Boole Microcap Fund

October 29, 2023

Peter Lynch is one of the great investors. When Lynch managed Fidelity Magellan from 1977 to 1990, the fund averaged 29.2% per year–more than doubling the annual return of the S&P 500 Index–making it the best performing mutual fund in the world.

In One Up On Wall Street: How to Use What You Already Know to Make Money in the Market (Fireside, 1989 and 2000), Lynch offers his best advice to individual investors.

Lynch explains how to find tenbaggers–stocks that increase by 10x–by looking among stocks that are too small for most professionals. Lynch also suggests that you pay attention to small businesses you may come across in your daily life. If you notice a company that seems to be doing well, then you should research its earnings prospects, financial condition, competitive position, and so forth, in order to determine if the stock is a bargain.

Moreover, Lynch notes that his biggest winners–tenbaggers, twentybaggers, and even a few hundredbaggers–typically have taken at least three to ten years to play out.

The main idea is that a stock tracks the earnings of the underlying company over time. If you can pay a cheap price relative to earnings, and if those earnings increase over subsequent years, then you can get some fivebaggers, tenbaggers, and even better as long as you hold the stock while the story is playing out.

Lynch also writes that being right six out of ten times on average works well over time. A few big winners will overwhelm the losses from stocks that don’t work out.

Don’t try to time the market. Focus on finding cheap stocks. Some cheap stocks do well even when the market is flat or down. But over the course of many years, the economy grows and the market goes higher. If you try to dance in and out of stocks, eventually you’ll miss big chunks of the upside.

Here are the sections in this blog post:

• • Introduction: The Advantages of Dumb Money
  • The Making of a Stockpicker
  • The Wall Street Oxymorons
  • Is This Gambling, or What?
  • Personal Qualities It Takes to Succeed
  • Is This a Good Market? Please Don’t Ask
  • Stalking the Tenbagger
  • I’ve Got It, I’ve Got It–What Is It?
  • The Perfect Stock, What a Deal!
  • Stocks I’d Avoid
  • Earnings, Earnings, Earnings
  • The Two-Minute Drill
  • Getting the Facts
  • Some Famous Numbers
  • Rechecking the Story
  • The Final Checklist
  • Designing a Portfolio
  • The Best Time to Buy and Sell

 

INTRODUCTION: THE ADVANTAGES OF DUMB MONEY

Lynch writes that two decades as a professional investor have convinced him that the ordinary individual investor can do just as well as–if not better than–than the average Wall Street expert.

Dumb money is only dumb when it listens to the smart money.

Lynch makes it clear that if you’ve already invested in a mutual fund with good long-term performance, then sticking with it makes sense. His point is that if you’ve decided to invest in stocks directly, then it’s possible to do as well as–if not better than–the average professional investor. This means ignoring hot tips and doing your own research on companies.

There are at least three good reasons to ignore what Peter Lynch is buying: (1) he might be wrong! (A long list of losers from my own portfolio constantly reminds me that the so-called smart money is exceedingly dumb about 40 percent of the time); (2) even if he’s right, you’ll never know when he’s changed his mind about a stock and sold; and (3) you’ve got better sources, and they’re all around you…

If you stay half-alert, you can pick the spectacular performers right from your place of business or out of the neighborhood shopping mall, and long before Wall Street discovers them… and if you work in the industry, so much the better. This is where you’ll find the tenbaggers. I’ve seen it happen again and again from my perch at Fidelity.

You can find tenbaggers even in weak markets, writes Lynch. If you have ten positions at 10% each, then one tenbagger will cause your total portfolio to increase 90% if the other nine positions are flat. If the other nine positions collectively lose 50% (perhaps in weak market), then your overall portfolio will still be up 45% if you have one tenbagger.

Most often, tenbaggers are in companies like Dunkin’ Donuts rather than in penny stocks that depend on a scientific breakthrough. Lynch also mentions La Quinta Motor Inns–a tenbagger from 1973 to 1983. (La Quinta modeled itself on Holiday Inn, but with 30% lower costs and 30% lower prices. If you’ve attended a Berkshire Hathaway Annual Shareholders meeting in the past decade, you may have stayed at La Quinta along with a bunch of other frugal Berkshire shareholders.)

• Note: When considering examples Lynch gives in his book, keep in mind that he first wrote the book in 1989. The examples are from that time period.

Lynch says he came across many of his best investment ideas while he was out and about:

Taco Bell, I was impressed with the burrito on a trip to California; La Quinta Motor Inns, somebody at the rival Holiday Inn told me about it; Volvo, my family and friends drive this car; Apple Computer, my kids had one at home and then the systems manager bought several for the office; Service Corporation International, a Fidelity electronics analyst… found on a trip to Texas; Dunkin’ Donuts, I loved the coffee…

Many individual investors think the big winners must be technology companies, but very often that’s not the case:

Among amateur investors, for some reason it’s not considered sophisticated practice to equate driving around town eating donuts with the initial phase of an investigation into equities. People seem more comfortable investing in something about which they are entirely ignorant. There seems to be an unwritten rule on Wall Street: If you don’t understand it, then put your life savings into it. Shun the enterprise around the corner, which can at least be observed, and seek out the one that manufactures an incomprehensible product.

Lynch is quick to point out that finding a promising company is only the first step. You then must conduct the research.

 

THE MAKING OF A STOCKPICKER

Lynch describes his experience at Boston College:

As I look back on it now, it’s obvious that studying history and philosophy was much better preparation for the stock market than, say, studying statistics. Investing in stocks is an art, not a science, and people who’ve been trained to rigidly quantify everything have a big disadvantage.

