
UNION PACIFIC
(Photo by Slambo, Wikimedia Commons)
After World War II, the construction of the interstate highway system gave trucks a competitive advantage over railroads for many types of cargo. Furthermore, fewer passengers took trains, partly due to the interstate highway system and partly due to the commercialization of the jet airplane. Excessive regulation of the railroads“”in an effort to help farmers“”also caused problems. In the 1960s and 1970s, many railroads went bankrupt. Finally, the government realized something had to be done and it passed the Staggers Act in 1980, deregulating the railroads:
The Staggers Act was a breath of fresh air. Railroads immediately started adjusting their rates to make economic sense. Unprofitable routes were dropped. With increased profits and with confidence in their future, railroads started spending more to modernize. New locomotives, freight cars, tracks, automated control systems, and computers reduced costs and increased reliability. The efficiencies allowed the railroads to reduce their rates and become more competitive with trucks and barges”¦.
In the 1980s and 1990s, the railroad industry also enjoyed increased efficiencies through consolidating mergers. In the west, the Burlington Northern merged with the Santa Fe, and the Union Pacific merged with the Southern Pacific.
Union Pacific reduced costs during the 2001-2002 recession, but later this led to congestion on many of its routes and to the need to hire and train new employees once the economy had picked up again. Union Pacific experienced an earnings shortfall, leading the shares to decline to $14.86.
Wachenheim thought that Union Pacific’s problems were temporary, and that the company would earn about $1.55 in 2006. With a conservative multiple of 14 times earnings, the shares would be worth over $22 in 2006. Also, the company was paying a $0.30 annual dividend. So the total return over a two-year period from buying the shares at $14½ would be 55 percent.
Wachenheim also thought Union Pacific stock had good downside protection because the book value was $12 a share.
Furthermore, even if Union Pacific stock just matched the expected return from the S&P 500 Index of 9½ percent a year, that would still be much better than cash.
The fact that the S&P 500 Index increases about 9½ percent a year is an important reason why shorting stocks is generally a bad business. To do better than the market, the short seller has to find stocks that underperform the market by 19 percent a year. Also, short sellers have limited potential gains and unlimited potential losses. On the whole, shorting stocks is a terrible business and often even the smartest short sellers struggle.
Greenhaven sold its shares in Union Pacific at $31 in mid-2007, since other investors had recognized the stock’s value. Including dividends, Greenhaven earned close to a 24 percent annualized return.
Wachenheim asks why most stock analysts are not good investors. For one, most analysts specialize in one industry or in a few industries. Moreover, analysts tend to extrapolate known information, rather than define future scenarios and their probabilities of occurrence:
“¦in my opinion, most individuals, including securities analysts, feel more comfortable projecting current fundamentals into the future than projecting changes that will occur in the future. Current fundamentals are based on known information. Future fundamentals are based on unknowns. Predicting the future from unknowns requires the efforts of thinking, assigning probabilities, and sticking one’s neck out””all efforts that human beings too often prefer to avoid.
Also, I believe it is difficult for securities analysts to embrace companies and industries that currently are suffering from poor results and impaired reputations. Often, securities analysts want to see tangible proof of better results before recommending a stock. My philosophy is that life is not about waiting for the storm to pass. It is about dancing in the rain. One usually can read a weather map and reasonably project when a storm will pass. If one waits for the moment when the sun breaks out, there is a high probability others already will have reacted to the improved prospects and already will have driven up the price of the stock””and thus the opportunity to earn large profits will have been missed.
Wachenheim then quotes from a New York Times op-ed piece written on October 17, 2008, by Warren Buffett:
A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10, and 20 years from now. Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month””or a year””from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.
AMERICAN INTERNATIONAL GROUP
(AIG Corporate, Photo by AIG, Wikimedia Commons)
Wachenheim is forthright in discussing Greenhaven’s investment in AIG, which turned out to be a huge mistake. In late 2005, Wachenheim estimated that the intrinsic value of AIG would be about $105 per share in 2008, nearly twice the current price of $55. Wachenheim also liked the first-class reputation of the company, so he bought shares.
In late April 2007, AIG’s shares had fallen materially below Greenhaven’s cost basis:
When shares of one of our holdings are weak, we usually revisit the company’s longer-term fundamentals. If the longer-term fundamentals have not changed, we normally will continue to hold the shares, if not purchase more. In the case of AIG, it appeared to us that the longer-term fundamentals remained intact.
When Lehman filed for Chapter 11 bankruptcy protection on September 15, 2008, all hell broke loose:
The decline in asset values caused financial institutions to mark down the carrying value of their assets, which, in turn, caused sharp reductions in their credit ratings. Sharp reductions in credit ratings required financial institutions to raise capital and, in the case of AIG, to post collateral on its derivative contracts. But the near freezing of the financial markets prevented the requisite raising of capital and cash and thus caused a further deterioration in creditworthiness, which further increased the need for new capital and cash, and so on… On Tuesday night, September 16, the U.S. government agreed to provide the requisite cash in return for a lion’s share of the ownership of AIG. As soon as I read the agreement, it was clear to me that we had a large permanent loss in our holdings of AIG.
Wachenheim defends the U.S. government bailouts. Much of the problem was liquidity, not solvency. Also, the bailouts helped restore confidence in the financial system.
Wachenheim asked himself if he would make the same decision today to invest in AIG:
My answer was ‘yes'””and my conclusion was that, in the investment business, relatively unpredictable outlier developments sometimes can quickly derail otherwise attractive investments. It comes with the territory. So while we work hard to reduce the risks of large permanent loss, we cannot completely eliminate large risks. However, we can draw a line on how much risk we are willing to accept””a line that provides sufficient apparent protection and yet prevents us from being so risk averse that we turn down too many attractive opportunities. One should not invest with the precept that the next 100-year storm is around the corner.
Wachenheim also points out that when Greenhaven learns of a flaw in its investment thesis, usually the firm is able to exit the position with only a modest loss. If you’re right 2/3 of the time and if you limit losses as much as possible, the results should be good over time.
LOWE’S
(Photo by Miosotis Jade, Wikimedia Commons)
In 2011, Wachenheim carefully analyzed the housing market and reached an interesting conclusion:
I was excited that we had a concept about a probable strong upturn in the housing market that was not shared by most others. I believed that the existing negativism about housing was due to the proclivity of human beings to uncritically project recent trends into the future and to overly dwell on existing problems. When analyzing companies and industries, I tend to be an optimist by nature and a pragmatist through effort. In terms of the proverbial glass of water, it is never half empty, but always half full””and, as a pragmatist, it is twice as large as it needs to be.
Next Wachenheim built a model to estimate normalized earnings for Lowe’s three years in the future (in 2014). He came up with normal earnings of $3 per share. He thought the appropriate price-to-earnings ratio was 16. So the stock would be worth $48 in 2014 versus its current price (in 2011) of $24. It looked like a bargain.
After gathering more information, Wachenheim revised his earnings model:
“¦I revise models frequently because my initial models rarely are close to being accurate. Usually, they are no better than directional. But they usually do lead me in the right direction, and, importantly, the process of constructing a model forces me to consider and weigh the central fundamentals of a company that will determine the company’s future value.
Wachenheim now thought that Lowe’s could earn close to $4.10 in 2015, which would make the shares worth even more than $48. In August 2013, the shares hit $45.
In late September 2013, after playing tennis, another money manager asked Wachenheim if he was worried that the stock market might decline sharply if the budget impasse in Congress led to a government shutdown:
I answered that I had no idea what the stock market would do in the near term. I virtually never do. I strongly believe in Warren Buffett’s dictum that he never has an opinion on the stock market because, if he did, it would not be any good, and it might interfere with opinions that are good. I have monitored the short-term market predictions of many intelligent and knowledgeable investors and have found that they were correct about half the time. Thus, one would do just as well by flipping a coin.
I feel the same way about predicting the short-term direction of the economy, interest rates, commodities, or currencies. There are too many variables that need to be identified and weighed.
As for Lowe’s, the stock hit $67.50 at the end of 2014, up 160 percent from what Greenhaven paid.
WHIRLPOOL CORPORATION
(Photo by Steven Pavlov, Wikimedia Commons)
Wachenheim does not believe in the Efficient Market Hypothesis:
It seems to me that the boom-bust of growth stocks in 1968-1974 and the subsequent boom-bust of Internet technology stocks in 1998-2002 serve to disprove the efficient market hypothesis, which states that it is impossible for an investor to beat the stock market because stocks always are efficiently priced based on all the relevant and known information on the fundamentals of the stocks. I believe that the efficient market hypothesis fails because it ignores human nature, particularly the nature of most individuals to be followers, not leaders. As followers, humans are prone to embrace that which already has been faring well and to shun that which recently has been faring poorly. Of course, the act of buying into what already is doing well and shunning what is doing poorly serves to perpetuate a trend. Other trend followers then uncritically join the trend, causing the trend to feed on itself and causing excesses.
Many investors focus on the shorter term, which generally harms their long-term performance:
“¦so many investors are too focused on short-term fundamentals and investment returns at the expense of longer-term fundamentals and returns. Hunter-gatherers needed to be greatly concerned about their immediate survival””about a pride of lions that might be lurking behind the next rock”¦ They did not have the luxury of thinking about longer-term planning”¦ Then and today, humans often flinch when they come upon a sudden apparent danger””and, by definition, a flinch is instinctive as opposed to cognitive. Thus, over years, the selection process resulted in a subconscious proclivity for humans to be more concerned about the short term than the longer term.
By far the best thing for long-term investors is to do is absolutely nothing. The investors who end up performing the best over the course of several decades are nearly always those investors who did virtually nothing. They almost never checked prices. They never reacted to bad news.
Regarding Whirlpool:
In the spring of 2011, Greenhaven studied Whirlpool’s fundamentals. We immediately were impressed by management’s ability and willingness to slash costs. In spite of a materially subnormal demand for appliances in 2010, the company was able to earn operating margins of 5.9 percent. Often, when a company is suffering from particularly adverse industry conditions, it is unable to earn any profit at all. But Whirlpool remained moderately profitable. If the company could earn 5.9 percent margins under adverse circumstances, what could the company earn once the U.S. housing market and the appliance market returned to normal?
Not surprisingly, Wall Street analysts were focused on the short term:
“¦A report by J. P. Morgan dated April 27, 2011, stated that Whirlpool’s current share price properly reflected the company’s increased costs for raw materials, the company’s inability to increase its prices, and the current soft demand for appliances”¦
The J. P. Morgan report might have been correct about the near-term outlook for Whirlpool and its shares. But Greenhaven invests with a two- to four-year time horizon and cares little about the near-term outlook for its holdings.
The bulk of Greenhaven’s returns has been generated by relatively few of its holdings:
If one in five of our holdings triples in value over a three-year period, then the other four holdings only have to achieve 12 percent average annual returns in order for our entire portfolio to achieve its stretch goal of 20 percent. For this reason, Greenhaven works extra hard trying to identify potential multibaggers. Whirlpool had the potential to be a multibagger because it was selling at a particularly low multiple of its potential earnings power. Of course, most of our potential multibaggers do not turn out to be multibaggers. But one cannot hit a multibagger unless one tries, and sometimes our holdings that initially appear to be less exciting eventually benefit from positive unforeseen events (handsome black swans) and unexpectedly turn out to be a complete winner. For this reason, we like to remain fully invested as long as our holdings remain reasonably priced and free from large risks of permanent loss.
Wachenheim likes to read about the history of each company that he studies.
On July 4, 1914, a flight took place in Seattle, Washington, that had a major effect on the history of aviation. On that day, a barnstormer named Terah Maroney was hired to perform a flying demonstration as part of Seattle’s Independence Day celebrations. After displaying aerobatics in his Curtis floatplane, Maroney landed and offered to give free rides to spectators. One spectator, William Edward Boeing, a wealthy owner of a lumber company, quickly accepted Maroney’s offer. Boeing was so exhilarated by the flight that he completely caught the aviation bug””a bug that was to be with him for the rest of his life.
Boeing launched Pacific Aero Products (renamed the Boeing Airplane Company in 1917). In late 1916, Boeing designed an improved floatplane, the Model C. The Model C was ready by April 1917, the same month the United States entered the war. Boeing thought the Navy might need training aircraft. The Navy bought two. They performed well, so the Navy ordered 50 more.
Boeing’s business naturally slowed down after the war. Boeing sold a couple of small floatplanes (B-1’s), then 13 more after Charles Lindberg’s 1927 transatlantic flight. Still, sales of commercial planes were virtually nonexistent until 1933, when the company started marketing its model 247.
The twin-engine 247 was revolutionary and generally is recognized as the world’s first modern airplane. It had a capacity to carry 10 passengers and a crew of 3. It had a cruising speed of 189 mph and could fly about 745 miles before needing to be refueled.
Boeing sold seventy-five 247’s before making the much larger 307 Stratoliner, which would have sold well were it not for the start of World War II.
Boeing helped the Allies defeat Germany. The Boeing B-17 Flying Fortress bomber and the B-29 Superfortress bomber became legendary. More than 12,500 B-17s and more than 3,500 B-29s were built (some by Boeing itself and some by other companies that had spare capacity).
Boeing prospered during the war, but business slowed down again after the war. In mid-1949, the de Havilland Aircraft Company started testing its Comet jetliner, the first use of a jet engine. The Comet started carrying passengers in 1952. In response, Boeing started developing its 707 jet. Commercial flights for the 707 began in 1958.
The 707 was a hit and soon became the leading commercial plane in the world.
Over the next 30 years, Boeing grew into a large and highly successful company. It introduced many models of popular commercial planes that covered a wide range of capacities, and it became a leader in the production of high-technology military aircraft and systems. Moreover, in 1996 and 1997, the company materially increased its size and capabilities by acquiring North American Aviation and McDonnell Douglas.
In late 2012, after several years of delays on its new, more fuel-efficient plane””the 787″”Wall Street and the media were highly critical of Boeing. Wachenheim thought that the company could earn at least $7 per share in 2015. The stock in late 2012 was at $75, or 11 times the $7. Wachenheim believed that this was way too low for such a strong company.
Wachenheim estimated that two-thirds of Boeing’s business in 2015 would come from commercial aviation. He figured that this was an excellent business worth 20 times earnings (he used 19 times to be conservative). He reckoned that defense, one-third of Boeing’s business, was worth 15 times earnings. Therefore, Wachenheim used 17.7 as the multiple for the whole company, which meant that Boeing would be worth $145 by 2015.
Greenhaven established a position in Boeing at about $75 a share in late 2012 and early 2013. By the end of 2013, Boeing was at $136. Because Wall Street now had confidence that the 787 would be a commercial success and that Boeing’s earnings would rise, Wachenheim and his associates concluded that most of the company’s intermediate-term potential was now reflected in the stock price. So Greenhaven started selling its position.
SOUTHWEST AIRLINES
(Photo by Eddie Maloney, Wikimedia Commons)
The airline industry has had terrible fundamentals for a long time. But Wachenheim was able to be open-minded when, in August 2012, one of his fellow analysts suggested Southwest Airlines as a possible investment. Over the years, Southwest had developed a low-cost strategy that gave the company a clear competitive advantage.
Greenhaven determined that the stock of Southwest was undervalued, so they took a position.
The price of Southwest’s shares started appreciating sharply soon after we started establishing our position. Sometimes it takes years before one of our holdings starts to appreciate sharply””and sometimes we are lucky with our timing.
After the shares tripled, Greenhaven sold half its holdings since the expected return from that point forward was not great. Also, other investors now recognized the positive fundamentals Greenhaven had expected. Greenhaven sold the rest of its position as the shares continued to increase.
GOLDMAN SACHS
(Photo of Marcus Goldman, Wikimedia Commons)
Wachenheim echoes Warren Buffett when it comes to recognizing how much progress the United States has made:
My experience is that analysts and historians often dwell too much on a company’s recent problems and underplay its strengths, progress, and promise. An analogy might be the progress of the United States during the twentieth century. At the end of the century, U.S. citizens generally were far wealthier, healthier, safer, and better educated than at the start of the century. In fact, the century was one of extraordinary progress. Yet most history books tend to focus on the two tragic world wars, the highly unpopular Vietnam War, the Great Depression, the civil unrest during the Civil Rights movement, and the often poor leadership in Washington. The century was littered with severe problems and mistakes. If you only had read the newspapers and the history books, you likely would have concluded that the United States had suffered a century of relative and absolute decline. But the United States actually exited the century strong and prosperous. So did Goldman exit 2013 strong and prosperous.
In 2013, Wachenheim learned that Goldman had an opportunity to gain market share in investment banking because some competitors were scaling back in light of new regulations and higher capital requirements. Moreover, Goldman had recently completed a $1.9 billion cost reduction program. Compensation as a percentage of sales had declined significantly in the past few years.
Wachenheim discovered that Goldman is a technology company to a large extent, with a quarter of employees working in the technology division. Furthermore, the company had strong competitive positions in its businesses, and had sold or shut down sub-par business lines. Wachenheim checked his investment thesis with competitors and former employees. They confirmed that Goldman is a powerhouse.
Wachenheim points out that it’s crucial for investors to avoid confirmation bias:
I believe that it is important for investors to avoid seeking out information that reinforces their original analyses. Instead, investors must be prepared and willing to change their analyses and minds when presented with new developments that adversely alter the fundamentals of an industry or company. Good investors should have open minds and be flexible.
Wachenheim also writes that it’s very important not to invent a new thesis when the original thesis has been invalidated:
We have a straightforward approach. When we are wrong or when fundamentals turn against us, we readily admit we are wrong and we reverse our course. We do not seek new theories that will justify our original decision. We do not let errors fester and consume our attention. We sell and move on.
Wachenheim loves his job:
I am almost always happy when working as an investment manager. What a perfect job, spending my days studying the world, economies, industries, and companies; thinking creatively; interviewing CEOs of companies”¦ How lucky I am. How very, very lucky.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: jb@boolefund.com
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.
Robert G. Hagstrom has written a number of excellent books on investing. One of his best is The Detective and the Investor (Texere, 2002).
Many investors are too focused on the short term, are overwhelmed with information, take shortcuts, or fall prey to cognitive biases. Hagstrom argues that investors can learn from the Great Detectives as well as from top investigative journalists.
Great detectives very patiently gather information from a wide variety of sources. They discard facts that turn out to be irrelevant and keep looking for new facts that are relevant. They painstakingly use logic to analyze the given information and reach the correct conclusion. They’re quite willing to discard a hypothesis, no matter how well-supported, if new facts lead in a different direction.
(Illustration of Sherlock Holmes by Sidney Paget (1891), via Wikimedia Commons)
Top investigative journalists follow a similar method.
Outline for this blog post:
The Detective and the Investor
Auguste Dupin
Jonathan Laing and Sunbeam
Top Investigative Journalists
Edna Buchanan–Pulitzer Prize Winner
Sherlock Holmes
Arthur Conan Doyle
Holmes on Wall Street
Father Brown
How to Become a Great Detective
The first Great Detective is Auguste Dupin, an invention of Edgar Allan Poe. The financial journalist Jonathan Laing’s patient and logicalanalysis of the Sunbeam Corporation bears similarity to Dupin’s methods.
Top investigative journalists are great detectives. The Pulitzer Prize-winning journalist Edna Buchanan is an excellent example.
Sherlock Holmes is the most famous Great Detective. Holmes was invented by Dr. Arthur Conan Doyle.
Last but not least, Father Brown is the third Great Detective discussed by Hagstrom. Father Brown was invented by G. K. Chesterton.
The last section–How To Become a Great Detective–sums up what you as an investor can learn from the three Great Detectives.
THE DETECTIVE AND THE INVESTOR
Hagstrom writes that many investors, both professional and amateur, have fallen into bad habits, including the following:
Short-term thinking: Many professional investors advertise their short-term track records, and many clients sign up on this basis. But short-term performance is largely random, and usually cannot be maintained. What matters (at a minimum) is performance over rolling five-year periods.
Infatuation with speculation: Speculation is guessing what other investors will do in the short term. Investing, on the other hand, is figuring out the value of a given business and only buying when the price is well below that value.
Overload of information: The internet has led to an overabundance of information. This makes it crucial that you, as an investor, know how to interpret and analyze the information.
Mental shortcuts: We know from Daniel Kahneman (see Thinking, Fast and Slow) that most people rely on System 1 (intuition) rather than System 2 (logic and math) when making decisions under uncertainty. Most investors jump to conclusions based on easy explanations, and then–due to confirmation bias–only see evidence that supports their conclusions.
Emotional potholes: In addition to confirmation bias, investors suffer from overconfidence, hindsight bias, loss aversion, and several other cognitive biases. These cognitive biases regularly cause investors to make mistakes in their investment decisions. I wrote about cognitive biases here:https://boolefund.com/cognitive-biases/
How can investors develop better habits? Hagstrom:
The core premise of this book is that the same mental skills that characterize a good detective also characterize a good investor… To say this another way, the analytical methods displayed by the best fictional detectives are in fact high-level decision-making tools that can be learned and applied to the investment world.
(Illustration of Sherlock Holmes by Sidney Paget, via Wikimedia Commons)
Hagstrom asks if it is possible to combine the methods of the three Great Detectives. If so, what would the ideal detective’s approach to investing be?
First, our investor-detective would have to keep an open mind, be prepared to analyze each new opportunity without any preset opinions. He or she would be well versed in the basic methods of inquiry, and so would avoid making any premature and possibly inaccurate assumptions. Of course, our investor-detective would presume that the truth might be hidden below the surface and so would distrust the obvious. The investor-detective would operate with cool calculation and not allow emotions to distract clear thinking. The investor-detective would also be able to deconstruct the complex situation into its analyzable parts. And perhaps most important, our investor-detective would have a passion for truth, and, driven by a nagging premonition that things are not what they seem to be, would keep digging away until all the evidence had been uncovered.
AUGUSTE DUPIN
(Illustration–byFrédéric Théodore Lix–to The Purloined Letter, via Wikimedia Commons)
The Murders in the Rue Morgue exemplifies Dupin’s skill as a detective. The case involves Madame L’Espanaye and her daughter. Madame L’Espanaye was found behind the house in the yard with multiple broken bones and her head almost severed. The daughter was found strangled to death and stuffed upside down into a chimney. The murders occurred in a fourth-floor room that was locked from the inside. On the floor were a bloody straight razor, several bloody tufts of grey hair, and two bags of gold coins.