Granted, since Lynch first wrote this book in 1989, more quantitative investors–using computer-based models–have come along. But when it comes to picking stocks that can do well if held for many years, the majority of successful investors still follow a much more traditional process: gathering information through observation, massive reading, and scuttlebutt, and then making investment decisions that are often partly qualitative in nature. Here is a partial list of successful stockpickers:

• Bill Ackman, David Abrams, Lee Ainslie, Chuck Akre, Bruce Berkowitz, Christopher Browne, Warren Buffett, Michael Burry, Leon Cooperman, Christopher Davis, David Einhorn, Jean-Marie Eveillard, Thomas Gayner, Glenn Greenberg, Joel Greenblatt, Mason Hawkins, Carl Icahn, Seth Klarman, Stephen Mandel, Charlie Munger, Bill Nygren, Mohnish Pabrai, Michael Price, Richard Pzena, Robert Rodriguez, Stephen Romick, Thomas Russo, Walter Schloss, Lou Simpson, Guy Spier, Arnold Van Den Berg, Prem Watsa, Wallace Weitz, and Donald Yacktman.

 

THE WALL STREET OXYMORONS

Lynch observes that professional investors are typically not able to invest in most stocks that become tenbaggers. Perhaps the most important reason is that most professional investors never invest in microcap stocks, stocks with market caps below $500 million. Assets under management (AUM) for many professional investors are just too large to be able to invest in microcap companies. Moreover, even smaller funds usually focus on small caps instead of micro caps. Often that’s a function of AUM, but sometimes it’s a function of microcap companies being viewed as inherently riskier.

There are thousands of microcap companies. And many micro caps are good businesses with solid revenues and earnings, and with healthy balance sheets. These are the companies you should focus on as an investor. (There are some microcap companies without good earnings or without healthy balance sheets. Simply avoid these.)

If you invest in a portfolio of solid microcap companies, and hold for at least 10 years, then the expected returns are far higher than would you get from a portfolio of larger companies. There is more volatility along the way, but if you can just focus on the long-term business results, then shorter term volatility is generally irrelevant. Real risk for value investors is not volatility, or a stock that goes down temporarily. Real risk is the chance of suffering a permanent loss–when the whole portfolio declines and is unable to bounce back.

Fear of volatility causes many professional investors only to look at stocks that have already risen a great deal, so that they’re no longer micro caps. You’ll miss a lot of tenbaggers and twentybaggers if you can’t even look at micro caps. That’s a major reason why individual investors have an advantage over professional investors. Individual investors can look at thousands of microcap companies, many of which are in very good shape.

Furthermore, even if a professional investor could look at microcap stocks, there are still strong incentives not to do so. Lynch explains:

…between the chance of making an unusually large profit on an unknown company and the assurance of losing only a small amount on an established company, the normal mutual-fund manager, pension-fund manager, or corporate-portfolio manager would jump at the latter. Success is one thing, but it’s more important not to look bad if you fail.

As Lynch says, if you’re a professional investor and you invest in a blue chip like General Electric which doesn’t work, clients and bosses will ask, ‘What is wrong with GE?’ But if you invest in an unknown microcap company and it doesn’t work, they’ll ask, ‘What is wrong with you?’

Lynch sums it up the advantages of the individual investor:

You don’t have to spend a quarter of your waking hours explaining to a colleague why you are buying what you are buying. [Also, you can invest in unknown microcap companies…] There’s nobody to chide you for buying back a stock at $19 that you earlier sold at $11–which may be a perfectly sensible move.

 

IS THIS GAMBLING, OR WHAT?

In general, stocks have done better than bonds over long periods of time.

Historically, investing in stocks is undeniably more profitable than investing in debt. In fact, since 1927, common stocks have recorded gains of 9.8 percent a year on average, as compared to 5 percent for corporate bonds, 4.4 percent for government bonds, and 3.4 percent for Treasury bills.

The long-term inflation rate, as measured by the Consumer Price Index, is 3 percent a year, which gives common stocks a real return of 6.8 percent a year. The real return on Treasury bills, known as the most conservative and sensible of all places to put money, has been nil. That’s right. Zippo.

Many people get scared out of stocks whenever there is a large drop of 20-40% (or more). But both the U.S. economy and U.S. stocks are very resilient and have always bounced back quickly. This is especially true since the Great Depression, which was a prolonged period of deep economic stagnation caused in large part by policy errors. A large fiscal stimulus and/or a huge program of money-printing (monetary stimulus) would have significantly shortened the Great Depression.

Lynch defines good investing as a system of making bets when the odds are in your favor. If you’re right 60% of the time and you have a good system, then you should do fine over time. Lynch compares investing to stud poker:

You can never be certain what will happen, but each new occurrence–a jump in earnings, the sale of an unprofitable subsidiary, the expansion into new markets–is like turning up another card. As long as the cards suggest favorable odds of success, you stay in the hand.

…Consistent winners raise their bets as their position strengthens, and they exit the game when the odds are against them…

Consistent winners also resign themselves to the fact that they’ll occasionally be dealt three aces and bet the limit, only to lose to a hidden royal flush. They accept their fate and go on to the next hand, confident that their basic method will reward them over time. People who succeed in the stock market also accept periodic losses, setbacks, and unexpected occurrences. Calamitous drops do not scare them out of the game… They realize the stock market is not pure science, and not like chess, where the superior position always wins. If seven out of ten of my stocks perform as expected, then I’m delighted. If six out of ten of my stocks perform as expected, then I’m thankful. Six out of ten is all it takes to produce on enviable record on Wall Street.