Several witnesses heard voices, but no one could say for sure which language it was. After deliberation, Dupin concludes that they must not have been hearing a human voice at all. He also dismisses the possibility of robbery, since the gold coins weren’t taken. Moreover, the murderer would have to possess superhuman strength to stuff the daughter’s body up the chimney. As for getting into a locked room, the murderer could have gotten in through a window. Finally, Dupin demonstrates that the daughter could not have been strangled by a human hand. Dupin concludes that Madame L’Espanaye and her daughter were killed by an orangutan.
Dupin places an advertisement in the local newspaper asking if anyone had lost an orangutan. A sailor arrives looking for it. The sailor explains that he had seen the orangutan with a razor, imitating the sailor shaving. The orangutan had then fled. Once it got into the room with Madame L’Espanaye and her daughter, the orangutan probably grabbed Madame’s hair and was waving the razor, imitating a barber. When the woman screamed in fear, the orangutan grew furious and killed her and her daughter.
Thus Dupin solves what at first seemed like an impossible case. The solution is completely unexpected but is the only logical possibility, given all the facts.
Hagstrom writes that investors can learn important lessons from the Great Detective Auguste Dupin:
First, look in all directions, observe carefully and thoughtfully everything you see, and do not make assumptions from inadequate information. On the other hand, do not blindly accept what you find. Whatever you read, hear, or overhear about a certain stock or company may not necessarily be true. Keep on with your research; give yourself time to dig beneath the surface.
If you’re a small investor, it’s often best to invest in microcap stocks. (This presumes that you have access to a proven investment process.) There are hundreds of tiny companies much too small for most professional investors even to consider. Thus, there is much more mispricing among micro caps. Moreover, many microcap companies are relatively easy to analyze and understand. (The Boole Microcap Fund invests in microcap companies.)
JONATHAN LAING AND SUNBEAM
(Sunbeam logo, via Wikimedia Commons)
Hagstrom writes that, in the spring of 1997, Wall Street was in love with the self-proclaimed ‘turnaround genius’ Al Dunlap. Dunlap was asked to take over the troubled Sunbeam Corporation, a maker of electric home appliances. Dunlap would repeat the strategy he used on previous turnarounds:
[Drive] up the stock price by any means necessary, sell the company, and cash in his stock options at the inflated price.
Although Dunlap made massive cost cuts, some journalists were skeptical, viewing Sunbeam as being in a weak competitive position in a harsh industry. Jonathan Laing of Barron’s, in particular, took a close look at Sunbeam. Laing focused on accounting practices:
First, Laing pointed out that Sunbeam took a huge restructuring charge ($337 million) in the last quarter of 1996, resulting in a net loss for the year of $228.3 million. The charges included moving reserves from 1996 to 1997 (where they could later be recharacterized as income); prepaying advertising expenses to make the new year’s numbers look better; a suspiciously high charge for bad-debt allowance; a $90 million write-off for inventory that, if sold at a later date, could turn up in future profits; and write-offs for plants, equipment, and trademarks used by business lines that were still operating.
To Laing, it looked very much like Sunbeam was trying to find every possible way to transfer 1997 projected losses to 1996 (and write 1996 off as a lost year, claiming it was ruined by previous management) while at the same time switching 1996 income into 1997…
(Photo by Evgeny Ivanov)
Hagstrom continues:
Even though Sunbeam’s first-quarter 1997 numbers did indeed show a strong increase in sales volume, Laing had collected evidence that the company was engaging in the practice known as ‘inventory stuffing’–getting retailers to place abnormally large orders either through high-pressure sales tactics or by offering them deep discounts (using the written-off inventory from 1996). Looking closely at Sunbeam’s financial reports, Laing also found a hodgepodge of other maneuvers designed to boost sales numbers, such as delaying delivery of sales made in 1996 so they could go on the books as 1997 sales, shipping more units than the customer had actually ordered, and counting as sales orders that had already been canceled.
The bottom line was simply that much of 1997’s results would be artificial. Hagstrom summarizes the lesson from Dupin and Laing:
The core lesson for investors here can be expressed simply: Take nothing for granted, whether it comes from the prefect of police or the CEO of a major corporation. This is, in fact, a key theme of this chapter. If something doesn’t make sense to you–no matter who says it–that’s your cue to start digging.
By July 1998, Sunbeam stock had lost 80 percent of its value and was lower than when Dunlap took over. The board of directors fired Dunlap and admitted that its 1997 financial statements were unreliable and were being audited by a new accounting firm. In February 2001, Sunbeam filed for Chapter 11 bankruptcy protection. On May 15, 2001, the Securities and Exchange Commission filed suit against Dunlap and four senior Sunbeam executives, along with their accounting firm, Arthur Andersen. The SEC charged them with a fraudulent scheme to create the illusion of a successful restructuring.
Hagstrom points out what made Laing successful as an investigative journalist:
He read more background material, dissected more financial statements, talked to more people, and painstakingly pieced together what many others failed to see.
TOP INVESTIGATIVE JOURNALISTS
Hagstrom mentions Professor Linn B. Washington, Jr., a talented teacher and experienced investigative reporter. (Washington was awarded the Robert F. Kennedy Prize for his series of articles on drug wars in the Richard Allen housing project.) Hagstrom quotes Washington:
Investigative journalism is not a nine-to-five job. All good investigative journalists are first and foremost hard workers. They are diggers. They don’t stop at the first thing they come to but rather they feel a need to persist. They are often passionate about the story they are working on and this passion helps fuel the relentless pursuit of information. You can’t teach that. They either have it or they don’t.
…I think most reporters have a sense of morality. They are outraged by corruption and they believe their investigations have a real purpose, an almost sacred duty to fulfill. Good investigative reporters want to right the wrong, to fight for the underdog. And they believe there is a real responsibility attached to the First Amendment.
(Photo by Robyn Mackenzie)
Hagstrom then refers to The Reporter’s Handbook, written by Steve Weinberg for investigative journalists. Weinberg maintains that gathering information involves two categories: documents and people. Hagstrom:
Weinberg asks readers to imagine three concentric circles. The outmost one is ‘secondary sources,’ the middle one ‘primary sources.’ Both are composed primarily of documents. The inner circle, ‘human sources,’ is made up of people–a wide range of individuals who hold some tidbit of information to add to the picture the reporter is building.
Ideally, the reporter starts with secondary sources and then primary sources:
At these two levels of the investigation, the best reporters rely on what has been called a ‘documents state of mind.‘ This way of looking at the world has been articulated by James Steele and Donald Bartlett, an investigative team from the Philadephia Inquirer. It means that the reporter starts from day one with the belief that a good record exists somewhere, just waiting to be found.
Once good background knowledge is accumulated from all the primary and secondary documents, the reporter is ready to turn to the human sources…
Photo by intheskies
Time equals truth:
As they start down this research track, reporters also need to remember another vital concept from the handbook: ‘Time equals truth.‘ Doing a complete job of research takes time, whether the researcher is a reporter following a story or an investor following a company–or for that matter, a detective following the evidence at a crime scene. Journalists, investors, and detectives must always keep in mind that the degree of truth one finds is directly proportional to the amount of time one spends in the search. The road to truth permits no shortcuts.
The Reporter’s Handbook also urges reporters to question conventional wisdom, to remember that whatever they learn in their investigation may be biased, superficial, self-serving for the source, or just plain wrong. It’s another way of saying ‘Take nothing for granted.‘ It is the journalist’s responsibility–and the investor’s–to penetrate the conventional wisdom and find what is on the other side.
The three concepts discussed above–’adopt a documents state of mind,’ ‘time equals truth,’ and ‘question conventional wisdom; take nothing for granted’–may be key operating principles for journalists, but I see them also as new watchwords for investors.
EDNA BUCHANAN–PULITZER PRIZE WINNER
Edna Buchanan, working for the Miami Herald and covering the police beat, won a Pulitzer Prize in 1986. Hagstrom lists some of Buchanan’s principles:
Do a complete background check on all the key players. Find out how a person treats employees, women, the environment, animals, and strangers who can do nothing for them. Discover if they have a history of unethical and/or illegal behavior.
Cast a wide net. Talk to as many people as you possibly can. There is always more information. You just have to find it. Often that requires being creative.
Take the time.Learning the truth is proportional to the time and effort you invest. There is always more that you can do. And you may uncover something crucial. Never take shortcuts.
Use common sense. Often official promises and pronouncements simply don’t fit the evidence. Often people lie, whether due to conformity to the crowd, peer pressure, loyalty (like those trying to protect Nixon et al. during Watergate), trying to protect themselves, fear, or any number of reasons. As for investing, some stories take a long time to figure out, while other stories (especially for tiny companies) are relatively simple.
Take no one’s word. Find out for yourself. Always be skeptical and read between the lines. Very often official press releases have been vetted by lawyers and leave out critical information. Take nothing for granted.
Double-check your facts, and then check them again. For a good reporter, double-checking facts is like breathing. Find multiples sources of information. Again, there are no shortcuts. If you’re an investor, you usually need the full range of good information in order to make a good decision.
In most situations, to get it right requires a great deal of work. You must look for information from a broad range of sources. Typically you will find differing opinions. Not all information has the same value. Always be skeptical of conventional wisdom, or what ‘everybody knows.’
SHERLOCK HOLMES
Image by snaptitude
Sherlock Holmes approaches every problem by following three steps:
First, he makes a calm, meticulous examination of the situation, taking care to remain objective and avoid the undue influence of emotion. Nothing, not even the tiniest detail, escapes his keen eye.
Next, he takes what he observes and puts it in context by incorporating elements from his existing store of knowledge. From his encyclopedic mind, he extracts information about the thing observed that enables him to understand its significance.
Finally, he evaluates what he observed in the light of this context and, using sound deductive reasoning, analyzes what it means to come up with the answer.
These steps occur and re-occur in an iterative search for all the facts and for the best hypothesis.
There was a case involving a young doctor, Percy Trevelyan. Some time ago, an older gentleman named Blessington offered to set up a medical practice for Trevelyan in return for a share of the profits. Trevelyan agreed.
A patient suffering from catalepsy–a specialty of the doctor–came to the doctor’s office one day. The patient also had his son with him. During the examination, the patient suffered a cataleptic attack. The doctor ran from the room to grab the treatment medicine. But when he got back, the patient and his son were gone. The two men returned the following day, giving a reasonable explanation for the mix-up, and the exam continued. (On both visits, the son had stayed in the waiting room.)
Shortly after the second visit, Blessington burst into the exam room, demanding to know who had been in his private rooms. The doctor tried to assure him that no one had. But upon going to Blessington’s room, he saw a strange set of footprints. Only after Trevelyan promises to bring Sherlock Holmes to the case does Blessington calm down.
Holmes talks with Blessington. Blessington claims not to know who is after him, but Holmes can tell that he is lying. Holmes later tells his assistant Watson that the patient and his son were fakes and had some sinister reason for wanting to get Blessington.
Holmes is right. The next morning, Holmes and Watson are called to the house again. This time, Blessington is dead, apparently having hung himself.
But Holmes deduces that it wasn’t a suicide but a murder. For one thing, there were four cigar butts found in the fireplace, which led the policeman to conclude that Blessington had stayed up late agonizing over his decision. But Holmes recognizes that Blessington’s cigar is a Havana, but the other three cigars had been imported by the Dutch from East India. Furthermore, two had been smoked from a holder and two without. So there were at least two other people in the room with Blessington.
Holmes does his usual very methodical examination of the room and the house. He finds three sets of footprints on the stairs, clearly showing that three men had crept up the stairs. The men had forced the lock, as Holmes deduced from scratches on it.
Holmes also realized the three men had come to commit murder. There was a screwdriver left behind. And he could further deduce (by the ashes dropped) where each man sat as the three men deliberated over how to kill Blessington. Eventually, they hung Blessington. Two killers left the house and the third barred the door, implying that the third murderer must be a part of the doctor’s household.
All these signs were visible: the three sets of footprints, the scratches on the lock, the cigars that were not Blessington’s type, the screwdriver, the fact that the front door was barred when the police arrived. But it took Holmes to put them all together and deduce their meaning: murder, not suicide. As Holmes himself remarked in another context, ‘The world is full of obvious things which nobody by any chance ever observes.’
…He knows Blessington was killed by people well known to him. He also knows, from Trevelyan’s description, what the fake patient and his son look like. And he has found a photograph of Blessington in the apartment. A quick stop at policy headquarters is all Holmes needs to pinpoint their identity. The killers, no strangers to the police, were a gang of bank robbers who had gone to prison after being betrayed by their partner, who then took off with all the money–the very money he used to set Dr. Trevelyan up in practice. Recently released from prison, the gang tracked Blessington down and finally executed him.
Spelled out thus, one logical point after another, it seems a simple solution.Indeed, that is Holmes’s genius: Everything IS simple, once he explains it.
Hagstrom then adds:
Holmes operates from the presumption that all things are explainable; that the clues are always present, awaiting discovery.
The first step–gathering all the facts–usually requires a great deal of careful effort and attention. One single fact can be the key to deducing the true hypothesis. The current hypothesis is revisable if there may be relevant facts not yet known. Therefore, a heightened degree of awareness is always essential. With practice, a heightened state of alertness becomes natural for the detective (or the investor).
“Details contain the vital essence of the whole matter.”– Sherlock Holmes
Moreover, it’s essential to keep emotion out of the process of discovery:
One reason Holmes is able to see fully what others miss is that he maintains a level of detached objectivity toward the people involved. He is careful not to be unduly influenced by emotion, but to look at the facts with calm, dispassionate regard. He sees everything that is there–and nothing that is not. For Holmes knows that when emotion seeps in, one’s vision of what is true can become compromised. As he once remarked to Dr. Watson, ‘Emotional qualities are antagonistic to clear reasoning… Detection is, or ought to be, an exact science and should be treated in the same cold and unemotional manner. You have attempted to tinge it with romanticism, which produces much the same effect as if you worked a love story or an elopement into the fifth proposition of Euclid.’
Image by snaptitude
Holmes himself is rather aloof and even antisocial, which helps him to maintain objectivity when collecting and analyzing data.
‘I make a point of never having any prejudices and of following docilely wherever fact may lead me.’ He starts, that is, with no preformed idea, and merely collects data. But it is part of Holmes’s brilliance that he does not settle for the easy answer. Even when he has gathered together enough facts to suggest one logical possibility, he always knows that this answer may not be the correct one. He keeps searching until he has found everything, even if subsequent facts point in another direction. He does not reject the new facts simply because they’re antithetical to what he’s already found, as so many others might.
Hagstrom observes that many investors are susceptible to confirmation bias:
…Ironically, it is the investors eager to do their homework who may be the most susceptible. At a certain point in their research, they have collected enough information that a pattern becomes clear, and they assume they have found the answer. If subsequent information then contradicts that pattern, they cannot bring themselves to abandon the theory they worked so hard to develop, so they reject the new facts.
Gathering information about an investment you are considering means gather all the information, no matter where it ultimately leads you. If you find something that does not fit your original thesis, don’t discard the new information–change the thesis.
ARTHUR CONAN DOYLE
Arthur Conan Doyle was a Scottish doctor. One of his professors, Dr. Bell, challenged his students to hone their skills of observation. Bell believed that a correct diagnosis required alert attention to all aspects of the patient, not just the stated problem. Doyle later worked for Dr. Bell. Doyle’s job was to note the patients’ problem along with all possibly relevant details.
Doyle had a very slow start as a doctor. He had virtually no patients. He spent his spare time writing, which he had loved doing since boarding school. Doyle’s main interest was historical fiction. But he didn’t get much money from what he wrote.
One day he wrote a short novel, A Study in Scarlet, which introduced a private detective, Sherlock Holmes. Hagstrom quotes Doyle:
I thought I would try my hand at writing a story where the hero would treat crime as Dr. Bell treated disease, and where science would take the place of chance.
Doyle soon realized that he might be able to sell short stories about Sherlock Holmes as a way to get some extra income. Doyle preferred historical novels, but his short stories about Sherlock Holmes started selling surprisingly well. Because Doyle continued to emphasize historical novels and the practice of medicine, he demanded higher and higher fees for his short stories about Sherlock Holmes. But the stories were so popular that magazine editors kept agreeing to the fee increases.
Photo by davehanlon
Soon thereafter, Doyle, having hardly a single patient, decided to abandon medicine and focus on writing. Doyle still wanted to do other types of writing besides the short stories. He asked for a very large sum for the Sherlock Holmes stories so that the editors would stop bothering him. Instead, the editors immediately agreed to the huge fee.
Many years later, Doyle was quite tired of Holmes and Watson after having written fifty-six short stories and four novels about them. But readers never could get enough. And the stories are still highly popular to this day, which attests to Doyle’s genius. Doyle has always been credited with launching the tradition of the scientific sleuth.
HOLMES ON WALL STREET
Sherlock Holmes is the most famous Great Detective for good reason. He is exceptionally thorough, unemotional, and logical.
Holmes knows a great deal about many different things, which is essential in order for him to arrange and analyze all the facts:
The list of things Holmes knows about is staggering: the typefaces used by different newspapers, what the shape of a skull reveals about race, the geography of London, the configuration of railway lines in cities versus suburbs, and the types of knots used by sailors, for a few examples. He has authored numerous scientific monographs on such topics as tattoos, ciphers, tobacco ash, variations in human ears, what can be learned from typewriter keys, preserving footprints with plaster of Paris, how a man’s trade affects the shape of his hands, and what a dog’s manner can reveal about the character of its owner.
(Illustration of Sherlock Holmes with various tools, by Elena Kreys)
Consider what Holmes says about his monograph on the subject of tobacco:
“In it I enumerate 140 forms of cigar, cigarette, and pipe tobacco… It is sometimes of supreme importance as a clue. If you can say definitely, for example, that some murder has been done by a man who was smoking an Indian lunkah, it obviously narrows your field of search.”
It’s very important to keep gathering and re-gathering facts to ensure that you haven’t missed anything. Holmes:
“It is a capital mistake to theorize before you have all the evidence. It biases the judgment.”
“The temptation to form premature theories upon insufficient data is the bane of our profession.”
Although gathering all facts is essential, at the same time, you must be organizing those facts since not all facts are relevant to the case at hand. Of course, this is an iterative process. You may discard a fact as irrelevant and realize later that it is relevant.
Part of the sorting process involves a logical analysis of various combinations of facts. You reject combinations that are logically impossible. As Holmes famously said:
“When you have eliminated the impossible, whatever remains, however improbable, must be the truth.”
Often there is more than one logical possibility that is consistent with the known facts. Be careful not to be deceived by obvious hypotheses. Often what is ‘obvious’ is completely wrong.
Sometimes finding the solution requires additional research. Entertaining several possible hypotheses may also be required. Holmes:
“When you follow two separate chains of thought you will find some point of intersection which should approximate to the truth.”
But be careful to keep facts and hypotheses separate, as Holmes asserts:
“The difficulty is to detach the frame of absolute undeniable facts from the embellishments of theorists. Then, having established ourselves upon this sound basis, it is our duty to see what inferences may be drawn and what are the special points upon which the whole mystery turns.”
For example, there was a case involving the disappearance of a valuable racehorse. The chief undeniable fact was that the dog did not bark, which meant that the intruder had to be familiar to the dog.
Sherlock Holmes As Investor
How would Holmes approach investing? Hagstrom:
Here’s what we know of his methods: He begins an examination with an objective mind, untainted by prejudice. He observes acutely and catalogues all the information, down to the tiniest detail, and draws on his broad knowledge to put those details into context. Then, armed with the facts, he walks logically, rationally, thoughtfully toward a conclusion, always on the lookout for new, sometimes contrary information that might alter the outcome.
It’s worth repeating that much of the process of gathering facts can be tedious and boring. This is the price you must pay to ensure you get all the facts. Similarly, analyzing all the facts often requires patience and can take a long time. No shortcuts.
FATHER BROWN
Hagstrom opens the chapter with a scene in which Aristide Valentin–head of Paris police and the most famous investigator in Europe–is chasing Hercule Flambeau, a wealthy and famous French jewel thief. Both Valentin and Flambeau are on the same train. But Valentin gets distracted by the behavior of a very short Catholic priest with a round face. The priest is carrying several brown paper parcels, and he keeps dropping one or the other, or dropping his umbrella.
When the train reaches London, Valentin isn’t exactly sure where Flambeau went. So Valentin decides to go systematically to the ‘wrong places.’ Valentin ends up at a certain restaurant that caught his attention. A sugar bowl has salt in it, while the saltcellar contains sugar. He learns from a waiter that two clergymen had been there earlier, and that one had thrown a half-empty cup of soup against the wall. Valentin inquires which way the priests went.
Valentin goes to Carstairs Street. He passes a greengrocer’s stand where the signs for oranges and nuts have been switched. The owner is still upset about a recent incident in which a parson knocked over his bin of apples.
Valentin keeps looking and notices a restaurant that has a broken window. He questions the waiter, who explains to him that two foreign parsons had been there. Apparently, they overpaid. The waiter told the two parsons of their mistake, at which point one parson said, ‘Sorry for the confusion. But the extra amount will pay for the window I’m about to break.’ Then the parson broke the window.
Valentin finally ends up in a public park, where he sees two men, one short and one tall, both wearing clerical garb. Valentin approaches and recognizes that the short man is the same clumsy priest from the train. The short priest suspected all along that the tall man was not a priest but a criminal. The short priest, Father Brown, had left the trail of hints for the police. At that moment, even without turning around, Father Brown knew the police were nearby ready to arrest Flambeau.
Father Brown was invented by G. K. Chesterton. Father Brown is very compassionate and has deep insight into human psychology, which often helps him to solve crimes.