Lynch concludes the chapter by saying that investing is more like 70-card poker than 7-card poker. If you have ten positions, it’s like playing ten 70-card hands at once.

 

PERSONAL QUALITIES IT TAKES TO SUCCEED

Lynch writes:

It seems to me the list of qualities ought to include patience, self-reliance, common sense, a tolerance for pain, open-mindedness, detachment, persistence, humility, flexibility, a willingness to do independent research, an equal willingness to admit mistakes, and the ability to ignore general panic…

It’s also important to be able to make decisions without complete or perfect information. Things are almost never clear on Wall Street, or when they are, then it’s too late to profit from them. The scientific mind that needs to know all the data will be thwarted here.

And finally, it’s crucial to be able to resist your human nature and your ‘gut feelings.’ It’s the rare investor who doesn’t secretly harbor the conviction that he or she has a knack for divining stock prices or gold prices or interest rates, in spite of the fact that most of us have been proven wrong again and again. It’s uncanny how often people feel most strongly that stocks are going to go up or the economy is going to improve just when the opposite occurs. This is borne out by the popular investment-advisory newsletter services, which themselves tend to turn bullish and bearish at inopportune moments.

According to information published by Investor’s Intelligence, which tracks investor sentiment via the newsletters, at the end of 1972, when stocks were about to tumble, optimism was at an all-time high, with only 15 percent of the advisors bearish. At the beginning of the stock market rebound in 1974, investor sentiment was at an all-time low, with 65 percent of the advisors fearing the worst was yet to come…. At the start of the 1982 sendoff into a great bull market, 55 percent of the advisors were bears, and just prior to the big gulp of October 19, 1987, 80 percent of the advisors were bulls again.

…Does the success of Ravi Batra’s book The Great Depression of 1990 almost guarantee a great national prosperity?

Lynch summarizes:

…The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them. Stand by your stocks as long as the fundamental story of the company hasn’t changed.

 

IS THIS A GOOD MARKET? PLEASE DON’T ASK

Lynch:

There’s another theory that we have recessions every five years, but it hasn’t happened that way so far… Of course, I’d love to be warned before we do go into a recession, so I could adjust my portfolio. But the odds of my figuring it out are nil. Some people wait for these bells to go off, to signal the end of a recession or the beginning of an exciting new bull market. The trouble is the bells never go off. Remember, things are never clear until it’s too late.

… No matter how we arrive at the latest financial conclusion, we always seem to be preparing ourselves for the last thing that’s happened, as opposed to what’s going to happen next. This penultimate preparedness is our way of making up for the fact that we didn’t see the last thing coming along in the first place.

Lynch continues:

I don’t believe in predicting markets. I believe in buying great companies–especially companies that are undervalued and/or underappreciated.

Lynch explains that the stock market itself is irrelevant. What matters is the current and future earnings of the individual business you’re considering. Lynch:

Several of my favorite tenbaggers made their biggest moves during bad markets. Taco Bell soared through the last two recessions.

Focus on specific companies rather than the market as a whole. Because you’re not restricted as an individual investor–you can look at microcap companies and you can look internationally–there are virtually always bargains somewhere.

A few good quotes from Warren Buffett on forecasting:

Market forecasters will fill your ear but never fill your wallet.

We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.

Charlie and I never have an opinion on the market because it wouldn’t be any good and it might interfere with the opinions we have that are good.

 

STALKING THE TENBAGGER

If you work in a particular industry, this can give you an edge:

If you work in the chemical industry, then you’ll be among the first to realize that demand…is going up, prices are going up, and excess inventories are going down. You’ll be in a position to know that no new competitors have entered the market and no new plants are under construction, and that it takes two to three years to build one.

Lynch also argues that if you’re a consumer of particular products, then you may be able to gain insight into companies that sell those products. Again, you still need to study the financial statements in order to understand earnings and the balance sheet. But noticing products that are doing well is a good start.

 

I’VE GOT IT, I’VE GOT IT–WHAT IS IT?

Most of the biggest moves–from tenbaggers to hundredbaggers–occur in smaller companies. Microcap companies are the best place to look for these multi-baggers, while small-cap companies are the second best place to look.

Lynch identifies six general categories: slow growers, stalwarts, fast growers, cyclicals, asset plays, and turnarounds. (Slow growers and stalwarts tend to be larger companies.)

Slow Growers

Many large companies grow slowly, but are relatively dependable and may pay dividends. A conservative investor may consider this category.

Stalwarts

These companies tend to grow annual earnings at 10 to 12 percent a year. If you buy the stock when it’s a bargain, you can make 30 to 50 percent, then sell and repeat the process. This is Lynch’s approach to Stalwarts. Also, Stalwarts can offer decent protection during weak markets.

Fast Growers

Some small, aggressive new companies can grow at 20 to 25 percent a year:

If you choose wisely, this is the land of the 10- to 40-baggers, and even the 200-baggers.

Of course, you have to be careful to identify the risks. Many younger companies may grow too quickly or be underfinanced. So look for the fast growers with good balance sheets and good underlying profitability.

Cyclicals

A cyclical is a company whose sales and profits rise and fall regularly. If you can buy when the company and the industry are out of favor–near the bottom of the cycle–then you can do well with a cyclical. (You also need to sell when the company and the industry are doing well again unless you think it’s a good enough company to hold for a decade or longer.)

Some cyclical stocks–like oil stocks–tend to have a low level of correlation with the broader stock market. This can help a portfolio, especially when the broader stock market offers few bargains.

Turnarounds

Lynch:

Turnaround stocks make up lost ground very quickly… The best thing about investing in successful turnarounds is that of all the categories of stocks, their ups and downs are least related to the general market.

Again, a low correlation with the broader market is especially an advantage when the broader market is overvalued. You do have to be careful with turnarounds, though. As Buffett has said, ‘Turnarounds seldom turn.’

Asset Plays

A company may have something valuable that the market has overlooked. It may be as simple as a pile of cash. Sometimes it’s real estate. It may be unrecognized intellectual property. Or it could be resources in the ground.

 

THE PERFECT STOCK, WHAT A DEAL!

Similar to Warren Buffett, Lynch prefers simple businesses:

Getting the story on a company is a lot easier if you understand the basic business. That’s why I’d rather invest in panty hose than in communications satellites, or in motel chains than in fiber optics. The simpler it is, the better I like it. When somebody says, ‘Any idiot could run this joint,’ that’s a plus as far as I’m concerned, because sooner or later any idiot probably is going to be running it.

… For one thing, it’s easier to follow. During a lifetime of eating donuts or buying tires, I’ve developed a feel for the product line that I’ll never have with laser beams or microprocessors.

Lynch then names thirteen attributes that are important to look for:

It Sounds Dull–Or, Even Better, Ridiculous

Lynch says a boring name is a plus, because that helps a company to stay neglected and overlooked, often causing the stock to be cheap. Bob Evans Farms is an example of a perfect name.

It Does Something Dull

Crown, Cork, and Seal makes cans and bottle caps, says Lynch. The more boring the business, the better. Again, this will help keep the stock neglected, often causing the stock to be cheap.

It Does Something Disagreeable

Safety-Kleen provides gas stations with a machine that washes greasy auto parts. Gas stations love it. But it’s a bit disgusting, which can cause the stock to be neglected and thus possibly cheap.

It’s a Spinoff

Large companies tend to make sure that divisions they spin off are in good shape. Generally spinoffs are neglected by most professional investors, often because the market cap of the spinoff is too small for them to consider.

The Institutions Don’t Own It, and the Analysts Don’t Follow It

With no institutional ownership, the stock may be neglected and possibly cheap. With no analyst coverage, the chance of neglect and cheapness is even higher. It’s not only microcap companies that are neglected. When popular stocks fall deeply out of favor, they, too, can become neglected.

Rumors Abound: It’s Involved with Toxic Waste

Waste Management, Inc. was a hundredbagger. People are so disturbed by sewage and waste that they tend to neglect such stocks.

There’s Something Depressing About It

Funeral home companies tend to be neglected and the stocks can get very cheap at times.

It’s a No-Growth Industry

In a no-growth industry, there’s much less competition. This gives companies in the industry room to grow.

It’s Got a Niche

The local rock pit has a niche. Lynch writes that if you have the only rock pit in Brooklyn, you have a virtual monopoly. A rival two towns away is not going to transport rocks into your territory because the mixed rocks only sell for $3 a ton.

People Have to Keep Buying It

Drugs, soft drinks, razor blades, etc., are products that people need to keep buying.

It’s a User of Technology

A company may be in a position to benefit from ongoing technological improvements.

The Insiders Are Buyers

Insider buying usually means the insiders think the stock is cheap.

Also, you want insiders to own as much stock as possible so that they are incentivized to maximize shareholder value over time. If executive salaries are large compared to stock ownership, then executives will focus on growth instead of on maximizing shareholder value (i.e., profitability).

The Company Is Buying Back Shares

If the shares are cheap, then the company can create much value through buybacks.

 

STOCKS I’D AVOID

Lynch advises avoiding the hottest stock in the hottest industry. Usually a stock like that will be trading at an extremely high valuation, which requires a great deal of future growth for the investor just to break even. When future growth is not able to meet lofty expectations, typically the stock will plummet.

Similarly, avoid the next something. If a stock is touted as the next IBM, the next Intel, or the next Disney, avoid it because very probably it will not be the next thing.

Avoid diworseifications: Avoid the stock of companies that are making foolish acquisitions of businesses in totally different industries. Such diworseifications rarely work out for shareholders. Two-thirds of all acquisitions do not create value. This is even more true when acquisitions are diworseifications.

Beware whisper stocks, which are often technological long shots or whiz-bang stories such as miracle drugs. Lynch notes that he’s lost money on every single whisper stock he’s ever bought.

One trick to avoiding whisper stocks is to wait until they have earnings. You can still get plenty of tenbaggers from companies that have already proven themselves. Buying long shots before they have earnings rarely works. This is a good rule for buying microcap stocks in general: Wait until the company has solid earnings and a healthy balance sheet.

 

EARNINGS, EARNINGS, EARNINGS

Lynch writes that a stock eventually will track the earnings of the business:

Analyzing a company’s stock on the basis of earnings and assets is no different from analyzing a local Laundromat, drugstore, or apartment building that you might want to buy. Although it’s easy to forget sometimes, a share of stock is not a lottery ticket. It’s part ownership of a business.

Lynch gives an example:

And how about Masco Corporation, which developed the single-handle ball faucet, and as a result enjoyed thirty consecutive years of up earnings through war and peace, inflation and recession, with the earnings rising 800-fold and the stock rising 1,300-fold between 1958 and 1987? What would you expect from a company that started out with the wonderfully ridiculous name of Masco Screw Products?