He knows, from hearing confessions and ministering in times of trouble, how people act when they have done something wrong. From observing a person’s behavior–facial expressions, ways of walking and talking, general demeanor–he can tell much about that person. In a word, he can see inside someone’s heart and mind, and form a clear impression about character…
His feats of detection have their roots in this knowledge of human nature, which comes from two sources: his years in the confessional, and his own self-awareness. What makes Father Brown truly exceptional is that he acknowledges the capacity for evildoing in himself. In ‘The Hammer of God’ he says, ‘I am a man and therefore have all devils in my heart.’
Because of this compassionate understanding of human weakness, from both within and without, he can see into the darkest corners of the human heart. The ability to identify with the criminal, to feel what he is feeling, is what leads him to find the identity of the criminal–even, sometimes, to predict the crime, for he knows the point at which human emotions such as fear or jealousy tip over from acceptable expression into crime. Even then, he believes in the inherent goodness of mankind, and sets the redemption of the wrongdoer as his main goal.
While Father Brown excels in understanding human psychology, he also excels at logical analysis of the facts. He is always open to alternative explanations.
(Frontispiece to G. K. Chesterton’s The Wisdom of Father Brown, Illustration by Sydney Semour Lucas, via Wikimedia Commons)
Later the great thief Flambeau is persuaded by Father Brown to give up a life of crime and become a private investigator. Meanwhile, Valentin, the famous detective, turns to crime and nearly gets away with murder. Chesterton loves such ironic twists.
Chesterton was a brilliant writer who wrote in an amazing number of different fields. Chesterton was very compassionate, with a highly developed sense of social justice, notes Hagstrom. The Father Brown stories are undoubtedly entertaining, but they also deal with questions of justice and morality. Hagstrom quotes an admirer of Chesterton, who said: ‘Sherlock Holmes fights criminals; Father Brown fights the devil.’ Whenever possible, Father Brown wants the criminal to find redemption.
Hagstrom lists what could be Father Brown’s investment guidelines:
Look carefully at the circumstances; do whatever it takes to gather all the clues.
Cultivate the understanding of intangibles.
Using both tangible and intangible evidence, develop such a full knowledge of potential investments that you can honestly say you know them inside out.
Trust your instincts. Intuition is invaluable.
Remain open to the possibility that something else may be happening, something different from that which first appears; remember that the full truth may be hidden beneath the surface.
Hagstrom mentions that psychology can be useful for investing:
Just as Father Brown’s skill as an analytical detective was greatly improved by incorporating the study of psychology with the method of observations, so too can individuals improve their investment performance by combining the study of psychology with the physical evidence of financial statement analysis.
HOW TO BECOME A GREAT DETECTIVE
Hagstrom lists the habits of mind of the Great Detectives:
Auguste Dupin
Develop a skeptic’s mindset; don’t automatically accept conventional wisdom.
Conduct a thorough investigation.
Sherlock Holmes
Begin an investigation with an objective and unemotional viewpoint.
Pay attention to the tiniest details.
Remain open-minded to new, even contrary, information.
Apply a process of logical reasoning to all you learn.
Father Brown
Become a student of psychology.
Have faith in your intuition.
Seek alternative explanations and re-descriptions.
Hagstrom argues that these habits of mind, if diligently and consistently applied, can help you to do better as an investor over time.
Furthermore, the true hero is reason, a lesson directly applicable to investing:
As I think back over all the mystery stories I have read, I realize there were many detectives but only one hero. That hero is reason. No matter who the detective was–Dupin, Holmes, Father Brown, Nero Wolfe, or any number of modern counterparts–it was reason that solved the crime and captured the criminal. For the Great Detectives, reason is everything. It controls their thinking, illuminates their investigation, and helps them solve the mystery.
Illustration by yadali
Hagstrom continues:
Now think of yourself as an investor. Do you want greater insight about a perplexing market? Reason will clarify your investment approach.
Do you want to escape the trap of irrational, emotion-based action and instead make decisions with calm deliberation? Reason will steady your thinking.
Do you want to be in possession of all the relevant investment facts before making a purchase? Reason will help you uncover the truth.
Do you want to improve your investment results by purchasing profitable stocks? Reason will help you capture the market’s mispricing.
In sum, conduct a thorough investigation. Painstakingly gather all the facts and keep your emotions entirely out of it. Skeptically question conventional wisdom and ‘what is obvious.’ Carefully use logic to reason through possible hypotheses. Eliminate hypotheses that cannot explain all the facts. Stay open to new information and be willing to discard the best current hypothesis if new facts lead in a different direction. Finally, be a student of psychology.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: jb@boolefund.com
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.
Walter Schloss generated one of the best investment track records of all time–close to 21% (gross) annually over 47 years–by investing exclusively in cigar butts (deep value stocks). Cigar-butt investing usually means buying stock at a discount to book value, i.e., a P/B < 1 (price-to-book ratio below 1).
The highest returning cigar butt strategy comes from Ben Graham, the father of value investing. It’s called the net-net strategy whereby you take current assets minus all liabilities, and then invest at 2/3 of that level or less.
The main trouble with net nets today is that many of them are tiny microcap stocks–below $50 million in market cap–that are too small even for most microcap funds.
Also, many net nets exist in markets outside the United States. Some of these markets have had problems periodically related to the rule of law.
Schloss used net nets in the early part of his career (1955 to 1960). When net nets became too scarce (1960), Schloss started buying stocks at half of book value. When those became too scarce, he went to buying stocks at two-thirds of book value. Eventually he had to adjust again and buy stocks at book value. Though his cigar-butt method evolved, Schloss was always using a low P/B to find cheap stocks.
(Photo by Sky Sirasitwattana)
One extraordinary aspect to Schloss’s track record is that he invested in roughly 1,000 stocks over the course of his career. (At any given time, his portfolio had about 100 stocks.) Warren Buffett commented:
Following a strategy that involved no real risk–defined as permanent loss of capital–Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500. It’s particularly noteworthy that he built this record by investing in about 1,000 securities, mostly of a lackluster type. A few big winners did not account for his success. It’s safe to say that had millions of investment managers made trades by a) drawing stock names from a hat; b) purchasing these stocks in comparable amounts when Walter made a purchase; and then c) selling when Walter sold his pick, theluckiest of them would not have come close to equaling his record. There is simply no possibility that what Walter achieved over 47 years was due to chance.
Schloss was aware that a concentrated portfolio–e.g., 10 to 20 stocks–could generate better long-term returns. However, this requires unusual insight on a repeated basis, which Schloss humbly admitted he didn’t have.
Most investors are best off investing in low-cost index funds or in quantitative value funds. For investors who truly enjoy looking for undervalued stocks, Schloss offered this advice:
It is important to know what you like and what you are good at and not worry that someone else can do it better. If you are honest, hardworking, reasonably intelligent and have good common sense, you can do well in the investment field as long as you are not too greedy and don’t get too emotional when things go against you.
I found a few articles I hadn’t seen before on The Walter Schloss Archive, a great resource page created by Elevation Capital:https://www.walterschloss.com/
Here’s the outline for this blog post:
Stock is Part Ownership; Keep It Simple
Have Patience; Don’t Sell on Bad News
Have Courage
Buy Assets Not Earnings
Buy Based on Cheapness Now, Not Cheapness Later
Boeing: Asset Play
Less Downside Means More Upside
Multiple Ways to Win
History; Honesty; Insider Ownership
You Must Be Willing to Make Mistakes
Don’t Try to Time the Market
When to Sell
The First 10 Years Are Probably the Worst
Stay Informed About Current Events
Control Your Emotions; Be Careful of Leverage
Ride Coattails; Diversify
STOCK IS PART OWNERSHIP; KEEP IT SIMPLE
A share of stock represents part ownership of a business and is not just a piece of paper or a blip on the computer screen.
Try to establish the value of the company. Use book value as a starting point. There are many businesses, both public and private, for which book value is a reasonable estimate of intrinsic value. Intrinsic value is what a company is worth–i.e., what a private buyer would pay for it. Book value–assets minus liabilities–is also called “net worth.”
Follow Buffett’s advice: keep it simple and don’t use higher mathematics.
(Illustration by Ileezhun)
Some kinds of stocks are easier to analyze than others. As Buffett has said, usually you don’t get paid for degree of difficulty in investing. Therefore, stay focused on businesses that you can fully understand.
There are thousands of microcap companies that are completely neglected by most professional investors. Many of these small businesses are simple and easy to understand.
HAVE PATIENCE; DON’T SELL ON BAD NEWS
Hold for 3 to 5 years. Schloss:
Have patience. Stocks don’t go up immediately.
Schloss again:
Things usually take longer to work out but they work out better than you expect.
(Illustration by Marek)
Don’t sell on bad news unless intrinsic value has dropped materially. When the stock drops significantly, buy more as long as the investment thesis is intact.
Schloss’s average holding period was 4 years. It was less than 4 years in good markets when stocks went up more than usual. It was greater than 4 years in bad markets when stocks stayed flat or went down more than usual.
HAVE COURAGE
Have the courage of your convictions once you have made a decision.
(Courage concept by Travelling-light)
Investors shun companies with depressed earnings and cash flows. It’s painful to own stocks that are widely hated. It can also be frightening. As John Mihaljevic explains in The Manual of Ideas (Wiley, 2013):
Playing into the psychological discomfort of Graham-style equities is the tendency of such investments to exhibit strong asset value but inferior earnings or cash flows. In a stressed situation, investors may doubt their investment theses to such an extent that they disregard the objectively appraised asset values. After all–the reasoning of a scared investor might go–what is an asset really worth if it produces no cash flow?
A related worry is that if a company is burning through its cash, it will gradually destroy net asset value. Ben Graham:
If the profits had been increasing steadily it is obvious that the shares would not sell at so low a price. The objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue, and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid.
It’s true that an individual cigar butt (deep value stock) is more likely to underperform than an average stock. But because the potential upside for a typical cigar butt is greater than the potential downside, a basket of cigar butts (portfolio of at least 30) does better than the market over time and also has less downside during bad states of the world–such as bear markets and recessions.
Schloss discussed an example: Cleveland Cliffs, an iron ore producer. Buffett owned the stock at $18 but then sold at about that level. The steel industry went into decline. The largest shareholder sold out because he thought the industry wouldn’t recover.
Schloss bought a lot of stock at $6. Nobody wanted it. There was talk of bankruptcy. Schloss noted that if he had lived in Cleveland, he probably wouldn’t have been able to buy the stock because all the bad news would have been too close.
Soon thereafter, the company sold some assets and bought back some stock. After the stock increased a great deal from the lows, then it started getting attention from analysts.
In sum, often when an industry is doing terribly, that’s the best time to find cheap stocks. Investors avoid stocks when they’re having problems, which is why they get so cheap. Investors overreact to negative news.
BUY ASSETS NOT EARNINGS
(Illustration byTeguh Jati Prasetyo)
Schloss:
Try to buy assets at a discount [rather] than to buy earnings. Earnings can change dramatically in a short time. Usually assets change slowly. One has to know much more about a company if one buys earnings.
Not only can earnings change dramatically; earnings can easily be manipulated–often legally. Schloss:
Ben made the point in one of his articles that if U.S. Steel wrote down their plants to a dollar, they would show very large earnings because they would not have to depreciate them anymore.
BUY BASED ON CHEAPNESS NOW, NOT CHEAPNESS LATER
Buy things based on cheapness now. Don’t buy based on cheapness relative to future earnings, which are hard to predict.
Graham developed two ways of estimating intrinsic value that don’t depend on predicting the future:
Net asset value
Current and past earnings
Professor Bruce Greenwald, in Value Investing (Wiley, 2004), has expanded on these two approaches.
As Greenwald explains, book value is a good estimate of intrinsic value if book value is close to the replacement cost of the assets. The true economic value of the assets is the cost of reproducing them at current prices.
Another way to determine intrinsic value is to figure out earnings power–also called normalized earnings–or how much the company should earn on average over the business cycle. Earnings power typically corresponds to a market level return on the reproduction value of the assets. In this case, your intrinsic value estimate based on normalized earnings should equal your intrinsic value estimate based on the reproduction value of the assets.
In some cases, earnings power may exceed a market level return on the reproduction value of the assets. This means that the ROIC (return on invested capital) exceeds the cost of capital. It can be exceedingly difficult, however, to determine by how much and for how long earnings power will exceed a market level return. Often it’s a question of how long some competitive advantage can be maintained. How long can a high ROIC be sustained?
As Buffett remarked:
The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.
A moat is a sustainable competitive advantage. Schloss readily admits he can’t determine which competitive advantages are sustainable. That requires unusual insight. Buffett can do it, but very few investors can.
As far as franchises or good businesses–companies worth more than adjusted book value–Schloss says he likes these companies, but rarely considers buying them unless the stock is close to book value. As a result, Schloss usually buys mediocre and bad businesses at book value or below. Schloss buys “difficult businesses” at clearly cheap prices.
Buying a high-growing company on the expectation that growth will continue can be quite dangerous. First, growth only creates value if the ROIC exceeds the cost of capital. Second, expectations for the typical growth stock are so high that even a small slowdown can cause the stock to drop noticeably. Schloss:
If observers are expecting the earnings to grow from $1.00 to $1.50 to $2.00 and then $2.50, an earnings disappointment can knock a $40 stock down to $20. You can lose half your money just because the earnings fell out of bed.
If you buy a debt-free stock with a $15 book selling at $10, it can go down to $8. It’s not great, but it’s not terrible either. On the other hand, if things turn around, that stock can sell at $25 if it develops its earnings.
Basically, we like protection on the downside. A $10 stock with a $15 book can offer pretty good protection. By using book value as a parameter, we can protect ourselves on the downside and not get hurt too badly.
Also, I think the person who buys earnings has got to follow it all the darn time. They’re constantly driven by earnings, they’re driven by timing. I’m amazed.
BOEING: ASSET PLAY
(Boeing 377 Stratocruiser, San Diego Air & Space Museum Archives, via Wikimedia Commons)
Cigar butts–deep value stocks–are characterized by two things:
Schloss has pointed out that Graham would often compare two companies. Here’s an example:
One was a very popular company with a book value of $10 selling at $45. The second was exactly the reverse–it had a book value of $40 and was selling for $25.
In fact, it was exactly the same company, Boeing, in two very different periods of time. In 1939, Boeing was selling at $45 with a book of $10 and earning very little. But the outlook was great. In 1947, after World War II, investors saw no future for Boeing, thinking no one was going to buy all these airplanes.
If you’d bought Boeing in 1939 at $45, you would have done rather badly. But if you’d bought Boeing in 1947 when the outlook was bad, you would have done very well.
Because a cigar butt is defined by poor recent performance and low expectations, there can be a great deal of upside if performance improves. For instance, if a stock is at a P/E (price-to-earnings ratio) of 5 and if earnings are 33% of normal, then if earnings return to normal and if the P/E moves to 15, you’ll make 900% on your investment. If the initial purchase is below true book value–based on the replacement cost of the assets–then you have downside protection in case earnings don’t recover.
LESS DOWNSIDE MEANS MORE UPSIDE
If you buy stocks that are protected on the downside, the upside takes care of itself.
The main way to get protection on the downside is by paying a low price relative to book value. If in addition to quantitative cheapness you focus on companies with low debt, that adds additional downside protection.
If the stock is well below probable intrinsic value, then you should buy more on the way down. The lower the price relative to intrinsic value, the less downside and the more upside. As risk decreases, potential return increases. This is the opposite of what modern finance theory teaches. According to theory, your expected return only increases if your risk also increases.
In The Superinvestors of Graham-and-Doddsville, Warren Buffett discusses the relationship between risk and reward. Sometimes risk and reward are positively correlated. Buffett gives the example of Russian roulette. Suppose a gun contains one cartridge and someone offers to pay you $1 million if you pull the trigger once and survive. Say you decline the bet as too risky, but then the person offers to pay you $5 million if you pull the trigger twice and survive. Clearly that would be a positive correlation between risk and reward. Buffett continues:
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.
One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned thePost, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.
Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million.
Most brokers don’t recommend buying more on the way down because most people (including brokers’ clients) don’t like to buy when the price keeps falling. In other words, most investors focus on price instead of intrinsic value.
MULTIPLE WAYS TO WIN
A stock trading at a low price relative to book value–a low P/B stock–is usually distressed and is experiencing problems. But there are several ways for a cigar-butt investor to win, as Schloss explains:
The thing about buying depressed stocks is that you really have three strings to your bow: 1) Earnings will improve and the stocks will go up; 2) somebody will come in and buy control of the company; or 3) the company will start buying its own stock and ask for tenders.
Schloss again:
But lots of times when you buy a cheap stock for one reason, that reason doesn’t pan out but another reason does–because it’s cheap.
HISTORY; HONESTY; INSIDER OWNERSHIP
Look at the history of the company. Value line is helpful for looking at history 10-15 years back. Also, read the annual reports. Learn about the ownership, what the company has done, when business they’re in, and what’s happened with dividends, sales, earnings, etc.
It’s usually better not to talk with management because it’s easy to be blinded by their charisma or sales skill:
When we buy into a company that has problems, we find it difficult talking to management as they tend to be optimistic.
That said, try to ensure that management is honest. Honesty is more important than brilliance, says Schloss:
…we try to get in with people we feel are honest. That doesn’t mean they’re necessarily smart–they may be dumb.
But in a choice between a smart guy with a bad reputation or a dumb guy, I think I’d go with the dumb guy who’s honest.
Finally, insider ownership is important. Management should own a fair amount of stock, which helps to align their incentives with the interests of the stockholders.
Speaking of insider ownership, Walter and Edwin Schloss had a good chunk of their own money invested in the fund they managed. You should prefer investment managers who, like the Schlosses, eat their own cooking.
YOU MUST BE WILLING TO MAKE MISTAKES
(Illustration by Lkeskinen0)
You have to be willing to make mistakes if you want to succeed as an investor. Even the best value investors tend to be right about 60% of the time and wrong 40% of the time. That’s the nature of the game.
You can’t do well unless you accept that you’ll make plenty of mistakes. The key, again, is to try to limit your downside by buying well below probable intrinsic value. The lower the price you pay (relative to estimated intrinsic value), the less you can lose when you’re wrong and the more you can make when you’re right.
DON’T TRY TO TIME THE MARKET
No one can predict the stock market. Ben Graham observed:
If I have noticed anything over these sixty years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.
(Illustration by Maxim Popov)
Or as value investor Seth Klarman has put it:
In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking.
Perhaps the best quote comes from Henry Singleton, a business genius (100 points from being a chess grandmaster) who was easily one of the best capital allocators in American business history:
I don’t believe all this nonsense about market timing. Just buy very good value and when the market is ready that value will be recognized.
Singleton built Teledyne using extraordinary capital allocation skills over the course of more than three decades, from 1960 to the early 1990’s. Fourteen of these years–1968 to 1982–were a secular bear market during which stocks were relatively flat and also experienced a few large downward moves (especially 1973-1974). But this long flat period punctuated by bear markets didn’t slow down or change Singleton’s approach. Because he consistently bought very good value, on the whole his acquisitions grew significantly in worth over time regardless of whether the broader market was down, flat, or up.
Of course, it’s true that if you buy an undervalued stock and then there’s a bear market, it may take longer for your investment to work. However, bear markets create many bargains. As long as you maintain a focus on the next 3 to 5 years, bear markets are wonderful times to buy cheap stocks (including more of what you already own).
In 1955, Buffett was advised by his two heroes, his father and Ben Graham, not to start a career in investing because the market was too high. Similarly, Graham told Schloss in 1955 that it wasn’t a good time to start.
Both Buffett and Schloss ignored the advice. In hindsight, both Buffett and Schloss made great decisions. Of course, Singleton would have made the same decision as Buffett and Schloss. Even if the market is high, there are invariably individual stocks hidden somewhere that are cheap.
Schloss always remained fully invested because he knew that virtually no one can time the market except by luck.
WHEN TO SELL
Don’t be in too much of a hurry to sell… Before selling try to reevaluate the company again and see where the stock sells in relation to its book value.
Selling is hard. Schloss readily admits that many stocks he sold later increased a great deal. But he doesn’t dwell on that.
The basic criterion for selling is whether the stock price is close to estimated intrinsic value. For a cigar butt investor like Schloss, if he paid a price that was half book, then if the stock price approaches book value, it’s probably time to start selling. (Unless it’s a rare stock that is clearly worth more than book value, assuming the investor was able to buy it low in the first place.)
If stock A is cheaper than stock B, some value investors will sell A and buy B. Schloss doesn’t do that. It often takes four years for one of Schloss’s investments to work. If he already has been waiting for 1-3 years with stock A, he is not inclined to switch out of it because he might have to wait another 1-3 years before stock B starts to move. Also, it’s very difficult to compare the relative cheapness of stocks in different industries.
Instead, Schloss makes an independent buy or sell decision for every stock. If B is cheap, Schloss simply buys B without selling anything else. If A is no longer cheap, Schloss sells A without buying anything else.
THE FIRST 10 YEARS ARE PROBABLY THE WORST
John Templeton’s worst ten years as an investor were his first ten years. The same was true for Schloss, who commented that it takes about ten years to get the hang of value investing.
STAY INFORMED ABOUT CURRENT EVENTS
(Photo by Juan Moyano)
Walter Schloss and his son Edwin sometimes would spend a whole day discussing current events, social trends, etc. Edwin Schloss said:
If you’re not in touch with what’s going on or you don’t see what’s going on around you, you can miss out on a lot of investment opportunities. So we try to be aware of everything around us–like John Templeton says in his book about being open to new ideas and new experiences.
CONTROL YOUR EMOTIONS; BE CAREFUL OF LEVERAGE
Try not to let your emotions affect your judgment. Fear and greed are probably the worst emotions to have in connection with the purchase and sale of stocks.
Quantitative investing is a good way to control emotion. This is what Graham suggested and practiced. Graham just looked at the numbers to make sure they were below some threshold–like 2/3 of current assets minus all liabilities (the net-net method). Graham typically was not interested in what the business did.
On the topic of discipline and controlling your emotions, Schloss told a great story about when Warren Buffett was playing golf with some buddies:
One of them proposed, “Warren, if you shoot a hole-in-one on this 18-hole course, we’ll give you $10,000 bucks. If you don’t shoot a hole-in-one, you owe us $10.”