Lynch advises not to invest in companies with high price-to-earnings (p/e) ratios:

If you remember nothing else about p/e ratios, remember to avoid stocks with excessively high ones. You’ll save yourself a lot of grief and a lot of money if you do. With few exceptions, an extremely high p/e ratio is a handicap to a stock, in the same way that extra weight in the saddle is a handicap to a racehorse.

Future earnings may not be predictable, but you can at least check how the company plans to increase future earnings. Lynch:

There are five basic ways a company can increase earnings: reduce costs; raise prices; expand into new markets; sell more of its product in the old markets; or revitalize, close, or otherwise dispose of a losing operation. These are the factors to investigate as you develop the story. If you have an edge, this is where it’s going to be most helpful.

 

THE TWO-MINUTE DRILL

Warren Buffett has said that he would have been a journalist if he were not an investor. Buffett says his job as an investor is to write the story for the company in question. Lynch has a similar view. He explains:

Before buying a stock, I like to be able to give a two-minute monologue that covers the reasons I’m interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its path. The two-minute monologue can be muttered under your breath or repeated out loud to colleagues who happen to be standing within earshot. Once you’re able to tell the story of a stock to your family, your friends, or the dog… and so that even a child could understand it, then you have a proper grasp of the situation.

Usually there are just a few key variables for a given investment idea. As value investor Bruce Berkowitz has said:

We’ve always done very well when we can use sixth-grade math on the back of a postcard to show how inexpensive something is relative to its free cash.

One good way to gain insight is to ask the executive of a company what he or she thinks the competition is doing right. Lynch discovered La Quinta Motor Inns while he was talking to the vice president of United Inns, a competitor.

Lynch later learned that La Quinta’s strategy was simple: to have both costs and prices that are 30% lower than Holiday Inn. La Quinta had everything exactly the same as at a Holiday Inn–same size rooms, same size beds, etc. However:

La Quinta had eliminated the wedding area, the conference rooms, the large reception area, the kitchen area, and the restaurant–all excess space that contributed nothing to the profits but added substantially to the costs. La Quinta’s idea was to install a Denny’s or some similar 24-hour place next door to every one of its motels. La Quinta didn’t even have to own the Denny’s. Somebody else could worry about the food. Holiday Inn isn’t famous for its cuisine, so it’s not as if La Quinta was giving up a major selling point… It turns out that most hotels and motels lose money on their restaurants, and the restaurants cause 95 percent of the complaints.

 

GATHERING THE FACTS

If it’s a microcap business, then you may be able to speak with a top executive simply by calling the company. For larger companies, often you will only reach investor relations. Either way, you want to check the story you’ve developed–your investment thesis–against the facts you’re able to glean through conversation (and through reading the financial statements, etc.).

If you don’t have a story developed enough to check, there are two general questions you can always ask, notes Lynch:

• What are the positives this year?
• What are the negatives?

Often your ideas will not be contradicted. But occasionally you’ll learn something unexpected, that things are either better or worse than they appear. Such unexpected information can be very profitable because it is often not yet reflected in the stock price. Lynch says he comes across something unexpected in about one out of every ten phone calls he makes.

Lynch also often will visit headquarters. The goal, he says, is to get a feel for the place. What Lynch really appreciates is when headquarters is obviously shabby, indicating that the executives are keeping costs as low as possible. When headquarters is very nice and fancy, that’s generally a bad signal about management.

Kicking the tires can help. It’s not a substitute for studying the financial statements or for asking good questions. But it can help you check out the practical side of the investment thesis. Lynch used to make a point of checking out as many companies as possible this way.

Finally, in addition to reading the financial statements, Lynch recommends Value Line.

 

SOME FAMOUS NUMBERS

If you’re looking at a particular product, then you need to know what percent of sales that particular product represents.

Lynch then notes that you can compare the p/e and the growth rate:

If the p/e of Coca-Cola is 15, you’d expect the company to be growing at about 15 percent a year, etc. But if the p/e ratio is less than the growth rate, you may have found yourself a bargain. A company, say, with a growth rate of 12 percent a year… and a p/e of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a p/e ratio of 12 is an unattractive prospect and headed for a comedown.

In general, a p/e that’s half the growth rate is very positive, and one that’s twice the growth rate is very negative.

You can do a similar calculation by taking earnings, adding dividends, and comparing that sum to the growth rate.

High debt-to-equity is something to avoid. Turnarounds with high debt tend to work far less often than turnarounds with low debt.

Free cash flow is important. Free cash flow equals net income plus depreciation, depletion, and amortization, minus capital expenditures. (There may also be adjustments for changes in working capital.)

The important point is that some companies and some industries–such as steel or autos–are far more capital-intensive than others. Some companies have to spend most of their incoming cash on capital expenditures just to maintain the business at current levels. Other companies have far lower reinvestment requirements; this means a much higher return on invested capital. The value that any given company creates over time is the cumulative difference between the return on invested capital and the cost of capital.

Another thing to track is inventories. If inventories have been piling up recently, that’s not a good sign. When inventories are growing faster than sales, that’s a red flag. Lynch notes that if sales are up 10 percent, but inventories are up 30 percent, then you should be suspicious.

Like Buffett, Lynch observes that a company that can raise prices year after year without losing customers can make for a terrific investment. Such a company will tend to have high free cash flow and high return on invested capital over time.

A last point Lynch makes is about the growth rate of earnings:

All else being equal, a 20-percent grower selling as 20 times earnings (a p/e of 20) is a much better buy than a 10-percent grower selling at 10 times earnings (a p/e of 10). This may sound like an esoteric point, but it’s important to understand what happens to the earnings of the faster growers that propels the stock price.