Warren thought about it and said, “I’m not taking the bet.”
The others said, “Why don’t you? The most you can lose is $10. You can make $10,000.”
Warren replied, “If you’re not disciplined in the little things, you won’tbe disciplined in the big things.”
Be careful of leverage. It can go against you. Schloss acknowledges that sometimes he has gotten too greedy by buying highly leveraged stocks because they seemed really cheap. Companies with high leverage can occasionally become especially cheap compared to book value. But often the risk of bankruptcy is too high.
Still, as conservative value investor Seth Klarman has remarked, there’s room in the portfolio occasionally for a super cheap, highly indebted company. If the probability of success is high enough and if the upside is great enough, it may not be a difficult decision. Often the upside can be 10x or 20x your investment, which implies a positive expected return even when the odds of success are 10%.
RIDE COATTAILS; DIVERSIFY
Sometimes you can get good ideas from other investors you know or respect. Even Buffett did this. Buffett called it “coattail riding.”
Schloss, like Graham and Buffett, recommends a diversified approach if you’re doing cigar butt (deep value) investing. Have at least 15-20 stocks in your portfolio. A few investors can do better by being more concentrated. But most investors will do better over time by using a quantitative, diversified approach.
Schloss tended to have about 100 stocks in his portfolio:
…And my argument was, and I made it to Warren, we can’t project the earnings of these companies, they’re secondary companies, but somewhere along the line some of them will work out. Now I can’t tell you which ones, so I buy a hundred of them. Of course, it doesn’t mean you own the same amount of each stock. If we like a stock we put more money in it. Positions we are less sure about we put less in… We then buy the stock on the way down and try to sell it on the way up.
Even though Schloss was quite diversified, he still took larger positions in the stocks he liked best and smaller positions in the stocks about which he was less sure.
Schloss emphasized that it’s important to know what you know and what you don’t know. Warren Buffett and Charlie Munger call this a circle of competence. Even if a value investor is far from being the smartest, there are hundreds of microcap companies that are easy to understand with enough work.
(Image by Wilma64)
The main trouble in investing is overconfidence: having more confidence than is warranted by the evidence. Overconfidence is arguably the most widespread cognitive bias suffered by humans, as Nobel Laureate Daniel Kahneman details in Thinking, Fast and Slow. By humbly defining your circle of competence, you can limit the impact of overconfidence. Part of this humility comes from making mistakes.
The best choice for most investors is either an index fund or a quantitative value fund. It’s the best bet for getting solid long-term returns, while minimizing or removing entirely the negative influence of overconfidence.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: jb@boolefund.com
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.
Hilary Kramer is the author ofThe Little Book of Big Profits from Small Stocks (2012, Wiley). Kramer is a highly successful investor who has made most of her money by investing in single-digit priced stocks. She reveals her methods in this book.
Important Note: I am a value investor. I am looking to buy stocks at 50% or less of intrinsic value. Kramer’s approach is similar in many ways, but she is not a value investor per se. Kramer is still trying to buy stocks for less than they are worth, either relative to future earnings or relative to book value.
Kramer writes:
So why aren’t more Main Street investors looking to low-priced stocks? Well, one of the biggest beliefs on Wall Street is that stocks under $10 are too dangerous for most investors. Many institutional investors, such as mutual funds and pensions, are actually prohibited from owning stocks that trade in the single digits. Stock that have fallen below that magic $10 mark often lose the attention of the research departments, so no analysts follow them and they tend to be ignored. Wall Street often treats the single-digit priced stock sector as a graveyard, best passed as quickly as possible while whistling on the way to other endeavors.
Kramer has identified three categories of low-priced stocks:
Fall angels: These are large company stocks that have stumbled and fallen out of favor for various reasons. Some are cyclical stocks, while some were companies where management made mistakes and earnings fell short of Wall Street expectations.
Undiscovered growth companies: Many of these happen to be overlooked because they are in unattractive industries.
Bargain bin stocks: These are stocks trading below book value.
Kramer notes that it’s essential to read the company’s financial statements and investor presentations. There’s no easy way to high stock market profits.
Here’s an outline:
The Classic Under $10 Stock
The Price Is Not Just Right, It’s Critical
Oh, How the Mighty Have Fallen
Growing Out of Sight
Shopping the Bargain Bin
Getting the World Healthy and Wealthy
Around the World Under $10
Forget Everything You Thought You Knew
Looking for the Right Stuff
Well Bought is Half Sold
Beware the Wolves of Wall Street
Low Prices and High Profits
THE CLASSIC UNDER $10 STOCK
Kramer mentions Darling International (DAR) as the classic $10 stock. The company collects used cooking oil and grease from restaurants all over the United States. Another division stops at slaughterhouses and butcher shops to collect hides, bone, and other animal by-products. They turn all this unusable stuff into useable products.
Kramer noticed Darling stock when it fell from $16 to $4. She found that Darling’s competitors were small, locally-owned companies that had a hard time competing with Darling’s economies of scale. At the time, the company had 39 facilities around the United States and 970 trucks and tractor-trailers collecting raw materials from 115,000 locations. Most of Darling’s customers were on long-term contracts.
Darling was growing rapidly both organically and by acquisition of smaller competitors. Revenues had increased from $323 million in 2003 to $645 million in 2007. Profits had almost doubled from $.29 a share to $.59 a share. The company had also paid down it’s long-term debt. Kramer:
Darling may be in a stinky business, but it is one profitable company. In spite of this, by the end of 2008 the stock was solidly in the single digits, trading at $5 and change. Recently, the company had moved into alternative energy where the collected grease could be used to create biofuel.
Darling stock hit $4, which is where Kramer bought. A little less than three years later, the stock exceeded $16. Kramer’s investment had produced a 300 percent gain. Kramer writes:
In this book, my goal is to help you find your Darlings. After two decades of investing, I can tell you that low-priced stocks are a great way to build, or rebuild, your wealth. Many of my biggest winning stocks over the years started out as single-digit priced stocks. They were stocks that were way off Wall Street’s radar screens for a variety of reasons, but once the Street and large institutional investors discovered them, they often soared in price.
Kramer says these breakout stocks share three characteristics:
Low-priced (mainly under $10).
Undervalued.
Have specific catalysts in the near future that put them on the threshold of breaking out to much higher prices.
That said, some stocks under $10 are cheap because they deserve to be. So it’s essential to have a good investment process, including reading the company’s financial statements and presentations. Kramer adds that she wish she hadn’t sold Darling, as the stock was soon in the mid-20s.
Kramer points out that there will always be recessions and economic slowdowns periodically. It is wise to build a list of obsessive lifestyle stocks, because usually these stocks sell off just like other stocks during a recession but the businesses in question tend not to decline nearly as much.
THE PRICE IS NOT JUST RIGHT, IT’S CRITICAL
The major brokerage houses have gone to great lengths to discourage trading in low-priced stocks. To be sure, there are many low-priced stocks belonging to bad businesses, bankrupt companies, and overhyped enterprises. But there are many solid companies that just happen to have hit challenges, causing their stocks to drop.
Kramer gives another example of a stock that hit single digits where the business itself was solid: Dendreon (DNDN).
Dendreon was developing a new drug manufactured from the patient’s own immune cells. This new drug represented a potentially groundbreaking step in the fight against prostate cancer. FDA approval looked imminent.
However, in May of 2007, the FDA decided they needed more trials and more information before they could approve the drug for widespread usage. The stock began dropping and by May of 2009, Dendreon stock hit $2.60. The market cap of the company had gone from $3 billion to $400 million.
Kramer did her homework and found that Dendreon’s new drug was likely to be approved after the new trials. It took some time for Kramer to buy a full position, but she ended up getting one at an average price of $5 per share.
In May 2009, the FDA approved Dendreon’s new drug. In less than two weeks, the stock was back over $20 and worth $3 billion again. The stock kept going up from there because it was clear the new drug would be a commercial success. A year later, Kramer sold for more than $50, a 900 percent profit–a ten-bagger. Kramer:
I am not going to tell you that every low-priced stock you buy in your lifetime will breakout and become a ten-bagger. Most investors only have a few of those in a lifetime. I am going to tell you that we can make Wall Street’s aversion to low-priced stocks work for you more often than not and produce consistent and exciting profits. Any ten-baggers you run across long the way will just be icing on the cake!
OH, HOW THE MIGHTY HAVE FALLEN
Kramer writes:
These are companies that were once considered blue chip or growth darlings that have fallen monstrously out of favor with Wall Street and investors. These are stocks that were once widely owned and if not loved, at least admired and respected. Something went drastically wrong for these companies and the share price plummeted into single digits. In most cases investors sold too late and much money was lost along the way, often creating a cloud of ill will and outright distrust for these companies in many cases…
Often in the stock market, though, aversion can signal opportunity.
Kramer explains:
When it comes to identifying true fallen angels, there are two key questions you need to ask. The first question iswhat went wrong? Did management overdiversify the basic business and expand into areas where they had no expertise or advantage? Did the company borrow too much money and is now having a hard time generating sufficient cash flow to service their debt load? Has a competitor surpassed them in the marketplace? Has there been a change in consumers’ buying habits and preferences that have left the company behind? Have there been accounting irregularities or regulatory issues that the company must put behind it in a satisfactory manner before the company can return to profitability? Are there customer or supplier lawsuits weighing on the company and its stock price? The list of problems, mistakes, and management stumbles that make a once great company into a fallen angel are legion. Before you even consider investing in a fallen angel stock you need to know exactly what went wrong and who is responsible for the problems.
The next question then becomescan it be fixed? Can the company shed itself of unprofitable divisions or subsidiaries that take away from the core business? Can management regain focus and catch back up to its competitors? Can the company generate sufficient cash flow to pay down its debt or can the balance sheet be restructured in a fashion that allows a return to profitability? Can regulatory issues be solved without permanent harm to the company? Can they maintain a reasonable relationship with key suppliers and customers until the current crisis has passed? Are the accounting and regulatory issues mistakes or are they fraudulent or criminal activity? Can their products and services regain acceptance from consumers? Once we figure out what has gone wrong, we need to figure out if the problems can be fixed. If so, we have a candidate for a fallen angel stock, and in my experience the companies that do achieve a turnaround can then see their stock price double or even triple before too much time passes.
Kramer is quick to note that many of these stocks are not good investments for a variety of reasons. So the investor has to carefully examine many such companies in order to identify one or a tiny handful of fallen angels.
Kramer gives the example of Ford Motor Company (F). For a long time, Ford was the bluest of blue chips. The company was incorporated in 1903 and is credited with inventing the production line method of assembling vehicles. In World War II, Ford creating a great number of vehicles to meet military demand.
Froom 2005 to 2010 however, the company stumbled. Not only had they acquired many other car companies and divisions that were not profitable, but they had rising healthcare costs combined with slowing sales and declining margins. Management then made a bet in 2006 that they might need cash. So they raised $23.6 billion in debt. The CEO said this would cushion the company if there were a recession. Kramer:
In 2008 the bottom came out from under the U.S. car market. The automakers were heavily exposed to the consumer lending market and as the credit crisis deepened default rates climbed and profits evaporated. In 2008 For had the worst year in its history, losing over $414 billion as the recession deepened. Auto industry executives ended up going hat in hand to Capitol Hill to plead for a federal bailout.
Here is where Ford’s gamble at the end of 2006 paid off. Both Chrysler and General Motors (GM) ended up having to file bankruptcy and accept government bailouts and funding. Ford had enough cash on hand from the cash-out refinancing that they did not have to go to those lengths to survive. Because they had cash on hand they could run their day-to-day operations without government assistance. They engineered an equity-for-debt sawp that reduced debt loads by more than $10 billion. Management worked out a deal with the UAW to accept stock in lieu of cash for pension and healthcare expenses. Ford’s stock fell under $2 in 2009 as things looked bleak for the entire industry, and it began to divest some of its noncore lines like Jaguar, Land Rover, and Volvo.
This was where Kramer got interested in Ford’s stock. Ford had lowered its debt and also Kramer found, after doing some research, that Ford’s F150 line of trucks was still dominant and the company had a loyal customer base. Two years later, Ford stock (F) had gone from $2 to $18.
Kramer next describes her greatest fallen angel investment ever, one where the stock increased dramatically over the 8+ years that Kramer held it: Priceline.com (PCLN). Many internet stocks had crashed after the bubble in 1999-2000. This included Priceline, which had hit $1 per share.
The company had made some misteps by trying to expand beyond travel services using a name-your-own-price model to sell gasoline, groceries, long distance telephone plans, and a host of other items. They also tried to compete with eBay (EBAY) in the online auction business. They even tried a name-your-own-price home mortgage program. Nearly all these ventures failed.
The stock had fallen from $165 to $1. But Kramer discovered that the company still had plenty of cash. And Priceline was exiting all of their noncore operations and schemes and returning to their basic travel business. Friends told Kramer they were still using the service and were still very satisfied. Kramer bought the stock in February 2003.
The company did a one for six reverse stock split. This made Kramer’s cost basis, adjusted for the reverse split, $7.63 per share. By 2011, the stock had hit $543 and Kramer was continuing to hold it. Kramer:
I have made over 70 times my money by finding this fallen angel and asking two crucial questions:What went wrong?andCan it be fixed?
What went wrong was obvious. The stock got caught up in the collapse of the Internet boom and management tried to enter businesses where they had no competitive advantage. And once they returned to their original core focus, I felt it could be fixed and that it was only a matter of time before business and the stock price began to grow again.
What’s the best way to find fallen angel candidates? Kramer offers several methods. Read the news, as the stocks of one-time leaders that have fallen are usually paid attention in the media. Look at 52-week low lists. Check all the stocks in the S&P 500 to see which ones are single-digit stocks. Finally, one of the best tools is to use a web-based stock screener.
After you have a list of candidates, you have to go to work reading the financial statements and company presentations. You have to ask the two questions: What went wrong?and Can it be fixed?
GROWING OUT OF SIGHT
You can make a lot of money if you own a growth stock, but the key is to buy at a low price. Kramer explains that many growth stocks are already very popular, which means their stock prices are already quite high. Kramer writes:
We are more interested in the type of stocks that legendary Peter Lynch described in his classic bookOne Up On Wall Street. Mr. Lynch described the perfect stock as one that was in a boring niche business. Preferably the company would be a business that was dull or downright disagreeable. He jokingly said that he would also like it if there were rumors of toxic waste or Mafia involvement! This type of stock would be way off the Wall Street radar screen, and few institutions would own it and analysts would not cover it or write reports for the sales force to pump the stock.
Kramer reminds the reader that she had already described just such a stock in the first chapter: Darling International. Rendering and grease collection is a dull messy business, but a necessary one. Kramer jokes that she has never been to a party and heard someone talking about the wonderful hide rendering company that was in their portfolio. Kramer:
This is exactly what made Darling such an outstanding investment opportunity. No one was paying any attention to the company as they grew into the largest company in the business and grew earnings rapidly. Darling was not only a classic under $10 breakout stock, it was also an undiscovered growth stock.
Of course, not all growth stocks that are still cheap are unknown. Sometimes investors simply give up on a company, which makes the stock low-priced.
Kramer suggests a class of companies she calls “obsessive product companies.”
These companies make products that people simply do not want to live without regardless of what is going on in the economy or the world. There are some hobbies or products that become lifestyles. Many of these are not recognized on Wall Street for the simple reason that they do not share the same interests or recognize that in many cases the company in question makes a product that is not going to go away regardless of the economy. If business does slow down a bit, it is simply going to create pent-up demand. Purchases may be delayed but they will not be denied!
Krames gives the example of Cabela’s (CAB), the outdoor superstore company. In late 2008, like other retailers, Cabela’s saw slowing sales and the stock fell to $5. Kramer explains what Wall Street missed: Cabela’s sells hunting and fishing products, and the buyers of these products are very serious about their chosen hobby. Also, while Cabela’s had over $300 million in debt, the company had close to $400 million in cash. Moreover, their credit card operation never really experienced big losses, again because their customers were very serious about their hobby and didn’t want to let their Cabela’s account become delinquent.
Furthermore, the company was asset rich. It owned 24 of their 29 locations, and the book value of the stock was over $12.
In 2008, Kramer began buying the stock under $5. By the end of 2009, Cabela’s had over $500 million in cash and they had reduced their debt. Kramer sold at $14.92, for a return of almost 200 percent in less than a year.
Kramer notes that there will always be recessions and slowdowns periodically. It is wise to build a list of obsessive lifestyle stocks. When recession hits, these stocks tend to decline just like other stocks even though the obsessive lifestyle businesses tend not to decline nearly as much as other businesses.
Furthermore, Kramer suggests looking for companies that can experience earnings growth without necessarily being exciting. She gives the example of Dole Foods (DOLE). The company was founded in 1891. In 2003, businessman David Murdoch bought the company from Castle and Cook. The company expanded into other lines of fruits and vegetables. In 2009, the company went public at $12.50 a share.
Nobody paid any attention. Kramer:
Dole had grown into the largest producer and distributor of fruits and vegetables in the world but to investors these were not exciting products. The stock price languished and early in 2010 it fell below the $10 mark where I began to take notice of the company.
Kramer believed that the demand for healthy foods was only going to grow in the years ahead. This was true not only in the United States, but also in many emerging markets globally. The stock soon increased 50 percent. Kramer writes:
The mantra of most growth stock investors is bigger, better, faster. They are looking for the newest fads and the most exciting products. The truth is that the best growth stories are often found in our cupboards and refrigerators. The regular seemingly boring products we use every day can create growth stories and when those companies see their stock price fall into the single digits, they become tremendous profit opportunities.
Kramer also recommends running a web-based stock screen. Search for companies that have been growing steadily for at least five years. Most of these stocks will already be high-priced, but occasionally you may find a low-priced one. Kramer:
…just finding oneof these before Wall Street does can make a huge difference in your net worth over time.
Kramer:
To run this search, set the screener to look for stocks that have grown earnings and revenues by at least 15 percent a year for the past five years. We also want companies that do not owe a lot of money and have decent balance sheets. Legendary investor Benjamin Graham once set that threshold as owning twice what you owe, so I think that’s a reasonable threshold. Set the debt to equity ratio at a maximum of .3. This will give us a company with at least 70 percent equity and 30 percent debt as part of the total capital structure.
Of course, you also include on the screen the requirement that the stock price be below $10. Kramer:
Your list of stocks is going to be short and the companies will be small. In fact if you ran it right now for U.S. stocks the resulting list would be just 51 names out of all the stocks listed on major exchanges and markets here in the United States. The largest company on this list is going to be just $750 million in market capitalization and the smallest is just under $30 million in total market cap. There are some pretty interesting companies and it will be worth your time to search this list and dig a little deeper to find the real winners out of this list. You want to look for companies with products that have exposure to huge potential markets like alternative energy, smartphones, and other communication devices, social networking, or any other product or service that can see continued steady growth for years to come… Decent levels of insider ownership are also preferable in these small, steady growers. If the founders and managers of these little growth gems still own a good share of the company, say 10 percent or more, they have a vested interest in seeing the stock price go higher over time.
Kramer next mentions a screen for explosive growers. These are low-priced breakout stocks that have seen a surge of earnings and revenues in the past year. Kramer:
We usually find two types of companies on this list. One is a company that stumbled or is caught by the economic cycle and has had depressed earnings and sales. Now the cycle has swung back in their direction and they are set to surge. The other is a company that has a breakthrough with some product or service that suddenly takes the world by storm and is set to explode upward.
We want explosive growth here so we will initially set the bar high. Set your screener to look for companies with earnings growth of at least 100 percent annually. Often profit margins are also exploding so revenue growth is not as critical with this screen. Again, we do not want too much debt, but we can give these exploders a little more room, so set the debt to equity ratio ceiling at 50 percent.
Once again, a recession or a bear market can create many low-priced stocks among the explosive growers. Kramer says the investor will learn to love recessions and bear markets for this very reason.
SHOPPING THE BARGAIN BIN
This is the method of finding stocks that are trading below tangible book value. (Intangible assets are not included.) Kramer:
Bargain bin stocks sell below book value for many reasons. The company could be experiencing a slowdown in its business and Wall Street has abandoned the stock. The whole industry may be unloved, as was once the case with electric utility stocks back in the 1980s. Cost overruns on nuclear power plants and a hostile regulatory environment had all of these stocks selling for less than their book value. In the aftermath of the Savings and Loan crisis in the early 1990s, almost all small bank and thrift stocks sold well below the value of their assets. Sometimes it is just a stock that is too small for analysts to follow and the stock price has languished as the assets have grown. Our job is to figure out if those assets can be converted to either a higher stock price or be turned into cash via a takeover or restructuring in the near future.
Kramer gives the example of Tesoro (TSO), a major North American refiner of petroleum products. In 2008, its stock fell well below its book value. When the economy slows down, business is awful for refiners. However, the company had many tangible assets and we knew the recession would eventually end. Tesoro owned seven refineries and 879 retail gas stations. Tesoro also owned 900 miles of oil pipelines around the country. The most important point, writes Kramer, is that there are not many refineries in the United States. There hasn’t been a new refinery built in the United States since 1977. Therefore, these are irreplaceable assets. Kramer:
The assets already appeared pretty valuable to me. Although the business was terrible the asset pile was worth a lot of money. With the stock trading around $8 or so the tangible book value of Tesoro was about $23 a share. The assets were being discounted in the marketplace by more than 65 percent. That was just the discount from the accounting value of the assets. Because refineries are irreplaceable assets the discount was even greater when you considered the real value of Tesoro’s asset collection.
Kramer bought Tesoro around $8. Once the economy recovered, so did Tesoro’s profits and the stock soon tripled.
As far as screening for companies trading below tangible book, Kramer also recommends that the companies be profitable so that they are not burning through their assets. Kramer then recommends including on the screen that the debt to equity be a maximum of .30. And of course, the screen includes stocks that are below $10. Kramer concludes the chapter:
When we look over the list of stocks priced cheap compared to their assets, we want to consider what the actual assets are. The key question is: Can they be turned into profits at some point? If the assets are cash or commodity inventories, the answer is probably yes. They can be sold, returned to shareholders, or perhaps a competitor or private equity investor will recognize the value and buy the company at a premium. Are the assets real estate, such as commercial properties, hotels, or apartments? If so they can also probably be sold at a profit at a point in the future.
GETTING THE WORLD HEALTHY AND WEALTHY
The opportunities in low-priced stocks, whether fallen angels, undiscovered growth gems, or bargain stocks, occur in a variety of sectors. That said, some sectors may be particularly interesting, depending upon the investor and his or her expertise. Kramer mentions the biotech and pharmaceutical sector:
This particular sector is absolutely overflowing with low-priced investment opportunities–a trend I expect to continue in the near future.
There are a few key reasons for the sector’s hot hand. The most obvious reason is the advancements in technology. It seems like there is a new breakthrough drug, medical treatment, or device almost every week. We have seen advances not just in biotechnology, but in robotic surgery, titanium hips, cancer protocols, and life extension programs. Increasingly we are seeing the breakthroughs come from smaller companies wth smaller stock prices.
Kramer adds that there is a real need for these products. For example, in 2010, nearly 1.6 million Americans were diagnosed with cancer, and 570,000 died from the disease, according to the American Cancer Society. Furthermore, according to the University of Texas M.D. Anderson Cancer Center, the number of new cancer cases diagnosed annually in the United States is expected to increase by 45 percent to 2.3 million in 2030. There are also increasingly more cancer cases globally.
In the United States, according to the National Cancer Institute, part of the National Institute of Health (NIH), total expenditures on cancer treatment will grow at least 27 percent from 2010 to 2020, advancing from $127.6 billion to $158 billion. Kramer notes that the good news is that these treatment dollars are being funneled into innovative companies fighting this disease.
Here’s where the importance of smaller, lower-priced companies in this sector comes into play. The giant drug companies are looking to partner with these smaller companies to develop new products as an addition to their own research and development efforts.
Sometimes big pharmaceuticals, if they don’t partner with a smaller company, will acquire the company instead.
Kramer mentions that she bought Ariad Pharmaceuticals at $8 a share in 2011. Ariad is an emerging biopharmaceutical company that at the time had three potentially game-changing cancer treatments. Kramer explains that for one of these treatments, Merck partnered with Ariad. Kramer comments:
The partnership approach to developing drugs is going to be the model of groundbreaking research in the future. By setting up news searches and tracking the news of the largest pharmaceutical companies, you can keep on top of the exciting smaller companies that are working on potential blockbuster drugs.
Successful partnerships with larger drug companies have turned some single-digit stocks into huge winners. Regeneron (RGEN) has seen its stock price go from under $6 a share to well over $60 in just over five years as its partnership with pharmaceutical giant Sanofi-aventis has allowed it to develop promising cancer and autoimmune system drugs. Incyte’s partnership with Novartis helped drive the strock price from $2 to over $20 in three years.
Smaller biotechnology companies can push the curve in new research in ways that larger more established companies simply cannot. Rather than invest in unproven drugs and technologies, the larger companies prefer to provide cash and assistance to the up-and-coming companies. In return they can access potential breakthrough drugs with less overhead. It is a win for the company, for investors in the smaller company, and often for patients. As researchers and biotech companies continue to search for the answers for mankind’s medical issues these opportunities for low-priced breakout stocks will be increasingly available to attentive investors.
Kramer also mentions breakthroughs in medical devices and surgical techniques. This includes new cardiac stents being developed, new robotic surgical devices, new bone and joint replacement products, and many other devices and products to improve health and combat age-old problems.
Kramer points out that it takes some specialized effort to effectively search the universe of healthcare, drug, and biotechnology companies. Sometimes growth screens will produce ideas, but often more digging is required. Kramer concludes:
You can find news on such developments at www.fda.gov. The site has a wealth of information of new drugs being approved and which companies are developing them. It also tracks which drugs are in short supply and could lead to production ramp-up or higher margins for their manufacturers. The site also has information and reports that will help you understand the approval process for new drugs which will prove useful over the long run as you search for cheap stocks in the medical and drug fields.
This is an area where you probably need to learn to steal ideas as well… It took me many years to develop the expertise and contacts needed to continually uncover the potential big winners, particularly in biotech stocks. You can get ideas from top managers in the field by searching through the portfolios of top mutual fund managers specializing in the medical and biootech fields. They have to disclose their portfolio to the SEC and are widely available on various research and financial sites on the Internet.
One new drug or technology can take a company from obscurity to superstardom and the stock price will go higher than you could have ever though possible. Staying on top of which smaller single-digit stocks have promising research and strong partnerships with large drug companies can be a tremendous source of single-digit stock winners over your investing career.
AROUND THE WORLD UNDER $10
Emerging markets have evolved and become more like U.S. markets. There are the same cycles of fear and greed that create fallen angel stocks. Kramer:
Companies will be created that have exciting new products with the potential for strong long-term growth and yet stay under the radar screen for an extended period of time. We can find low-priced potential breakout stocks located all around the world in today’s dynamic, connected stock markets.
Kramer comments:
In a lot of ways emerging economies look a lot like the United States did back around the turn of the century. Back then people moved from the rural towns into the cities as jobs in new industries became available. Automobiles began to replace the horse and buggy. Radios and telephones became items that were desired by every household. Investing in companies that built infrastructure, like the steel and railroad companies, was hugely successful. So was putting your money into electric utilities and energy companies that served the growing demand for power. Early investors in companies that sprang up to serve these new consumers, like Sears, Roebuck and Company, also did very well.
Today we are seeing similar trends developing, as smartphones and portable commmunications and entertainment devices are adopted throughout the world and are in high demand in emerging economies like China, Brazil, and India. Further, the robust demographic growth in emerging economies is creating the need for bigger, better, and more efficient infrastructure to maintain such growth.
Kramer gives the example of Cemex (CX). When she was in Mexico in 2001, Kramer noticed the country was experiencing a building boom. She got curious about all the cement trucks and construction vehicles, not to mention cranes. CX not only sold cement in Mexico, but also in the United States, Europe, the Philippines, and the Middle East. Kramer bought the stock around $8 in early 2003, and over the next three years, the stock went over $30, allowing her so sell at around $29. Kramer continues:
Interestingly, the stock collapsed again in the global recession of 2008. As global building began to collapse as credit tightened and the economy slowed, the shares fell all the way back into the single digits. In fact, Cemex stock fell below $4. Once again, as the global economy began to dig itself out, the stock slowly reversed and reached a high of $14 a share a little more than a year later.
Building materials stocks like Cemex are going to get hit hard during a time of a global slowdown, but will be among the first and fastest to recover at the first sign of an improvement in economic conditions. Emerging markets may have frequent stumbles along the way to progress but once the trend towards a more industrialized consumer society begins, history tells us it rarely reverses itself. Following building supply- and infrastructure-related stocks and buying when they are low priced and unpopular can be a path to large long-term profits.
Moreover, as an emerging economy creates a new middle class, there will be demand for goods and services that make life more interesting.
FORGET EVERYTHING YOU THOUGHT YOU KNEW
First, the efficient market hypothesis, which says all available information is already reflected in all stocks and therefore it’s impossible to beat the market except by luck, is simply not true. Most of the examples Kramer has given illustrate this. Also, various value investors have beaten the market over time for nearly a century.
Second, a low P/E ratio is not typically how to find a low-priced breakout stock because often a low-priced breakout stock has very little earnings, which makes the P/E ratio very high.
My note here: My fund, the Boole Microcap Fund, uses five metrics for cheapness:
low price-to-earnings (low P/E)
low price-to-cash flow (low P/CF)
low price-to-sales (low P/S)
low price-to-book (low P/B)
low enterprise value-to-EBITDA (low EV/EBITDA)
In the terrific book,What Works on Wall Street (4th edition), James P. O’Shaughnessy demonstrates that using all five of these metrics of cheapness simultaneously has produced the highest returns historically.
My fund also uses other quantitative information like a high Piotroski F-Score, low debt, high insider ownership, insider buying, high ROE, and positive 6-month and 1-year momentum.
So while I do agree with Kramer’s explanation of fallen angels, undiscovered growth stocks, and bargain bin favorites, I don’t entirely agree on low P/E. It’s OK for the P/E to be high (or even negative!) as long as most of the other metrics of cheapness are low. However, I do estimate normalized sales, earnings, and cash flows, and if most of the metrics for cheapness are quite low relative to normalized estimates, then these can be particularly interesting stocks.
Moreover, if a company has been profitable for years, and then suddenly has its profits disappear for temporary reasons like a recession, that can be the makings of an excellent investment when the stock price has collapsed.
Kramer says a high P/E is OK if earnings have temporarily collapsed, but she does write the following:
As a rule we want our companies to be profitable. As we discussed, many of them stumbled and that’s why they are a low-priced stock in the first place. The fact that they are still profitable in the worst of times gives us an indication management knows what they are doing and can return to higher profitability levels in short order. If they are not profitable there needs to be some reason or catalyst that we can see that will restore the bottom line to black ink in a relatively short period of time.
Kramer continues by explaining that an improvement or deterioration in various metrics can be more important than the absolute level:
Let’s consider return on equity for a second. This is a widely used measure in financial research that evaluates how much a company is earning relative to the amount of equity invested in the company. It is a pretty good measure of how profitably management is using the money entrusted to it by shareholders. However just the number by itself is not enough to evaluate a stock for breakout potential.
Kramer gives the example of Toll Brothers (TOL). The company has a decent year in 2006 and had a return on equity (ROE) of 20 percent. That seems good, however year over year the ROE had declined from 53 percent to 20 percent. This was, for Kramer, a huge red flag. The trend continued and TOL had a small ROE in 2007 and negative ROE in 2008. This example illustrates why the direction of many metrics can be more important than the absolute level.
LOOKING FOR THE RIGHT STUFF
Kramer holds that the company should have a relatively strong balance sheet, and own at least as much as they owe. In other words, the debt to total capitalization should be below 0.50. If it’s higher than that, there is an increased risk of bankruptcy during a recession or business slowdown.
Kramer writes:
It is also very important to read the footnotes and fine print in a filing of a prospective stock. I want to see if the auditors signed off and issued an unqualified opinion of the company’s financials. If they issued a qualified opinion that’s a huge red flag that something may be wrong with the data I am using to evaluate the company. Has the company recently changed auditors? That can be a flag as well, and indicates the previous firm had some questions that company didn’t want to answer or did not like the conclusions the auditor drew out of the financial data. Is there a concern about the company’s ability to continue as a going concern? Are there a lot of complex off-balance-sheet arrangements? These could have a substantial negative influence on the company’s leverage and operating ratios that are not included in the basic balance sheet and income statement presentation.
Kramer highly recommends going to the investor relations part of a company’s website. She gives Wendy’s/Arby’s Group (WEN). (Keep in mind Kramer was writing this book in 2011. Today Wendy’s and Arby’s are separate entities.)
When I go to the investor relations section of their website I find links to all their SEC filings, historical information about their finances, and stock price. The last few years of press releases, including quarterly earnings reports, are readily available. The really interesting section to me is webcasts and presentations. Here I find links to recent presentations at various conferences and investor meetings, including videos and PowerPoint presentations.
…
I see from the presentation that the company is introducing a new line of burger products in the second half of 2011 that look pretty enticing. They have a strong balance sheet and are buying back stock. I see in the presentation that they have recently increased the dividend. Managing is continuing with their efforts to sell the Arby’s business and refocus on the core Wendy’s brand. The presentation contains information about international expansion plans, menu changes, as well as a discussion of finances. This is all valuable information and reinforced my conviction about owning the company.
Kramer adds that not all companies have in-depth investor presentations, but many do. Note: Many microcap companies–the focus of my fund, the Boole Microcap Fund–do not have these presentations, but some do.
Kramer continues:
The next thing I like to do is look at the stock price chart. I am not a chartist by any means, but the price chart can provide valuable information, especially in timing my purchase of a low-priced breakout stock. Is the stock moving higher on increased buying activity in the stock? This could be a sign that the larger investors, such as hedge funds, are starting to notice the company and I want to get in as soon as possible. Is the stock breaking out to new highs? Has it bounced off a level of support, such as a double price bottom that might indicate institutional buying is putting a bottom in the stock and the time to buy has been reached? I never make a decision because of the chart itself but if the stock has passed the research process, charts can provide valuable information about what other investors think of the company.
Kramer adds:
Another important piece of information I like to check when evaluating a stock is who is buying and selling the shares. Are insiders buying or selling the stock? If they are selling is it just one officer or director or several of them? One seller could be someone in need of cash for some personal reason but many sellers over a period of time is a huge red flag. If the folks running the company are selling, I am not so sure I should be buying the stock. I need to check my conclusion. Insiders may sell for several reasons, but they only buy for one: They like the potential of the company and think the stock is underpriced relative to the potential for gains in the future. Insider buying increases my conviction about a company that has passed all my other tests.
Kramer also recommends calling experts, which is easier if you happen to know some, but can still be done even if you don’t.
Moreover, Kramer mentions some great research resources, including Value Line, which not only has momentum-based rankings, but also has a decade’s worth of historical financial data plus analyst commentary. Standard and Poor’s also publishes valuable stock research. Furthermore, some of Morningstar’s equity research is available for free. Yahoo! finance has free information on companies.
Note: There are other resouces, too, including Seeking Alpha, for which you have to pay roughly $33 a month. And, for microocap investors, there is the Micro Cap Club (https://microcapclub.com/), which you can join for $500 a year (or for free if you write up an investment idea and it is accepted) and also Small Cap Discoveries (https://smallcapdiscoveries.com/), which costs $1,000 a year.
WELL BOUGHT IS HALF SOLD
First, every investor will make plenty of mistakes. Many top investors are only right 49% of the time or up to 60% of the time. How you deal with mistakes is important. I wrote last week about this: https://boolefund.com/the-art-of-execution/
Sometimes, if the stock falls, it makes sense to buy more. Other times, it’s best to sell. The most important question to ask yourself is: Knowing what I know now, would I buy the stock at its current price? If yes, then buying more after the decline is the right move. If no, then immediately selling is the right move. Remember the quote attributed to John Maynard Keynes:
When the facts change, I change my mind; what do you do?
Kramer writes:
You want to read any filings or news releases since you bought the stock. Has the company taken on more debt? Did they miss a key product launch date? Is the company spending its cash at an alarming rate? Are inventories growing as customers delay or cancel orders? Have regulatory or legal issues emerged that change the outlook for the company? Have the macroeconomic issues that face the company changed since you bought the stock? You are looking for material negative changes in the company or its outlook since you originally bought the stock. If there are any, then you want to sell the stock. The old adage that the first loss is the best one holds true. If the situation worsens, do not wait for a bounce or to get back to even–sell the stock and move on.
Kramer next handles the topic of when to sell winners. If the stock price has gone up, you want to review the situation. Are revenues and profits still growing or rebounding? Is the company paying down debt or otherwise fixing any balance sheet issues? Are the company’s products being well-received?
Kramer then adds:
On the technical side of things, is daily trading volume increasing or at least staying steady? This can be a sign that the big institutions that sold the stock when it was falling are now buying back in and this is going to push the stock price still higher. Is the stock making new 52-week highs? Are you seeing a steady pattern of higher highs and, more importantly, higher short-term lows in the stock? Stocks are always going to move in ebbs and flows. When you chart a low point of a pullback above the low point of the prior round of profit taking, this is a very bullish sign for the stock. Buyers are moving in and the stock is probably heading higher, so ride the wave and let your profits grow.
As long as things are improving you want to own the stock. I have stocks today like Priceline that I have simply never sold even though they have risen by hundreds of percent.
Kramer then writes:
As a stock move higher there are some indications that indicate it is time to part ways with the stock. If business starts to slow and is no longer improving it is time to sell. If revenues and earnings have been rising and then the company announces a down quarter, it is time to ring the register and take your profits. If you have a stock that has moved higher and the company announces a large debt or equity offering, you want to consider selling the shares…. The need to raise moeny is a sign that the company is not generating enough cash to meet its goal and it’s a reason to consider taking profits.
Sometimes it also makes sense to sell part of the position as the stock movies higher. This, too, is covered in last week’s blog post about The Art of Execution: https://boolefund.com/the-art-of-execution/
Kramer makes another important point: If it seems like now everyone loves the stock, whereas previously (when the stock price was low) they hated or ignored the stock–which is what created the opportunity for you to buy at a low price–then it’s time to consider selling. The question becomes: if everyone loves it, who is left to buy?
Finally, sometimes the stock you own will get acquired, in which case you have to sell but can usually do so at a higher price than you paid. It also makes sense, argues Kramer, to be aware of when larger companies may want to buy smaller competitors. Often such inorganic growth (via acquistions) is less expensive than organic growth (opening new locations, developing new products, etc.). As discussed earlier, this can frequently be the case for large drug companies: In order to expand their product lines, they will look to acquire smaller companies.
BEWARE THE WOLVES OF WALL STREET
Low-priced stocks are viewed as riskier than higher-priced stocks, but usually that’s not case. Kramer writes:
All things being equal, the answers to the risk versus reward equation are found in the financial statements, not the stock price. This is a classic case of broad-based statements, such as ‘all low-priced stocks are risky,’ just being wrong.
That said, as an investor you do have to be careful of “pump and dump” schemes, which historically have often happened with very low-priced stocks. Kramer:
Unscrupulous operators accumulate or create a large block of stock at a very low price. They then hype the stock as the next big thing to unsuspecting investors. They talk about getting in on the ground floor, revolutionary breakthroughs, and other buzzwords designed to get the blood pumping and the greed flowing. When investors get excited about this wonderful company, the operators simply dump their stock at much higher prices and walk away with investors’ hard-earned money.
Most of the time these companies have no real business or assets. They are just shell companies set up for the specific purpose of fleecing investors. Some of them may be little mining stocks or small tech companies that are badly underfunded and will be broke and bankrupt very shortly.
Kramer adds:
The SEC has done a great job of cleaning up the penny stock brokerage firms and they are not as prevalent as they once were. However there are still a few out there and as long as greed and dishonesty exist there always will be.
Krames then writes:
I do not want to imply that all Internet-based research on low-priced stocks or advisory services devoted to low-priced stocks are bad. I run such a service myself and I know several other reputable conscientious folks who do the same. The best defense against being taken advantage of in the stock market is to do the homework yourself and check the facts before you buy the story! You will quickly be able to see who is trying to make you money and who is trying to rip you off.
Furthermore, you must be aware that there are many low-priced stocks that deserve to be low-priced. Also, nearly every company that goes bankrupt sees its stock go to a low price before bankruptcy. That’s why it’s important, again, to do your homework. You have to be sure the company doesn’t have too much debt. Also, is the company making money or losing money? If the company is losing money, do they have a credible turnaround plan in place? Kramer:
If you see allegations of accounting or securities fraud in a company’s reports, it is best just to take a pass on that issue even if you think there is potential. Unless you are a very experienced forensic accountant or securities attorney, it becomes very difficult to decipher exactly how these cases will end. Lots of people thought companies like Enron and WorldCom would be able to survive after the initial fraud allegations were revealed. They were not and a lot of people lost a lot of money.
Kramer concludes the chapter:
The key to avoiding risks in the stock market, especially in low-priced stocks, is to use common sense. No one is going to send you an email to tell you all about a stock that is going to make you rich beyond your wildest dreams. As I have said earlier in this book, finding these gems takes work and effort on your part and no one is going to give you the keys to the kingdom with no effort or cost on your part. Keep in mind, if your Uncle Fred were really a great stock picker he would not borrow $100 every time you see him. Read the 10Q and 10K, go through the financials, and read management’s discussion of the business. Check the footnotes for warning signs and red flags.
Most of the time the alleged risks of low-priced stocks are just that–alleged. If you find a stock with the right financial and business characteristics the risks are actually nonexistent. It is the perception of greatly increased risks with low-priced stocks that is creating the opportunities for us to earn breakout profits.
LOW PRICES AND HIGH PROFITS
In this chapter, Kramer wraps up the book. She writes:
Hopefully I have given you the tools and information you need to begin investing in the exciting world of low-priced breakout stocks. Over my years in and around the financial markets I have found this to be the single best area for investors to earn explosive gains in stocks.
Kramer again:
By getting ahead of Wall Street in lower-priced stocks we benefit from the institutional pack-mentality that dominates many traditional investment managers. When they are selling and pushing stocks to low prices, we are buying. Then, when their excitement for these stocks return, we are selling to them. We are finding solid growth stocks before Wall Street notices and will see our stocks soar when they show up on the Street’s radar screen. There simply is no better way for individual investors to outperform the market in my opinion.
Kramer argues that it pays to be optimistic about the long term:
If you focus on the fear you miss opportunities. If you focused on all that was wrong with the auto industry in 2008, you would have totally missed the fact that Ford was in fine shape and stood to benefit fomr the problems of its competitors. If you gave up when Dendreon got the first delay from the FDA, you would have missed some spectacular gains by never investigating further to discover that it was just a delay and approval for their cancer drugs was probably forthcoming.
The same applies to the stock market itself. Markets are going to have declines. There will be recessions and bear markets throughout your career. The right way to look at these occasions is as inventory creation events, not catastrophes.
I would add that often microcap stocks have a low correlation with the broader market. Warren Buffett, arguably the greatest investor of all time, said in 1999 during the internet bubble:
If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.
Kramer writes:
There is another advantage to owning low-priced stocks when the market corrects. Many of these stocks are fallen angels or growth companies that stumbled briefly, driving the stock below $10. Wall Street and the big institutions already sold their shares and your stocks will not experience the type of selling pressure higher-priced issues are experiencing. When the large leveraged investors, like hedge funds, need to sell stocks they sell the higher priced more liquid issues to meet margin calls, not lower-priced smaller companies. So not only does the selling not hit your stocks as hard as the big names, they often push the big companies down to where they become inventory for you!
Kramer continues:
The best investors fit into the category that I like to call optimistic cynics. They are well aware that every bear market has ended and every economic recession has been followed by an economic recovery. They also know that the world is fully of entrepreneurs and innovators who will discover new solutions to old problems and the world gets better over time throughout history. They know that companies that are out of favor today are often tomorrow’s darlings. In the stock market, optimism pays off over time. It always has and always will.