Lynch gives an example. Assume Company A and Company B both start with earnings of $1.00 per share. But assume that Company A grows at 20 percent a year while Company B grows at 10 percent a year. (So the stock of Company A starts at $20, while the stock of Company B is at $10.) What happens after 10 years, assuming the growth rates stay the same? Company A will be earning $6.19 while Company B will be earning $2.59.

If the multiples haven’t changed, then the stock of Company A will be at $123.80, while the stock of Company B will only be at $26. Even if the p/e for Company A falls to 15 instead of 20, the stock will still be at $92. Going from $20 to $92 (or $123.80) is clearly better than going from $10 to $26.

One last point. In the case of a successful turnaround, the stock of a relatively low-profit margin (and perhaps also high debt) company will do much better than the stock of a relatively high-profit margin (and low debt) company. It’s just a matter of leverage.

For a long-term stock that you’re going to hold through good times and bad, you want high profit margins and low debt. If you’re going to invest in a successful turnaround, then you want low profit margins and high debt, all else equal. (In practice, most turnarounds don’t work, and high debt should be avoided unless you want to specialize in equity stubs.)

 

RECHECKING THE STORY

Every few months, you should check in on the company. Are they on track? Have they made any adjustments to their plan? How are sales? How are the earnings? What are industry conditions? Are their products still attractive? What are their chief challenges? Et cetera. Basically, writes Lynch, have any new cards been turned over?

In the case of a growth company, Lynch holds that there are three phases. In the start-up phase, the company may still be working the kinks out of the business. This is the riskiest phase because the company isn’t yet established. The second phase is rapid expansion. This is generally the safest phase, and also where you can make the most money as an investor. The third phase is the mature phase, or the saturation phase, when growth has inevitably slowed down. The third phase can be the most problematic, writes Lynch, since it gets increasingly difficult to grow earnings.

 

THE FINAL CHECKLIST

Lynch offers a brief checklist.

• The p/e ratio. Is it high or low for this particular company and for similar companies in the same industry.
• The percentage of institutional ownership. The lower the better.
• Whether insiders are buying and whether the company itself is buying back its own shares. Both are positive signs.
• The record of earnings growth to date and whether the earnings are sporadic or consistent. (The only category where earnings may not be important is in the asset play.)
• Whether the company has a strong balance sheet or a weak balance sheet (high debt-to-equity ratio) and how it’s rated for financial strength.
• The cash position. With $16 in net cash, I know Ford is unlikely to drop below $16 a share.

Lynch also gives a checklist for each of the six categories. Then he gives a longer checklist summarizes all the main points (which have already been mentioned in the previous sections).

 

DESIGNING A PORTFOLIO

Some years you’ll make 30 percent, other years you’ll make 2 percent, and occasionally you’ll lose 20 or 30 percent. It’s important to stick to a disciplined approach and not get impatient. Stick with the long-term strategy through good periods and bad. (Even great investors have periods of time when their strategy trails the market, often even several years in a row.)

Regarding the number of stocks to own, Lynch mentions a couple of stocks in which he wouldn’t mind investing his entire portfolio. But he says you need to analyze each stock one at a time:

…The point is not to rely on any fixed number of stocks but rather to investigate how good they are, on a case-by-case basis.

In my view it’s best to own as many stocks as there are situations in which: (a) you’ve got an edge; and (b) you’ve uncovered an exciting prospect that passes all the tests of research. Maybe it’s a single stock, or maybe it’s a dozen stocks. Maybe you’ve decided to specialize in turnarounds or asset plays and you buy several of those; or perhaps you happen to know something special about a single turnaround or a single asset play. There’s no use diversifying into unknown companies just for the sake of diversity. A foolish diversity is the hobgoblin of small investors.

Lynch then recommends, for small portfolios, owning between 3 and 10 stocks. It makes sense to concentrate on your best ideas and on what you understand best. At the same time, it often happens that the tenbagger comes–unpredictably–from your 8^th or 9^th best idea. The value investor Mohnish Pabrai has had this experience.

• Important Note: One of the best edges you can have as an individual investor–in addition to being able to focus on microcap companies–is that you can have at least a 3- to 5-year holding period. Because so many investors focus on shorter periods of time, very often the best bargains are stocks that are cheap relative to earnings in 3 to 5 years.

Lynch advises against selling winners and holding on to losers, which is like pulling out the flowers and watering the weeds. But Lynch’s real point is that price movements are often random. Just because a stock has gone up or down doesn’t mean the fundamental value of the business has changed.

If business value has increased–or if fundamentals have improved–then it often makes sense to add to a stock even if it’s gone from $11 to $19.

If business value has not declined, or has improved, then it often makes sense to add to a stock that has declined. On the other hand, if business value has decreased–or if fundamentals have deteriorated–then it often makes sense to sell, regardless of whether the stock has gone up or down.

In general, as long as the investment thesis is intact and business value is sufficiently high, you should hold a stock for at least 3 to 5 years:

If I’d believed in ‘Sell when it’s a double,’ I would never have benefited from a single big winner, and I wouldn’t have been given the opportunity to write a book. Stick around to see what happens–as long as the original story continues to make sense, or gets better–and you’ll be amazed at the results in several years.

 

THE BEST TIME TO BUY AND SELL

Often there is tax loss selling near the end of the year, which means it can be a good time to buy certain stocks.

As mentioned, you should hold for at least 3 to 5 years as long as the investment thesis is intact and normalized business value is sufficiently high. Be careful not to listen to negative nellies who yell ‘Sell!’ way before it’s time:

Even the most thoughtful and steadfast investor is susceptible to the influence of skeptics who yell ‘Sell’ before it’s time to sell. I ought to know. I’ve been talked out of a few tenbaggers myself.

Lynch took a big position in Toys ‘R’ Us in 1978. He had done his homework, and he loaded up at $1 per share:

…By 1985, when Toys ‘R’ Us hit $25, it was a 25-bagger for some. Unfortunately, those some didn’t include me, because I sold too soon. I sold too soon because somewhere along the line I’d read that a smart investor named Milton Petrie, one of the deans of retailing, had bought 20 percent of Toys ‘R’ Us and that his buying was making the stock go up. The logical conclusion, I thought, was that when Petrie stopped buying, the stock would go down. Petrie stopped buying at $5.

I got in at $1 and out at $5 for a fivebagger, so how can I complain? We’ve all been taught the same adages: ‘Take profits when you can,’ and ‘A sure gain is always better than a possible loss.’ But when you’ve found the right stock and bought it, all the evidence tells you it’s going higher, and everything is working in your direction, then it’s a shame if you sell.

Lynch continues by noting that individual investors are just as susceptible to selling early as are professional investors:

Maybe you’ve received the ‘Congratulations: Don’t Be Greedy’ announcement. That’s when the broker calls to say: ‘Congratulations, you’ve doubled your money on ToggleSwitch, but let’s not be greedy. Let’s sell ToggleSwitch and try KinderMind.’ So you sell ToggleSwitch and it keeps going up, while KinderMind goes bankrupt, taking all of your profits with it.

One major problem for all investors is that there are so many market, economic, and political forecasts. Market forecasts and economic forecasts can be very expensive if you follow them, as Buffett has often noted. The only thing you can really know is the individual company in which you’ve invested, and what its long-term business value is. Everything else is noise that can only interfere with your ability to focus on long-term business value.

I quoted Buffett earlier. Now let’s quote the father of value investing, Buffett’s teacher and mentor, Ben Graham:

… if I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.

Of course, there could be a bear market and/or recession at any time. But even then, there will be at least a few stocks somewhere in the world that perform well if bought cheaply enough.

The main point made by Graham and Buffett is that repeatedly buying stocks at bargain levels relative to business value can work very well over time if you’re patient and disciplined. Market forecasting can only distract you from what works.

What works is investing in businesses you can understand at sensible prices, and holding each one for at least 3 to 5 years, if not 10 years or longer, as long as the thesis is intact. Lynch:

Frankly, I’ve never been able to predict which stocks will go up tenfold, or which will go up fivefold. I try to stick with them as long as the story’s intact, hoping to be pleasantly surprised. The success of a company isn’t the surprise, but what the shares bring often is. I remember buying Stop & Shop as a conservative, dividend-paying stock, and then the fundamentals kept improving and I realized I had a fast grower on my hands.

It’s important to note that sometimes years can go by while the stock does nothing. That, in itself, doesn’t tell you anything. If the business continues to make progress, and long-term business value is growing (or is sufficiently high), then you should stick with it or perhaps add to the position:

Here’s something else that’s certain to occur: If you give up on a stock because you’re tired of waiting for something wonderful to happen, then something wonderful will begin to happen the day after you get rid of it. I call this the postdiverstiture flourish.

…Most of the money I make is in the third or fourth year that I’ve owned something… If all’s right with the company, and whatever attracted me in the first place hasn’t changed, then I’m confident that sooner or later my patience will be rewarded.

…It takes remarkable patience to hold on to a stock in a company that excites you, but which everybody else seems to ignore. You begin to think everybody else is right and you are wrong. But where the fundamentals are promising, patience is often rewarded…

Lynch again later:

… my biggest winners continue to be stocks I’ve held for three and even four years.

Lynch offers much commentary on a long list of macro concerns that are going to sink stocks. (Remember he was writing in 1989.) Here is a snipet:

I hear every day that AIDS will do us in, the drought will do us in, inflation will do us in, recession will do us in, the budget deficit will do us in, the trade deficit will do us in, and the weak dollar will do us in. Whoops. Make that the strong dollar will do us in. They tell me real estate prices are going to collapse. Last month people started worrying about that. This month they’re worrying about the ozone layer. If you believe the old investment adage that the stock market climbs a ‘wall of worry,’ take note that the worry wall is fairly good-sized now and growing every day.

Like Buffett, Lynch is very optimistic about America and long-term investing in general. Given the strengths of America, and all the entrepreneurial and scientific energy creating ongoing innovation, it seems to me that Buffett and Lynch are right to be long-term optimists. That’s not to say there won’t be setbacks, recessions, bear markets, and other problems. But such setbacks will be temporary. Over the long term, innovation will amaze, profits will grow, and stocks will follow profits higher.

 

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.

October 22, 2023

To boost our productivity–including our ability to think and make decisions–nothing beats continuous learning. Broad study makes us better people. See:https://boolefund.com/lifelong-learning/

Michael Mauboussin is a leading expert in the multidisciplinary study of businesses and markets. His book–More Than You Know: Finding Financial Wisdom in Unconventional Places–has been translated into eight languages.

Each chapter in Mauboussin’s book is meant to stand on its own. I’ve summarized most of the chapters below.