The cynical part comes from not taking anyone’s word for anything. Trust but verify is the order of the day. Great investors do not act on tips, rumors, and sales pitches. By doing their research and homework they avoid many of the mistakes investors can make that will damage their net worth. They dig into the financial filings and company presentations to determine what is really going on with the company and the likelihood they can recover or continue to grow. When markets are soaring and everyone is piling into stocks, great investors ask the most critical question of all:Is it really different this time? When markets are collapsing they ask themselves if the world is really ending. The answers to those questions help to temper your enthusiasm at market tops and turn your fear into action at market bottoms.
Kramer advises reading as much as possible, which she says is “some of the best advice I can give you about successful investing.” Not just people who agree with your views of the world, the market, and stocks, but also people who disagree with your views. Sometimes you will find holes in your thought process and other times you will gain more confidence in your previous conclusions. Either way, it can make you a better investor.
Kramer reminds us that we have to pay close attention to the footnotes to search for any red flags or time bombs. Also, the company presentation, often available on their website, usually contains valuable information about new products, services, or markets, as well as management’s plans.
It’s also a good idea to see if insiders are buying. If they are, that’s always a bullish signal because it means the people running the company believe the stock is undervalued. On the other hand, if groups of insiders are selling, especially at a low price, that’s a huge red flag. Moreover, if excellent professional investors are buying or selling, it’s a good idea to pay attention to that.
Kramer ends with the following:
Investing in low-priced potential breakout stocks is work. However it can increase your net worth quicker than almost any other effort applied to investing I am aware of. One investment like Priceline can make it easier to put the kids through college or retire a few years earlier. An investment in an undiscovered growth gem like Darling can pay for a dream vacation or even a dream home. If you are willing to work at it, investing in single-digit stocks should add many digits to your account values over time.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: jb@boolefund.com
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.
The best way to build wealth is through long-term investing. The more wealth you have, the more freedom you have to achieve your goals in life.
A smart long-term investment for many investors is an S&P 500 index fund. It’s just basic arithmetic, as Jack Bogle and Warren Buffett frequently point out: https://boolefund.com/warren-buffett-jack-bogle/
But you can get much higher returns–at least 18% per year (instead of 10% per year)–by investing in cheap, solid microcap stocks.
Because most professional investors have large assets under management, they cannot even consider investing in microcap stocks. That’s why there continues to be a wonderful opportunity for enterprising investors. Microcaps are ignored, which causes most of them to become significantly undervalued from time to time.
Warren Buffett obtained the highest returns of his career when he invested primarily in microcap stocks. Buffett says that he could get 50 percent a year today if he were managing a small enough sum so that he could focus on microcap stocks: https://boolefund.com/buffetts-best-microcap-cigar-butts/
Check out this summary of the CRSP Decile-Based Size and Return Data from 1927 to 2020:
The smallest two deciles–9+10–are microcap stocks, which are stocks with market caps below $500 million. What jumps out is the equal weighted returns of the 9th and 10th size deciles from 1927 to 2020:
Microcap equal weighted returns = 15.8% per year
Large-cap equal weighted returns = ~10% per year
In actuality, the annual returns from microcap stocks will be 1-2% lower because of the cost of entering and exiting positions. So it’s better to say that an equal weighted microcap approach has returned 14% per year from 1927 to 2020, versus 10% per year for an equal weighted large-cap approach.
VALUE SCREEN: +2-3%
By consistently applying a value screen–e.g., low EV/EBITDA, low P/E, low P/S, etc.–to a microcap strategy, you can add 2-3% per year.
IMPROVING FUNDAMENTALS: +2-3%
You can further increase performance by screening for improving fundamentals. One powerful way to do this is using the Piotroski F_Score, which works best for cheap micro caps. See: https://boolefund.com/joseph-piotroski-value-investing/
BOTTOM LINE
If you invest in microcap stocks, you can get about 14% a year. If you also implement a simple screen for value, that adds at least 2% a year. If you then screen for improving fundamentals, that boosts performance by at least another 2% a year.
In brief, if you invest systematically in undervalued microcap stocks with improving fundamentals, you can get at least 18% a year. That compares quite well to the 10% a year you could get from an S&P 500 index fund.
What’s the difference between 10% a year and 18% a year? If you invest $100,000 at 10% a year for 30 years, you end up with $1.7 million, which is quite good. If you invest $100,000 at 18% a year for 30 years, you end up with $14.3 million, which is significantly better.
Please contact me with any questions or comments.
My email: jb@boolefund.com.
My cell: 206.518.2519
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.
William Thorndike is the author of The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success (Harvard Business Review Press, 2012). It’s an excellent book profiling eight CEOs who compounded shareholder value at extraordinary rates over decades.
Through this book, value investors can improve their understanding of how to identify CEOs who maximize long-term returns to shareholders. Also, investors can become better businesspeople, while businesspeople can become better investors.
I am a better investor because I am a businessman and a better businessman because I am an investor. – Warren Buffett
Thorndike explains that you only need three things to evaluate CEO performance:
the compound annual return to shareholders during his or her tenure
the return over the same period for peer companies
the return over the same period for the broader market (usually measured by the S&P 500)
Thorndike notes that 20 percent returns is one thing during a huge bull market–like 1982 to 1999. It’s quite another thing if it occurs during a period when the overall market is flat–like 1966 to 1982–and when there are several bear markets.
Moreover, many industries will go out of favor periodically. That’s why it’s important to compare the company’s performance to peers.
Thorndike mentions Henry Singleton as the quintessential outsider CEO. Long before it was popular to repurchase stock, Singleton repurchased over 90% of Teledyne’s stock. Also, he emphasized cash flow over earnings. He never split the stock. He didn’t give quarterly guidance. He almost never spoke with analysts or journalists. And he ran a radically decentralized organization. Thorndike:
If you had invested a dollar with Singleton in 1963, by 1990, when he retired as chairman in the teeth of a severe bear market, it would have been worth $180. That same dollar invested in a broad group of conglomerates would have been worth only $27, and $15 if invested in the S&P 500. Remarkably, Singleton outperformed the index by over twelve times.
Thorndike observes that rational capital allocation was the key to Singleton’s success. Thorndike writes:
Basically, CEOs have five essential choices for deploying capital–investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or repurchasing stock–and three alternatives for raising it–tapping internal cash flow, issuing debt, or raising equity. Think of these options collectively as a tool kit. Over the long term, returns for shareholders will be determined largely by the decisions a CEO makes in choosing which tools to use (and which to avoid) among these various options. Stated simply, two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders.
Warren Buffett has noted that most CEOs reach the top due to their skill in marketing, production, engineering, administration, or even institutional politics. Thus most CEOs have not been prepared to allocate capital.
Thorndike also points out that the outsider CEOs were iconoclastic, independent thinkers. But the outsider CEOs, while differing noticeably from industry norms, ended up being similar to one another. Thorndike says that the outsider CEOs understood the following principles:
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 vital… as is occasional boldness.
(Illustration by yiorgosgr)
Here are the sections in the blog post:
Introduction
Tom Murphy and Capital Cities Broadcasting
Henry Singleton and Teledyne
Bill Anders and General Dynamics
John Malone and TCI
Katharine Graham and The Washington Post Company
Bill Stiritz and Ralston Purina
Dick Smith and General Cinema
Warren Buffett and Berkshire Hathaway
Radical Rationality
INTRODUCTION
Only two of the eight outsider CEOs had MBAs. And, writes Thorndike, they did not attract or seek the spotlight:
As a group, they shared old-fashioned, premodern values including frugality, humility, independence, and an unusual combination of conservatism and boldness. They typically worked out of bare-bones offices (of which they were inordinately proud), generally eschewed perks such as corporate plans, avoided the spotlight wherever possible, and rarely communicated with Wall Street or the business press. They also actively avoided bankers and other advisers, preferring their own counsel and that of a select group around them. Ben Franklin would have liked these guys.
Thorndike describes how the outsider CEOs were iconoclasts:
Like Singleton, these CEOs consistently made very different decisions than their peers did. They were not, however, blindly contrarian. Theirs was an intelligent iconoclasm informed by careful analysis and often expressed in unusual financial metrics that were distinctly different from industry or Wall Street conventions.
Thorndike compares the outsider CEOs to Billy Beane as described by Michael Lewis in Moneyball. Beane’s team, despite having the second-lowest payroll in the league, made the playoffs in four of his first six years on the job. Beane had discovered new–and unorthodox–metrics that were more correlated with team winning percentage.
Thorndike mentions a famous essay about Leo Tolstoy written by Isaiah Berlin. Berlin distinguishes between a “fox” who knows many things and a “hedgehog” who knows one thing extremely well. Thorndike continues:
Foxes… also have many attractive qualities, including an ability to make connections across fields and to innovate, and the CEOs in this book were definite foxes. They had familiarity with other companies and industries and disciplines, and this ranginess translated into new perspectives, which in turn helped them to develop new approaches that eventually translated into exceptional results.
(Photo by mbridger68)
TOM MURPHY AND CAPITAL CITIES BROADCASTING
When Murphy became CEO of Capital Cities in 1966, CBS’ market capitalization was sixteen times than that of Capital Cities. Thirty years later, Capital Cities was three times as valuable as CBS. Warren Buffett has said that in 1966, it was like a rowboat (Capital Cities) against QE2 (CBS) in a trans-Atlantic race. And the rowboat won decisively!
Bill Paley, who ran CBS, used the enormous cash flow from its network and broadcast operations and undertook an aggressive acquisition program of companies in entirely unrelated fields. Paley simply tried to make CBS larger without paying attention to the return on invested capital (ROIC).
Without a sufficiently high ROIC, growth destroys shareholder value instead of creating it. But, like Paley, many business leaders at the time sought growth for its own sake. Even if growth destroys value (due to low ROIC), it does make the business larger, bringing greater benefits to the executives.
Murphy’s goal, on the other hand, was to make his company as valuable as possible. This meant maximizing profitability and ROIC:
…Murphy’s goal was to make his company more valuable… Under Murphy and his lieutenant, Dan Burke, Capital Cities rejected diversification and instead created an unusually streamlined conglomerate that focused laser-like on the media businesses it knew well. Murphy acquired more radio and TV stations, operated them superbly well, regularly repurchased his shares, and eventually acquired CBS’s rival broadcast network ABC.
(Capital Cities/ABC, Inc. logo, via Wikimedia Commons)
Burke excelled in operations, while Murphy excelled in making acquisitions. Together, they were a great team–unmatched, according to Warren Buffett. Burke said his ‘job was to create free cash flow and Murphy’s was to spend it.’
During the mid-1970s, there was an extended bear market. Murphy aggressively repurchased shares, mostly at single-digit price-to-earnings (P/E) multiples.
Thorndike writes that in January 1986, Murphy bought the ABC Network and its related broadcasting assets for $3.5 billion with financing from his friend Warren Buffett. Thorndike comments:
Burke and Murphy wasted little time in implementing Capital Cities’ lean, decentralized approach–immediately cutting unnecessary perks, such as the executive elevator and the private dining room, and moving quickly to eliminate redundant positions, laying off fifteen hundred employees in the first several months after the transaction closed. They also consolidated offices and sold off unnecessary real estate, collecting $175 million for the headquarters building in midtown Manhattan…
In the nine years after the transaction, revenues and cash flows grew significantly in every major ABC business line, including the TV stations, the publishing assets, and ESPN. Even the network, which had been in last place at the time of the acquisition, was ranked number one in prime time ratings and was more profitable than either CBS or NBC.
In 1993, Burke retired. And in 1995, Murphy, at Buffett’s suggestion, met with Michael Eisner, the CEO of Disney. Over a few days, Murphy sold Capital Cities/ABC to Disney for $19 billion, which was 13.5 times cash flow and 28 times net income. Thorndike:
He left behind an ecstatic group of shareholders–if you had invested a dollar with Tom Murphy as he became CEO in 1966, that dollar would have been worth $204 by the time he sold the company to Disney. That’s a remarkable 19.9 percent internal rate of return over twenty-nine years, significantly outpacing the 10.1 percent return for the S&P 500 and 13.2 percent return for an index of leading media companies over the same period.
Thorndike points out that decentralization was one of the keys to success for Capital Cities. There was a single paragraph on the inside cover of every Capital Cities annual report:
‘Decentralization is the cornerstone of our philosophy. Our goal is to hire the best people we can and give them the responsibility and authority they need to perform their jobs. All decisions are made at the local level… We expect our managers… to be forever cost conscious and to recognize and exploit sales potential.’
Headquarters had almost no staff. There were no vice presidents in marketing, strategic planning, or human resources. There was no corporate counsel and no public relations department. The environment was ideal for entrepreneurial managers. Costs were minimized at every level.
Burke developed an extremely detailed annual budgeting process for every operation. Managers had to present operating and capital budgets for the coming year, and Burke (and his CFO, Ron Doerfler) went through the budgets line-by-line:
The budget sessions were not perfunctory and almost always produced material changes. Particular attention was paid to capital expenditures and expenses. Managers were expected to outperform their peers, and great attention was paid to margins, which Burke viewed as ‘a form of report card.’ Outside of these meetings, managers were left alone and sometimes went months without hearing from corporate.
High margins resulted not only from cost minimization, but also from Murphy and Burke’s focus on revenue growth and advertising market share. They invested in their properties to ensure leadership in local markets.
When it came to acquisitions, Murphy was very patient and disciplined. His benchmark ‘was a double-digit after-tax return over ten years without leverage.’ Murphy never won an auction as a result of his discipline. Murphy also had a unique negotiating style.
Murphy thought that, in the best transactions, everyone comes away happy. He believed in ‘leaving something on the table’ for the seller. Murphy would often ask the seller what they thought the property was worth. If Murphy thought the offer was fair, he would take it. If he thought the offer was high, he would counter with his best price. If the seller rejected his counter-offer, Murphy would walk away. He thought this approach saved time and avoided unnecessary friction.
Thorndike concludes his discussion of Capital Cities:
Although the focus here is on quantifiable business performance, it is worth noting that Murphy built a universally admired company at Capital Cities with an exceptionally strong culture and esprit de corps (at least two different groups of executives still hold regular reunions).
HENRY SINGLETON AND TELEDYNE
Singleton earned bachelor’s, master’s, and PhD degrees in electrical engineering from MIT. He programmed the first student computer at MIT. He won the Putnam Medal as the top mathematics student in the country in 1939. And he was 100 points away from being a chess grandmaster.
Singleton worked as a research engineer at North American Aviation and Hughes Aircraft in 1950. Tex Thornton recruited him to Litton Industries in the late 1950s, where Singleton invented an inertial guidance system–still in use–for commercial and military aircraft. By the end of the decade, Singleton had grown Litton’s Electronic Systems Group to be the company’s largest division with over $80 million in revenue.
Once he realized he wouldn’t succeed Thornton as CEO, Singleton left Litton and founded Teledyne with his colleague George Kozmetzky. After acquiring three small electronics companies, Teledyne successfully bid for a large naval contract. Teledyne became a public company in 1961.
(Photo of Teledyne logo by Piotr Trojanowski)
In the 1960’s, conglomerates had high price-to-earnings (P/E) ratios and were able to use their stock to buy operating companies at relatively low multiples. Singleton took full advantage of this arbitrage opportunity. From 1961 to 1969, he purchased 130 companies in industries from aviation electronics to specialty metals and insurance. Thorndike elaborates:
Singleton’s approach to acquisitions, however, differed from that of other conglomerateurs. He did not buy indiscriminately, avoiding turnaround situations, and focusing instead on profitable, growing companies with leading market positions, often in niche markets… Singleton was a very disciplined buyer, never paying more than twelve times earnings and purchasing most companies at significantly lower multiples. This compares to the high P/E multiple on Teledyne’s stock, which ranged from a low of 20 to a high of 50 over this period.
In mid-1969, Teledyne was trading at a lower multiple, while acquisition prices were increasing. So Singleton completely stopped acquiring companies.
Singleton ran a highly decentralized company. Singleton also did not report earnings, but instead focused on free cash flow (FCF)–what Buffett calls owner earnings. The value of any business is all future FCF discounted back to the present.
FCF = net income + DDA – capex
(There are also adjustments to FCF based on changes in working capital. DDA is depreciation, depletion, and amortization.)
At Teledyne, bonus compensation for all business unit managers was based on the maximization of free cash flow. Singleton–along with his roommate from the Naval Academy, George Roberts–worked to improve margins and significantly reduce working capital. Return on assets at Teledyne was greater than 20 percent in the 1970s and 1980s. Charlie Munger calls these results from Teledyne ‘miles higher than anybody else… utterly ridiculous.’ This high profitability generated a great deal of excess cash, which was sent to Singleton to allocate.
Starting in 1972, Singleton started buying back Teledyne stock because it was cheap. During the next twelve years, Singleton repurchased over 90 percent of Teledyne’s stock. Keep in mind that in the early 1970s, stock buybacks were seen as a lack of investment opportunity. But Singleton realized buybacks were far more tax-efficient than dividends. And buybacks done when the stock is noticeably cheap create much value. Whenever the returns from a buyback seemed higher than any alternative use of cash, Singleton repurchased shares. Singleton spent $2.5 billion on buybacks–an unbelievable amount at the time–at an average P/E multiple of 8. (When Teledyne issued shares, the average P/E multiple was 25.)
In the insurance portfolios, Singleton invested 77 percent in equities, concentrated on just a few stocks. His investments were in companies he knew well that had P/E ratios at or near record lows.
In 1986, Singleton started going in the opposite direction: deconglomerating instead of conglomerating. He was a pioneer of spinning off various divisions. And in 1987, Singleton announced the first dividend.
From 1963 to 1990, when Singleton stepped down as chairman, Teledyne produced 20.4 percent compound annual returns versus 8.0 percent for the S&P 500 and 11.6 percent for other major conglomerates. A dollar invested with Singleton in 1963 would have been worth $180.94 by 1990, nearly ninefold outperformance versus his peers and more than twelvefold outperformance versus the S&P 500.
BILL ANDERS AND GENERAL DYNAMICS
In 1989, the Berlin Wall came down and the U.S. defense industry’s business model had to be significantly downsized. The policy of Soviet containment had become obsolete almost overnight.
General Dynamics had a long history selling major weapons to the Pentagon, including the B-29 bomber, the F-16 fighter plane, submarines, and land vehicles (such as tanks). The company had diversified into missiles and space systems, as well as nondefense business including Cessna commercial planes.
(General Dynamics logo, via Wikimedia Commons)
When Bill Anders took over General Dynamics in January 1991, the company had $600 million in debt and negative cash flow. Revenues were $10 billion, but the market capitalization was just $1 billion. Many thought the company was headed into bankruptcy. It was a turnaround situation.
Anders graduated from the Naval Academy in 1955 with an electrical engineering degree. He was an airforce fighter pilot during the Cold War. In 1963 he earned a master’s degree in nuclear engineering and was chosen to join NASA’s elite astronaut corps. Thorndike writes:
As the lunar module pilot on the 1968 Apollo 8 mission, Anders took the now-iconic Earthrise photograph, which eventually appeared on the covers of Time, Life, and American Photography.
Anders was a major general when he left NASA. He was made the first chairman of the Nuclear Regulatory Commission. Then he served as ambassador to Norway. After that, he worked at General Electric and was trained in their management approach. In 1984, Anders was hired to run the commercial operations of Textron Corporation. He was not impressed with the mediocre businesses and the bureaucratic culture. In 1989, he was invited to join General Dynamics as vice-chairman for a year before becoming CEO.
Anders realized that the defense industry had a great deal of excess capacity after the end of the Cold War. Following Welch’s approach, Anders concluded that General Dynamics should only be in businesses where it was number one or two. General Dynamics would stick to businesses it knew well. And it would exit businesses that didn’t meet these criteria.
Anders also wanted to change the culture. Instead of an engineering focus on ‘larger, faster, more lethal’ weapons, Anders wanted a focus on metrics such as return on equity (ROE). Anders concluded that maximizing shareholder returns should be the primary business goal. To help streamline operations, Anders hired Jim Mellor as president and COO. In the first half of 1991, Anders and Mellor replaced twenty-one of the top twenty-five executives.
Anders then proceeded to generate $5 billion in cash through the sales of noncore businesses and by a significant improvement in operations. Anders and Mellor created a culture focused on maximizing shareholder returns. Anders sold most of General Dynamics’ businesses. He also sought to grow the company’s largest business units through acquisition.
When Anders went to acquire Lockheed’s smaller fighter plane division, he met with a surprise: Lockheed’s CEO made a high counteroffer for General Dynamics’ F-16 business. Because the fighter plane division was a core business for General Dynamics–not to mention that Anders was a fighter pilot and still loved to fly–this was a crucial moment for Anders. He agreed to sell the business on the spot for a very high price of $1.5 billion. Anders’ decision was rational in the context of maximizing shareholder returns.
With the cash pile growing, Anders next decided not to make additional acquisitions, but to return cash to shareholders. First he declared three special dividends–which, because they were deemed ‘return of capital,’ were not subject to capital gains or ordinary income taxes. Next, Anders announced an enormous $1 billion tender offer for 30 percent of the company’s stock.
A dollar invested when Anders took the helm would have been worth $30 seventeen years later. That same dollar would have been worth $17 if invested in an index of peer companies and $6 if invested in the S&P.
JOHN MALONE AND TCI
While at McKinsey, John Malone came to realize how attractive the cable television business was. Revenues were very predictable. Taxes were low. And the industry was growing very fast. Malone decided to build a career in cable.
Malone’s father was a research engineer and his mother a former teacher. Malone graduated from Yale with degrees in economics and electrical engineering. Then Malone earned master’s and PhD degrees in operations research from Johns Hopkins.
Malone’s first job was at Bell Labs, the research arm of AT&T. After a couple of years, he moved to McKinsey Consulting. In 1970, a client, General Instrument, offered Malone the chance to run its cable television equipment division. He jumped at the opportunity.
After a couple of years, Malone was sought by two of the largest cable companies, Warner Communications and Tele-Communications Inc. (TCI). Malone chose TCI. Although the salary would be 60 percent lower, he would get more equity at TCI. Also, he and his wife preferred Denver to Manhattan.
(TCI logo, via Wikimedia Commons)
The industry had excellent tax characteristics:
Prudent cable operators could successfully shelter their cash flow from taxes by using debt to build new systems and by aggressively depreciating the costs of construction. These substantial depreciation charges reduced taxable income as did the interest expense on the debt, with the result that well-run cable companies rarely showed net income, and as a result, rarely paid taxes, despite very healthy cash flows. If an operator then used debt to buy or build additional systems and depreciated the newly acquired assets, he could continue to shelter his cash flow indefinitely.
Just after Malone took over as CEO of TCI in 1973, the 1973-1974 bear market left TCI in a dangerous position. The company was on the edge of bankruptcy due to its very high debt levels. Malone spent the next few years meeting with bankers and lenders to keep the company out of bankruptcy. Also during this time, Malone instituted new discipline in operations, which resulted in a frugal, entrepreneurial culture. Headquarters was austere. Executives stayed together in motels while on the road.
Malone depended on COO J. C. Sparkman to oversee operations, while Malone focused on capital allocation. TCI ended up having the highest margins in the industry as a result. They earned a reputation for underpromising and overdelivering.
In 1977, the balance sheet was in much better shape. Malone had learned that the key to creating value in cable television was financial leverage and leverage with suppliers (especially programmers). Both types of leverage improved as the company became larger. Malone had unwavering commitment to increasing the company’s size.
The largest cost in a cable television system is fees paid to programmers (HBO, MTV, ESPN, etc.). Larger cable operators can negotiate lower programming costs per subscriber. The more subscribers the cable company has, the lower its programming cost per subscriber. This led to a virtuous cycle:
[If] you buy more systems, you lower your programming costs and increase your cash flow, which allows more financial leverage, which can then be used to buy more systems, which further improves your programming costs, and so on… no one else at the time pursued scale remotely as aggressively as Malone and TCI.
Malone also focused on minimizing reported earnings (and thus taxes). At the time, this was highly unconventional since most companies focused on earnings per share. TCI gained an important competitive advantage by minimizing earnings and taxes. Terms like EBITDA were introduced by Malone.
Between 1973 and 1989, the company made 482 acquisitions. The key was to maximize the number of subscribers. (When TCI’s stock dropped, Malone repurchased shares.)
By the late 1970s and early 1980s, after the introduction of satellite-delivered channels such as HBO and MTV, cable television went from primarily rural customers to a new focus on urban markets. The bidding for urban franchises quickly overheated. Malone avoided the expensive urban franchise wars, and stayed focused on acquiring less expensive rural and suburban subscribers. Thorndike:
When many of the early urban franchises collapsed under a combination of too much debt and uneconomic terms, Malone stepped forward and acquired control at a fraction of the original cost.
Malone also established various joint ventures, which led to a number of cable companies in which TCI held a minority stake. Over time, Malone created a great deal of value for TCI by investing in young, talented entrepreneurs.
From 1973 to 1998, TCI shareholders enjoyed a compound annual return of 30.3 percent, compared to 20.4 percent for other publicly traded cable companies and 14.3 percent for the S&P 500. A dollar invested in TCI at the beginning was worth over $900 by mid-1998. The same dollar was worth $180 if invested in other publicly traded cable companies and $22 if invested in the S&P 500.
Malone never used spreadsheets. He looked for no-brainers that could be understood with simple math. Malone also delayed capital expenditures, generally until the economic viability of the investment had been proved. When it came to acquisitions–of which there were many–Malone would only pay five times cash flow.
KATHARINE GRAHAM AND THE WASHINGTON POST COMPANY
Katharine Graham was the daughter of financier Eugene Meyer. In 1940, she married Philip Graham, a brilliant lawyer. Meyer hired Philip Graham to run The Washington Post Company in 1946. He did an excellent job until his tragic suicide in 1963.
(The Washington Post logo, via Wikimedia Commons)
Katharine was unexpectedly thrust into the CEO role. At age forty-six, she had virtually no preparation for this role and she was naturally shy. But she ended up doing an amazing job. From 1971 to 1993, the compound annual return to shareholders was 22.3 percent versus 12.4 percent for peers and 7.4 percent for the S&P 500. A dollar invested in the IPO was worth $89 by the time she retired, versus $5 for the S&P and $14 for her peer group. These are remarkable margins of outperformance.
After a few years of settling into the new role, she began to take charge. In 1967, she replaced longtime editor in chief Russ Wiggins with the brash Ben Bradlee, who was forty-four years old.
In 1971, she took the company public to raise capital for acquisitions. This was what the board had recommended. At the same time, the newspaper encountered the Pentagon Papers crisis. The company was going to publish a highly controversial (and negative) internal Pentagon opinion of the war in Vietnam that a court had barred the New York Times from publishing. The Nixon administration threatened to challenge the company’s broadcast licenses if it published the report:
Such a challenge would have scuttled the stock offering and threatened one of the company’s primary profit centers. Graham, faced with unclear legal advice, had to make the decision entirely on her own. She decided to go ahead and print the story, and the Post’s editorial reputation was made. The Nixon administration did not challenge the TV licenses, and the offering, which raised $16 million, was a success.
In 1972, with Graham’s full support, the paper began in-depth investigations into the Republican campaign lapses that would eventually become the Watergate scandal. Bradlee and two young investigative reporters, Carl Bernstein and Bob Woodward, led the coverage of Watergate, which culminated with Nixon’s resignation in the summer of 1974. This led to a Pulitzer for the Post–one of an astonishing eighteen during Bradlee’s editorship–and established the paper as the only peer of the New York Times. All during the investigation, the Nixon administration threatened Graham and the Post. Graham firmly ignored them.
In 1974, an unknown investor eventually bought 13 percent of the paper’s shares. The board advised Graham not to meet with him. Graham ignored the advice and met the investor, whose name was Warren Buffett. Buffett quickly became Graham’s business mentor.
In 1975, the paper faced a huge strike led by the pressmen’s union. Graham, after consulting Buffett and the board, decided to fight the strike. Graham, Bradlee, and a very small crew managed to get the paper published for 139 consecutive days. Then the pressmen finally agreed to concessions. These concessions led to significantly improved profitability for the paper. It was also the first time a major city paper had broken a strike.
Also on advice from Buffett, Graham began aggressively buying back stock. Over the next few years, she repurchased nearly 40 percent of the company’s stock at very low prices (relative to intrinsic value). No other major papers did so.
In 1981, the Post‘s rival, the Washington Star, ceased publication. This allowed the Post to significantly increase circulation. At the same time, Graham hired Dick Simmons as COO. Simmons successfully lowered costs and improved profits. Simmons also emphasized bonus compensation based on performance relative to peer newspapers.
In the early 1980s, the Post spent years not acquiring any companies, even though other major newspapers were making more deals than ever. Graham was criticized, but stuck to her financial discipline. In 1983, however, after extensive research, the Post bought cellular telephone businesses in six major markets. In 1984, the Post acquired the Stanley Kaplan test prep business. And in 1986, the paper bought Capital Cities’ cable television assets for $350 million. All of these acquisitions would prove valuable for the Post in the future.
In 1988, Graham sold the paper’s telephone assets for $197 million, a very high return on investment. Thorndike continues:
During the recession of the early 1990s, when her overleveraged peers were forced to the sidelines, the company became uncharacteristically acquisitive, taking advantage of dramatically lower prices to opportunistically purchase cable television systems, underperforming TV stations, and a few education businesses.
When Kay Graham stepped down as chairman in 1993, the Post Company was by far the most diversified among its major newspaper peers, earning almost half its revenues and profits from non-print sources. This diversification would position the company for further outperformance under her son Donald’s leadership.
BILL STIRITZ AND RALSTON PURINA
Bill Stiritz was at Ralston seventeen years before becoming CEO at age forty-seven.
This seemingly conventional background, however, masked a fiercely independent cast of mind that made him a highly effective, if unlikely, change agent. When Stiritz assumed the CEO role, it would have been impossible to predict the radical transformation he would effect at Ralston and the broader influence it would have on his peers in the food and packaged goods industries.
(Purina logo, via Wikimedia Commons)
Stiritz attended the University of Arkansas for a year but then joined the navy for four years. While in the navy, he developed his poker skills enough so that poker eventually would pay for his college tuition. Stiritz completed his undergraduate degree at Northwestern, majoring in business. (In his mid-thirties, he got a master’s degree in European history from Saint Louis University.)
Stiritz first worked at the Pillsbury Company as a field rep putting cereal on store shelves. He was promoted to product manager and he learned about consumer packaged goods (CPG) marketing. Wanting to understand advertising and media better, he started working two years later at the Gardner Advertising agency in St. Louis. He focused on quantitative approaches to marketing such as the new Nielsen ratings service, which gave a detailed view of market share as a function of promotional spending.
In 1964, Stiritz joined Ralston Purina in the grocery products division (pet food and cereals). He became general manager of the division in 1971. While Stiritz was there, operating profits increased fiftyfold due to new product introductions and line extensions. Thorndike:
Stiritz personally oversaw the introduction of Purina Puppy and Cat Chow, two of the most successful launches in the history of the pet food industry. For a marketer, Stiritz was highly analytical, with a natural facility for numbers and a skeptical, almost prickly temperament.
Thorndike continues:
On assuming the CEO role in 1981, Stiritz wasted little time in aggressively restructuring the company. He fully appreciated the exceptionally attractive economics of the company’s portfolio of consumer brands and promptly reorganized the company around these businesses, which he believed offered an attractive combination of high margins and low capital requirements. He immediately began to remove the underpinnings of his predecessor’s strategy, and his first moves involved actively divesting businesses that did not meet his criteria for profitability and returns.
After a number of divestitures, Ralston was a pure branded products company. In the early 1980s, Stiritz began repurchasing stock aggressively. No other major branded products company was repurchasing stock at that time.
Stiritz then bought Continental Baking, the maker of Twinkies and Wonder Bread. He expanded distribution, cut costs, introduced new products, and increased cash flow materially, creating much value for shareholders.
Then in 1986, Stiritz bought the Energizer Battery division from Union Carbide for $1.5 billion. The business had been a neglected operation at Union Carbide. Stiritz thought it was undermanaged and also part of a growing duopoly market.
By the late 1980s, almost 90 percent of Ralston’s revenues were from consumer packaged goods. Pretax profit margins increased from 9 to 15 percent. ROE went from 15 to 37 percent. Since the share base was reduced by aggressive buybacks, earnings and cash flow per share increased dramatically. Stiritz continued making very careful acquisitions and divestitures, with each decision based on an in-depth analysis of potential returns for shareholders.
Stiritz also began spinning off some businesses he thought were not receiving the attention they deserved–either internally or from Wall Street. Spin-offs not only can highlight the value of certain business units. Spin-offs also allow the deferral of capital gains taxes.
Finally, Stiritz sold Ralston itself to Nestle for $10.4 billion, or fourteen times cash flow. This successfully concluded Stiritz’ career at Ralston. A dollar invested with Stiritz when he became CEO was worth $57 nineteen years later. The compound return was 20.0 percent versus 17.7 percent for peers and 14.7 percent for the S&P 500.
Stiritz didn’t like the false precision of detailed financial models. Instead, he focused only on the few key variables that mattered, including growth and competitive dynamics. When Ralston bought Energizer, Stiritz and his protégé Pat Mulcahy, along with a small group, took a look at Energizer’s books and then wrote down a simple, back of the envelope LBO model. That was it.
Since selling Ralston, Stiritz has energetically managed an investment partnership made up primarily of his own capital.
DICK SMITH AND GENERAL CINEMA
In 1922, Phillip Smith borrowed money from friends and family, and opened a theater in Boston’s North End. Over the next forty years, Smith built a successful chain of theaters. In 1961, Phillip Smith took the company public to raise capital. But in 1962, Smith passed away. His son, Dick Smith, took over as CEO. He was thirty-seven years old.
(General Cinema logo, via Wikimedia Commons)
Dick Smith demonstrated a high degree of patience in using the company’s cash flow to diversify away from the maturing drive-in movie business.
Smith would alternate long periods of inactivity with the occasional very large transaction. During his tenure, he would make three significant acquisitions (one in the late 1960s, one in the mid-1980s, and one in the early 1990s) in unrelated businesses: soft drink bottling (American Beverage Company), retailing (Carter Hawley Hale), and publishing (Harcourt Brace Jovanovich). This series of transactions transformed the regional drive-in company into an enormously successful consumer conglomerate.
Dick Smith later sold businesses that he had earlier acquired. His timing was extraordinarily good, with one sale in the late 1980s, one in 2003, and one in 2006. Thorndike writes:
This accordion-like pattern of expansion and contraction, of diversification and divestiture, was highly unusual (although similar in some ways to Henry Singleton’s at Teledyne) and paid enormous benefits for General Cinema’s shareholders.
Smith graduated from Harvard with an engineering degree in 1946. He worked as a naval engineer during World War II. After the war, he didn’t want an MBA. He wanted to join the family business. In 1956, Dick Smith’s father made him a full partner.
Dick Smith recognized before most others that suburban theaters were benefitting from strong demographic trends. This led him to develop two new practices.
First, it had been assumed that theater owners should own the underlying land. But Smith realized that a theater in the right location could fairly quickly generate predictable cash flow. So he pioneered lease financing for new theaters, which significantly reduced the upfront investment.
Second, he added more screens to each theater, thereby attracting more people, who in turn bought more high-margin concessions.
Throughout the 1960s and into the early 1970s, General Cinema was getting very high returns on its investment in new theaters. But Smith realized that such growth was not likely to continue indefinitely. He started searching for new businesses with better long-term prospects.
In 1968, Smith acquired the American Beverage Company (ABC), the largest, independent Pepsi bottler in the country. Smith knew about the beverage business based on his experience with theater concessions. Smith paid five times cash flow and it was a very large acquisition for General Cinema at the time. Thorndike notes:
Smith had grown up in the bricks-and-mortar world of movie theaters, and ABC was his first exposure to the value of businesses with intangible assets, like beverage brands. Smith grew to love the beverage business, which was an oligopoly with very high returns on capital and attractive long-term growth trends. He particularly liked the dynamics within the Pepsi bottler universe, which was fragmented and had many second- and third-generation owners who were potential sellers (unlike the Coke system, which was dominated by a smaller number of large independents). Because Pepsi was the number two brand, its franchises often traded at lower valuations than Coke’s.
ABC was a platform company–other companies could be added easily and efficiently. Smith could buy new franchises at seemingly high multiples of the seller’s cash flow and then quickly reduce the effective price through reducing expenses, minimizing taxes, and improving marketing. So Smith acquired other franchises.
Due to constant efforts to reduce costs by Smith and his team, ABC had industry-leading margins. Soon thereafter, ABC invested $20 million to launch Sunkist. In 1984, Smith sold Sunkist to Canada Dry for $87 million.
Smith sought another large business to purchase. He made a number of smaller acquisitions in the broadcast media business. But his price discipline prevented him from buying very much.
Eventually General Cinema bought Carter Hawley Hale (CHH), a retail conglomerate with several department store and specialty retail chains. Woody Ives, General Cinema’s CFO, was able to negotiate attractive terms:
Ives negotiated a preferred security that guaranteed General Cinema a 10 percent return, allowed it to convert its interest into 40 percent of the common stock if the business performed well, and included a fixed-price option to buy Waldenbooks, a wholly owned subsidiary of CHH…
Eventually General Cinema would exchange its 40 percent ownership in CHH shares for a controlling 60 percent stake in the company’s specialty retail division, whose primary asset was the Neiman Marcus chain. The long-term returns on the company’s CHH investment were an extraordinary 51.2 percent. The CHH transaction moved General Cinema decisively into retailing, a new business whose attractive growth prospects were not correlated with either the beverage or the theater businesses.
In the late 1980s, Smith noticed that a newly energetic Coke was attacking Pepsi in local markets. At the same time, beverage franchises were selling for much higher prices as their good economics were more widely recognized. So Smith sold the bottling business in 1989 to Pepsi for a record price. After the sale, General Cinema was sitting on $1 billion in cash. Smith started looking for another diversifying acquisition.
It didn’t take him long to find one. In 1991, after a tortuous eighteen-month process, Smith made his largest and last acquisition, buying publisher Harcourt Brace Jovanovich (HBJ) in a complex auction process and assembling General Cinema’s final third leg. HBJ was a leading educational and scientific publisher that also owned a testing business and an outplacement firm. Since the mid-1960s, the firm had been run as a personal fiefdom by CEO William Jovanovich. In 1986, the company received a hostile takeover bid from the renegade British publisher Robert Maxwell, and in response Jovanovich had taken on large amounts of debt, sold off HBJ’s amusement park business, and made a large distribution to shareholders.
General Cinema management concluded, after examining the business, that HBJ would fit their acquisition criteria. Moreover, General Cinema managers thought HBJ’s complex balance sheet would probably deter other buyers. Thorndike writes:
After extensive negotiations with the company’s many debt holders, Smith agreed to purchase the company for $1.56 billion, which represented 62 percent of General Cinema’s enterprise value at the time–an enormous bet. This price equaled a multiple of six times cash flow for HBJ’s core publishing assets, an attractive price relative to comparable transactions (Smith would eventually sell those businesses for eleven times cash flow).
Thorndike continues:
Following the HBJ acquisition in 1991, General Cinema spun off its mature theater business into a separate publicly traded entity, GC Companies (GCC), allowing management to focus its attention on the larger retail and publishing businesses. Smith and his management team proceeded to operate both the retail and the publishing businesses over the next decade. In 2003, Smith sold the HBJ publishing assets to Reed Elsevier, and in 2006 he sold Neiman Marcus, the last vestige of the General Cinema portfolio, to a consortium of private equity buyers. Both transactions set valuation records within their industries, capping an extraordinary run for Smith and General Cinema shareholders.
From 1962 to 1991, Smith had generated 16.1 percent compound annual return versus 9 percent for the S&P 500 and 9.8 percent for GE. A dollar invested with Dick Smith in 1962 would be worth $684 by 1991. The same dollar would $43 if invested in the S&P and $60 if invested in GE.
WARREN BUFFETT AND BERKSHIRE HATHAWAY
Buffett was first attracted to the old textile mill Berkshire Hathaway because its price was cheap compared to book value. Thorndike tells the story:
At the time, the company had only a weak market position in a brutally competitive commodity business (suit linings) and a mere $18 million in market capitalization. From this undistinguished start, unprecedented returns followed; and measured by long-term stock performance, the formerly crew-cut Nebraskan is simply on another planet from all other CEOs. These otherworldly returns had their origin in that aging New England textile company, which today has a market capitalization of $140 billion and virtually the same number of shares. Buffett bought his first share of Berkshire for $7; today it trades for over $120,000 share. [Value of Berkshire share as of 10/21/18: $517.2 billion market capitalization, or $314,477 a share]
(Company logo, byBerkshire Hathaway Inc., via Wikimedia Commons)
Buffett was born in 1930 in Omaha, Nebraska. His grandfather ran a well-known local grocery store. His father was a stockbroker in downtown Omaha and later a congressman. Starting at age six, Buffett started various entrepreneurial ventures. He would buy a 6-pack of Coke for 25 cents and resell each one for 5 cents. He later had several paper routes and then pinball machines, too. Buffett attended Wharton, but didn’t feel he could learn much. So he returned to Omaha and graduated from the University of Nebraska at age 20.
He’d always been interested in the stock market. But it wasn’t until he was nineteen that he discovered The Intelligent Investor, by Benjamin Graham. Buffett immediately realized that value investing–as explained by Graham in simple terms–was the key to making money in the stock market.
Buffett was rejected by Harvard Business School, which was a blessing in that Buffett attended Columbia University where Graham was teaching. Buffett was the star in Graham’s class, getting the only A+ Graham ever gave in more than twenty years of teaching. Others in that particular course said the class was often like a conversation between Graham and Buffett.
Buffett graduated from Columbia in 1952. He applied to work for Graham, but Graham turned him down. At the time, Jewish analysts were having a hard time finding work on Wall Street, so Graham only hired Jewish people. Buffett returned to Omaha and worked as a stockbroker.
One idea Buffett had tried to pitch while he was a stockbroker was GEICO. He realized that GEICO had a sustainable competitive advantage: a permanently lower cost structure because GEICO sold car insurance direct, without agents or branches. Buffett had trouble convincing clients to buy GEICO, but he himself loaded up in his own account.
Meanwhile, Buffett regularly mailed investment ideas to Graham. After a couple of years, in 1954, Graham hired Buffett.
In 1956, Graham dissolved the partnership to focus on other interests. Buffett returned to Omaha and launched a small investment partnership with $105,000 under management. Buffett himself was worth $140,000 at the time (over $1 million today).
Over the next thirteen years, Buffett crushed the market averages. Early on, he was applying Graham’s methods by buying stocks that were cheap relative to net asset value. But in the mid-1960s, Buffett made two large investments–in American Express and Disney–that were based more on normalized earnings than net asset value. This was the beginning of a transition Buffett made from buying statistically cheap cigar butts to buying higher quality companies.
Buffett referred to deep value opportunities–stocks bought far below net asset value–as cigar butts. Like a soggy cigar butt found on a street corner, a deep value investment would often give “one free puff.” Such a cigar butt is disgusting, but that one puff is “all profit.”
Buffett started acquiring shares in Berkshire Hathaway–a cigar butt–in 1965. In the late 1960s, Buffett was having trouble finding cheap stocks, so he closed down the Buffett partnership.
After getting control of Berkshire Hathaway, Buffett put in a new CEO, Ken Chace. The company generated $14 million in cash as Chace reduced inventories and sold excess plants and equipment. Buffett used most of this cash to acquire National Indemnity, a niche insurance company. Buffett invested National Indemnity’s float quite well, buying other businesses like the Omaha Sun, a weekly newspaper, and a bank in Rockford, Illinois.
During this period, Buffett met Charlie Munger, another Omaha native who was then a brilliant lawyer in Los Angeles. Buffett convinced Munger to run his own investment partnership, which he did with excellent results. Later on, Munger became vice-chairman at Berkshire Hathaway.
Partly by reading the works of Phil Fisher, but more from Munger’s influence, Buffett realized that a wonderful company at a fair price was better than a fair company at a wonderful price. A wonderful company would have a sustainably high ROIC, which meant that its intrinsic value would compound over time. In order to estimate intrinsic value, Buffett now relied more on DCF (discounted cash flow) and private market value–methods well-suited to valuing good businesses (often at fair prices)–rather than an estimate of liquidation value–a method well-suited to valuing cigar butts (mediocre businesses at cheap prices).
In the 1970s, Buffett and Munger invested in See’s Candies and the Buffalo News. And they bought large stock positions in the Washington Post, GEICO, and General Foods.
In the first half of the 1980s, Buffett bought the Nebraska Furniture Mart for $60 million and Scott Fetzer, a conglomerate of niche industrial businesses, for $315 million. In 1986, Buffett invested $500 million helping his friend Tom Murphy, CEO of Capital Cities, acquire ABC.
Buffett then made no public market investments for several years. Finally in 1989, Buffett announced that he invested $1.02 billion, a quarter of Berkshire’s investment portfolio, in Coca-Cola, paying five times book value and fifteen times earnings. The return on this investment over the ensuing decade was 10x.
(Coca-Cola Company logo, via Wikimedia Commons)
Also in the late 1980s, Buffett invested in convertible preferred securities in Salomon Brothers, Gillette, US Airways, and Champion Industries. The dividends were tax-advantaged, and he could convert to common stock if the companies did well.
In 1991, Salomon Brothers was in a major scandal based on fixing prices in government Treasury bill auctions. Buffett ended up as interim CEO for nine months. Buffett told Salomon employees:
“Lose money for the firm and I will be understanding. Lose even a shred of reputation for the firm, and I will be ruthless.”
In 1996, Salomon was sold to Sandy Weill’s Travelers Corporation for $9 billion, which was a large return on investment for Berkshire.
In the early 1990s, Buffett invested–taking large positions–in Wells Fargo (1990), General Dynamics (1992), and American Express (1994). In 1996, Berkshire acquired the half of GEICO it didn’t own. Berkshire also purchased the reinsurer General Re in 1998 for $22 billion in Berkshire stock.
In the late 1990s and early 2000s, Buffett bought a string of private companies, including Shaw Carpets, Benjamin Moore Paints, and Clayton Homes. He also invested in the electric utility industry through MidAmerican Energy. In 2006, Berkshire announced its first international acquisition, a $5 billion investment in Iscar, an Israeli manufacturer of cutting tools and blades.
In early 2010, Berkshire purchased the nation’s largest railroad, the Burlington Northern Santa Fe, for $34.2 billion.
From June 1965, when Buffett assumed control of Berkshire, through 2011, the value of the company’s shares increased at a compound rate of 20.7 percent compared to 9.3 percent for the S&P 500. A dollar invested in Berkshire was worth $6,265 forty-five years later. The same dollar invested in the S&P 500 was worth $62.
The Nuts and Bolts
Having learned from Murphy, Buffett and Munger created Berkshire to be radically decentralized. Business managers are given total autonomy over everything except large capital allocation decisions. Buffett makes the capital allocation decisions, and Buffett is an even better investor than Henry Singleton.
Another key to Berkshire’s success is that the insurance and reinsurance operations are profitable over time, and meanwhile Buffett invests most of the float. Effectively, the float has an extremely low cost (occasionally negative) because the insurance and reinsurance operations are profitable. Buffett always reminds Berkshire shareholders that hiring Ajit Jain to run reinsurance was one of the best investments ever for Berkshire.
As mentioned, Buffett is in charge of capital allocation. He is arguably the best investor ever based on the longevity of his phenomenal track record.
Buffett and Munger have always believed in concentrated portfolios. It makes sense to take very large positions in your best ideas. Buffett invested 40 percent of the Buffett partnership in American Express after the salad oil scandal in 1963. In 1989, Buffett invested 25 percent of the Berkshire portfolio–$1.02 billion–in Coca-Cola.
Buffett and Munger still have a very concentrated portfolio. But sheer size requires them to have more positions than before. It also means that they can no longer look at most companies, which are too small to move the needle.
Buffett and Munger also believe in holding their positions for decades. Over time, this saves a great deal of money by minimizing taxes and transaction costs.
Thorndike:
Buffett’s approach to investor relations is also unique and homegrown. Buffett estimates that the average CEO spends 20 percent of his time communicating with Wall Street. In contrast, he spends no time with analysts, never attends investment conferences, and has never provided quarterly earnings guidance. He prefers to communicate with his investors through detailed annual reports and meetings, both of which are unique.
… The annual reports and meetings reinforce a powerful culture that values frugality, independent thinking, and long-term stewardship.
RADICAL RATIONALITY: THE OUTSIDER’S MINDSET
You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right–and that’s the only thing that makes you right. And if your facts and reasoning are right, you don’t have to worry about anybody else.– Warren Buffett
Thorndike sums up the outsider’s mindset:
Always Do the Math
The Denominator Matters
A Feisty Independence
Charisma is Overrated
A Crocodile-Like Temperament That Mixes Patience with Occasional Bold Action
The Consistent Application of a Rational, Analytical Approach to Decisions Large and Small
A Long-Term Perspective
Always Do the Math
The outsider CEOs always focus on the ROIC for any potential investment. They do the analysis themselves just using the key variables and without using a financial model. Outsider CEOs realize that it’s the assumptions about the key variables that really matter.
The Denominator Matters
The outsider CEOs focus on maximizing value per share. Thus, the focus is not only on maximizing the numerator–the value–but also on minimizing the denominator–the number of shares. Outsider CEOs opportunistically repurchase shares when the shares are cheap. And they are careful when they finance investment projects.
A Feisty Independence
The outsider CEOs all ran very decentralized organizations. They gave people responsibility for their respective operations. But outsider CEOs kept control over capital allocation decisions. And when they did make decisions, outsider CEOs didn’t seek others’ opinions. Instead, they liked to gather all the information, and then think and decide with as much independence and rationality as possible.
Charisma Is Overrated
The outsider CEOs tended to be humble and unpromotional. They tried to spend the absolute minimum amount of time interacting with Wall Street. Outsider CEOs did not offer quarterly guidance and they did not participate in Wall Street conferences.
A Crocodile-Like Temperament That Mixes Patience With Occasional Bold Action
The outsider CEOs were willing to wait very long periods of time for the right opportunity to emerge.
Like Katharine Graham, many of them created enormous shareholder value by simply avoiding overpriced ‘strategic’ acquisitions, staying on the sidelines during periods of acquisition feeding frenzy.
On the rare occasions when there was something to do, the outsider CEOs acted boldly and aggressively. Tom Murphy made an acquisition of a company (ABC) larger than the one he managed (Capital Cities). Henry Singleton repeatedly repurchased huge amounts of stock at cheap prices, eventually buying back over 90 percent of Teledyne’s shares.
The Consistent Application of a Rational, Analytical Approach to Decisions Large and Small
The total value that any company creates over time is the cumulative difference between ROIC and the cost of capital. The outsider CEOs made every capital allocation decision in order to maximize ROIC over time, thereby maximizing long-term shareholder value.
These CEOs knew precisely what they were looking for, and so did their employees. They didn’t overanalyze or overmodel, and they didn’t look to outside consultants or bankers to confirm their thinking–they pounced.
A Long-Term Perspective
The outsider CEOs would make investments in their business as long as they thought that it would contribute to maximizing long-term ROIC and long-term shareholder value. The outsiders were always willing to take short-term pain for long-term gain:
[They] disdained dividends, made disciplined (occasionally large) acquisitions, used leverage selectively, bought back a lot of stock, minimized taxes, ran decentralized organizations, and focused on cash flow over reported net income.
Thorndike notes that the advantage the outsider CEOs had was temperament, not intellect (although they were all highly intelligent). They understood that what mattered was rationality and patience.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: jb@boolefund.com
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.
He has also written numerous papers, including Thirty Years: Reflections on the Ten Attributes of Great Investors: https://bit.ly/2zlaljc
When it comes to value investing, Mauboussin is one of the best writers in the world. Mauboussin highlights market efficiency, competitive strategy analysis, valuation, and decision making as chief areas of focus for him the past couple of decades. Mauboussin:
What we know about each of these areas today is substantially greater than what we did in 1986, and yet we have an enormous amount to learn. As I like to tell my students, this is an exciting time to be an investor because much of what we teach in business schools is a work-in-progress.
(Image by magele-picture)
Here are the Ten Attributes of Great Investors:
Be numerate (and understand accounting).
Understand value (the present value of free cash flow).
Properly assess strategy (or how a business makes money).
Compare effectively (expectations versus fundamentals).
Think probabilistically (there are few sure things).
Update your views effectively (beliefs are hypotheses to be tested, not treasures to be protected).
Beware of behavioral biases (minimizing constraints to good thinking).
Know the difference between information and influence.
Position sizing (maximizing the payoff from edge).
Read (and keep an open mind).
BE NUMERATE (AND UNDERSTAND ACCOUNTING)
Mauboussin notes that there are two goals when analyzing a company’s financial statements:
Translate the financial statements into free cash flow.
Determine how the competitive strategy of the company creates value.
The value of any business is the future free cash flow it will produce discounted back to the present.
(Photo by designer491)
Free cash flow is cash earnings minus investments that must be made to grow future earnings. Free cash flow represents what owners of the business receive. Warren Buffett refers to free cash flow as owner earnings.
Earnings alone cannot give you the value of a company. You can grow earnings without growing value. Whether earnings growth creates value depends on how much money the company invests to generate that growth. If the ROIC (return on invested capital) of the company’s investment is below the cost of capital, then the resulting earnings growth destroys value rather than creates it.
After calculating free cash flow, the next goal in financial statement analysis is to figure out how the company’s strategy creates value. For the company to create value, the ROIC must exceed the cost of capital. Analyzing the company’s strategy means determining precisely how the company can get ROIC above the cost of capital.
Mauboussin writes that one way to analyze strategy is to compare two companies in the same business. If you look at how the companies spend money, you can start to understand competitive positions.
Another way to grasp competitive position is by analyzing ROIC.
Photo by stanciuc
You can break ROIC into two parts:
profitability (net operating profit after tax / sales)
capital velocity (sales / invested capital)
Companies with high profitability but low capital velocity are using a differentiation strategy. Their product is positioned in such a way that the business can earn high profit margins. (For instance, a luxury jeweler.)
Companies with high capital velocity but low profitability have adopted a cost leadership strategy. These businesses may have very thin profit margins, but they still generate high ROIC because their capital velocity is so high. (Wal-Mart is a good example.)
Understanding how the company makes money can lead to insight about how long the company can maintain a high ROIC (if ROIC is high) or what the company must do to improve (if ROIC is low).
UNDERSTAND VALUE (THE PRESENT VALUE OF FREE CASH FLOW)
Mauboussin:
Great fundamental investors focus on understanding the magnitude and sustainability of free cash flow. Factors that an investor must consider include where the industry is in its life cycle, a company’s competitive position within its industry, barriers to entry, the economics of the business, and management’s skill at allocating capital.
It’s worth repeating: The value of any business (or any financial asset) is the future free cash flow it will produce discounted back to the present. Successful investors understand the variables that impact free cash flow.
Illustration by OpturaDesign
PROPERLY ASSESS STRATEGY (OR HOW A COMPANY MAKES MONEY)
Mauboussin says this attribute has two elements:
How does the company make money?
Does the company have a sustainable competitive advantage, and if so, how durable is it?
To see how a business makes money, you have to figure out the basic unit of analysis. Mauboussin points out that the basic unit of analysis for a retailer is store economics: How much does it cost to build a store? What revenues will it generate? What are the profit margins?
The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.
If a company has a sustainable competitive advantage, then ROIC (return on invested capital) is above the cost of capital. To assess the durability of that advantage, you have to analyze the industry and how the company fits in. Looking at the five forces that determine industry attractiveness is a common step. You should also examine potential threats from disruptive innovation.
Mauboussin:
Great investors can appreciate what differentiates a company that allows it to build an economic moat around its franchise that protects the business from competitors. The size and longevity of the moat are significant inputs into any thoughtful valuation.
Bodiam Castle, Photo by valeryegorov
Buffett popularized the term economicmoat to refer to a sustainable competitive advantage. Here’s what Buffett said at the Berkshire annual meeting in 2000:
So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes. However, if the moat is widened every year, the business will do very well.
COMPARE EFFECTIVELY (EXPECTATIONS VERSUS FUNDAMENTALS)
Mauboussin:
Perhaps the most important comparison an investor must make, and one that distinguishes average from great investors, is between fundamentals and expectations. Fundamentals capture a sense of a company’s future financial performance. Value drivers including sales growth, operating profit margins, investment needs, and return on investment shape fundamentals. Expectations reflect the financial performance implied by the stock price.
Fundamentals are how fast the horse will run, while expectations are the odds.
If a company has good fundamentals, but the stock price already reflects that, then you can’t expect to beat the market by investing in the stock.
If a company has bad fundamentals, but the stock price is overly pessimistic, then you can expect to beat the market by investing in the stock.
The best business in the world will not bring excess returns if the stock price already fully reflects the high quality of the business. Similarly, a terrible business can produce excess returns if the stock price indicates that investors have overreacted.
To make money by investing in a stock, you have to have what great investor Michael Steinhardt calls a variant perception“”a view at odds with the consensus view (as reflected in the stock price). And you have to be right.
Mauboussin observes that humans are quick to compare but aren’t good at it. This includes reasoning by analogy, e.g., asking whether a particular turnaround is similar to some other turnaround. However, it’s usually better to figure out the base rate: What percentage of all turnarounds succeed? (Not a very high number, which is why Buffett quipped, “Turnarounds seldom turn.”)
Another limitation of humans making comparisons is that people tend to see similarities when they’re looking for similarities, but they tend to see differences when they’re looking for differences. For instance, Amos Tversky did an experiment in which the subjects were asked which countries are more similar, West Germany and East Germany, or Nepal and Ceylon? Two-thirds answered West Germany and East Germany. But then the subjects were asked which countries seemed more different. Logic says that they would answer Nepal and Ceylon, but instead subjects again answered West Germany and East Germany.
THINK PROBABILISTICALLY (THERE ARE FEW SURE THINGS)
Great investors are always seeking an edge, where the price of an asset misrepresents the probabilities or the outcomes. By similar logic, great investors evaluate each investment decision based on the process used rather than based on the outcome.
A good investment decision is one that if repeatedly made would be profitable over time.
A bad investment decision is one that if repeatedly made would lead to losses over time.
However, a good decision will sometimes lead to a bad outcome, while a bad decision will sometimes lead to a good outcome. Investing is similar to other forms of betting in that way.
Photo by annebel146
Furthermore, what matters is not how often an investor is right, but rather how much the investor makes when he is right versus how much he loses when he is wrong. In other words, what matters is not batting average but slugging percentage. This is hard to put into practice due to loss aversion“”the fact that as humans we feel a loss at least twice as much as an equivalent gain.
There are three ways of determining probabilities. Subjective probability is a number that corresponds with your state of knowledge or belief. Mauboussin gives an example: You might come up with a probability that two countries will go to war. Propensity is usually based on the physical properties of the system. If a six-sided die is a perfect cube, then you know that the odds of a particular side coming up must be one out of six. Frequency is the third approach. Frequency””also called the base rate“”is measured by looking at the outcomes of a proper reference class. How often will a fair coin land on heads? If you gather all the records you can of a fair coin being tossed, you’ll find that it lands on heads 50 percent of the time. (You could run your own trials, too, by tossing a fair coin thousands or millions of times.)
Often subjective probabilities are useful as long as you remain open to new information and properly adjust your probabilities based on that information. (The proper way to update such beliefs is using Bayes’s theorem.) Subjective probabilities are useful when there’s no clear reference class””no relevant base rate.
When you’re looking at corporate performance””like sales or profit growth””it’s usually best to look at frequencies, i.e., base rates.
An investment decision doesn’t have to be complicated. In fact, most good investment decisions are simple. Mauboussin quotes Warren Buffett:
Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.
Buffett again:
Investing is simple, but not easy.
UPDATE YOUR VIEWS EFFECTIVELY (BELIEFS ARE HYPOTHESES TO BE TESTED, NOT TREASURES TO BE PROTECTED)
We have a strong preference for consistency when it comes to our own beliefs. And we expect others to be consistent. The problem is compounded by confirmation bias, the tendency to look for and see only information that confirms our beliefs, and the tendency to interpret ambiguous information in a way that supports our beliefs. As long as we feel like our beliefs are both consistent and correct””and, as a default psychological setting, most of us feel this way most of the time””we’ll feel comfortable and we won’t challenge our beliefs.
Illustration by intheskies
Great investors seek data and arguments that challenge their views. Great investors also update their beliefs when they come across evidence that suggests they should. The proper way to update beliefs is using Bayes’s theorem. To see Bayes’s theorem and also a clear explanation and example, see: https://boolefund.com/the-signal-and-the-noise/
Mauboussin:
The best investors among us recognize that the world changes constantly and that all of the views that we hold are tenuous. They actively seek varied points of view and update their beliefs as new information dictates. The consequence of updated views can be action: changing a portfolio stance or weightings within a portfolio. Others, including your clients, may view this mental flexibility as unsettling. But good thinking requires maintaining as accurate a view of the world as possible.
BEWARE OF BEHAVIORAL BIASES (MINIMIZING CONSTRAINTS TO GOOD THINKING)
Mauboussin:
Keith Stanovich, a professor of psychology, likes to distinguish between intelligence quotient (IQ), which measures mental skills that are real and helpful in cognitive tasks, and rationality quotient (RQ), the ability to make good decisions. His claim is that the overlap between these abilities is much lower than most people think. Importantly, you can cultivate your RQ.
Rationality is only partly genetic. You can train yourself to be more rational.
Great investors relentlessly train themselves to be as rational as possible. Typically they keep an investment journal in which they write down the reasoning for every investment decision. Later they look back on their decisions to analyze what they got right and where they went wrong.
Great investors also undertake a comprehensive study of cognitive biases. For a list of cognitive biases, see these two blog posts:
It’s rarely enough just to know about cognitive biases. Great investors take steps””like using a checklist””designed to mitigate the impact that innate cognitive biases have on investment decision-making.
Photo by Kenishirotie
KNOW THE DIFFERENCE BETWEEN INFORMATION AND INFLUENCE
A stock price generally represents the collective wisdom of investors about how a given company will perform in the future. Most of the time, the crowd is more accurate than virtually any individual investor.
(Illustration by Marrishuanna)
However, periodically a stock price can get irrational. (If this weren’t the case, great value investors could not exist.) People regularly get carried away with some idea. For instance, as Mauboussin notes, many investors got rich on paper by investing in dot-com stocks in the late 1990’s. Investors who didn’t own dot-com stocks felt compelled to jump on board when they saw their neighbor getting rich (on paper).
Mauboussin mentions the threshold model from Mark Granovetter, a professor of sociology at Stanford University. Mauboussin:
Imagine 100 potential rioters milling around in a public square. Each individual has a “riot threshold,” the number of rioters that person would have to see in order to join the riot. Say one person has a threshold of 0 (the instigator), one has a threshold of 1, one has a threshold of 2, and so on up to 99. This uniform distribution of thresholds creates a domino effect and ensures that a riot will happen. The instigator breaks a window with a rock, person one joins in, and then each individual piles on once the size of the riot reaches his or her threshold. Substitute “buy dotcom stocks” for “join the riot” and you get the idea.
The point is that very few of the individuals, save the instigator, think that rioting is a good idea. Most would probably shun rioting. But once the number of others rioting reaches a threshold, they will jump in. This is how the informational value of stocks is set aside and the influential component takes over.
Great investors are not influenced much at all by the behavior of other investors. Great investors know that the collective wisdom reflected in a stock price is usually right, but sometimes wrong. These investors can identify the occasional mispricing and then make an investment while ignoring the crowd.
POSITION SIZING (MAXIMIZING THE PAYOFF FROMEDGE)
Great investors patiently wait for situations where they have an edge, i.e., where the odds are in their favor. Many investors understand the need for an edge. However, fewer investors pay much attention to position sizing.
If you know the odds, there’s a formula””the Kelly criterion””that tells you exactly how much to bet in order to maximize your long-term returns. The Kelly criterion can be written as follows:
F = p ““ [q/o]
where
F = Kelly criterion fraction of current capital to bet
o = Net odds, or dollars won per $1 bet if the bet wins (e.g., the bet may pay 5 to 1, meaning you win $5 per each $1 bet if the bet wins)
p = probability of winning
q = probability of losing = 1 ““ p
The Kelly criterion has a unique mathematical property: if you know the probability of winning and the net odds (payoff), then betting exactly the percentage determined by the Kelly criterion leads to the maximum long-term compounding of capital. (This assumes that you’re going to make a long series of bets.) Betting any percentage that is not equal to that given by the Kelly criterion will inevitably lead to lower compound growth over a long period of time.
Mauboussin adds:
Proper portfolio construction requires specifying a goal (maximize sum for one period or parlayed bets), identifying an opportunity set (lots of small edge or lumpy but large edge), and considering constraints (liquidity, drawdowns, leverage). Answers to these questions suggest an appropriate policy regarding position sizing and portfolio construction.
In brief, most investors are ineffective at position sizing, but great investors are good at it.
READ (AND KEEP AN OPEN MIND)
Great investors generally read a ton. They also read widely across many disciplines. Moreover, as noted earlier, great investors seek to learn about the arguments of people who disagree with them. Mauboussin:
Berkshire Hathaway’s Charlie Munger said that he really liked Albert Einstein’s point that “success comes from curiosity, concentration, perseverance and self-criticism. And by self-criticism, he meant the ability to change his mind so that he destroyed his own best-loved ideas.” Reading is an activity that tends to foster all of those qualities.
(Photo by Lapandr)
Mauboussin continues:
Munger has also said, “In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time””none, zero.” This may be hyperbolic, but seems to be true in the investment world as well.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: jb@boolefund.com
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.