Here’s an outline:

• Process and Outcome in Investing
• Risky Business
• Are You an Expert?
• The Hot Hand in Investing
• Time is on my Side
• The Low Down on the Top Brass
• Six Psychological Tendencies
• Emotion and Intuition in Decision Making
• Beware of Behavioral Finance
• Importance of a Decision Journal
• Right from the Gut
• Weighted Watcher
• Why Innovation is Inevitable
• Accelerating Rate of Industry Change
• How to Balance the Long Term with the Short Term
• Fitness Landscapes and Competitive Advantage
• The Folly of Using Average P/E’s
• Mean Reversion and Turnarounds
• Considering Cooperation and Competition Through Game Theory
• The Wisdom and Whim of the Collective
• Vox Populi
• Complex Adaptive Systems
• The Future of Consilience in Investing

(Photo: Statue of Leonardo da Vinci in Italy, by Raluca Tudor)

 

PROCESS AND OUTCOME IN INVESTING

(Image by Amir Zukanovic)

Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome.

Robert Rubin made this remark in his Harvard Commencement Address in 2001. Mauboussin points out that the best long-term performers in any probabilistic field–such as investing, bridge, sports-team management, and pari-mutuel betting–all emphasize process over outcome.

Mauboussin also writes:

Perhaps the single greatest error in the investment business is a failure to distinguish between the knowledge of a company’s fundamentals and the expectations implied by the market price.

If you don’t understand why your view differs from the consensus, and why the consensus is likely to be wrong, then you cannot reasonably expect to beat the market. Mauboussin quotes horse-race handicapper Steven Crist:

The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory… This may sound elementary, and many players may think that they are following this principle, but few actually do. Under this mindset, everything but the odds fades from view. There is no such thing as “liking” a horse to win a race, only an attractive discrepancy between his chances and his price.

Robert Rubin’s four rules for probabilistic decision-making:

• The only certainty is that there is no certainty. It’s crucial not to be overconfident, because inevitably that leads to big mistakes. Many of the biggest hedge fund blowups resulted when people were overconfident about particular bets.
• Decisions are a matter of weighing probabilities. Moreover, you also have to consider payoffs. Probabilities alone are not enough if the payoffs are skewed. A high probability of winning does not guarantee that it’s a positive expected value bet if the potential loss is far greater than the potential gain.
• Despite uncertainty, we must act. Often in investing and in life, we have to make decisions based in imperfect or incomplete information.
• Judge decisions not only on results, but also on how they were made. If you’re making decisions under uncertainty–probabilistic decisions–you have to focus on developing the best process you can. Also, you must accept that some good decisions will have bad outcomes, while some bad decisions will have good outcomes.

Rubin again:

It’s not that results don’t matter. They do. But judging solely on results is a serious deterrent to taking risks that may be necessary to making the right decision. Simply put, the way decisions are evaluated affects the way decisions are made.

 

RISKY BUSINESS

(Photo by Shawn Hempel)

Mauboussin:

So how should we think about risk and uncertainty? A logical starting place is Frank Knight’s distinction: Risk has an unknown outcome, but we know what the underlying outcome distribution looks like. Uncertainty also implies an unknown outcome, but we don’t know what the underlying distribution looks like. So games of chance like roulette or blackjack are risky, while the outcome of a war is uncertain. Knight said that objective probability is the basis for risk, while subjective probability underlies uncertainty.

Mauboussin highlights three ways to get a probability, as suggested by Gerd Gigerenzer inCalculated Risks:

• Degrees of belief. Degrees of belief are subjective probabilities and are the most liberal means to translate uncertainty into a probability. The point here is that investors can translate even onetime events into probabilities provided they satisfy the laws of probability–the exhaustive and exclusive set of alternatives adds up to one. Also, investors can frequently update probabilities based on degrees of belief when new, relevant information becomes available.
• Propensities. Propensity-based probabilities reflect the properties of the object or system. For example, if a die is symmetrical and balanced, then you have a one-in-six probability of rolling any particular side… This method of probability assessment does not always consider all the factors that may shape an outcome (such as human error).
• Frequencies. Here the probability is based on a large number of observations in an appropriate reference class. Without an appropriate reference class, there can be no frequency-based probability assessment. So frequency users would not care what someone believes the outcome of a die roll will be, nor would they care about the design of the die. They would focus only on the yield of repeated die rolls.

When investing in a stock, we try to figure out the expected value by delineating possible scenarios along with a probability for each scenario. This is the essence of what top value investors like Warren Buffett strive to do.

 

ARE YOU AN EXPERT?

In 1996, Lars Edenbrandt, a Lund University researcher, set up a contest between an expert cardiologist and a computer. The task was to sort a large number of electrocardiograms (EKGs) into two piles–heart attack and no heart attack.

(Image by Johannes Gerhardus Swanepoel)

The human expert was Dr. Hans Ohlin, a leading Swedish cardiologist who regularly evaluated as many as 10,000 EKGs per year. Edenbrandt, an artificial intelligence expert, trained his computer by feeding it thousands of EKGs. Mauboussin describes:

Edenbrandt chose a sample of over 10,000 EKGs, exactly half of which showed confirmed heart attacks, and gave them to machine and man. Ohlin took his time evaluating the charts, spending a week carefully separating the stack into heart-attack and no-heart-attack piles. The battle was reminiscent of Garry Kasparov versus Deep Blue, and Ohlin was fully aware of the stakes.

As Edenbrandt tallied the results, a clear-cut winner emerged: the computer correctly identified the heart attacks in 66 percent of the cases, Ohlin only in 55 percent. The computer proved 20 percent more accurate than a leading cardiologist in a routine task that can mean the difference between life and death.

Mauboussin presents a table illustrating that expert performance depends on the problem type:

Domain Description (Column)	Expert Performance	Expert Agreement	Examples
Rules based: Limited Degrees of Freedom	Worse than computers	High (70-90%)	Credit scoring Simple medical diagnosis
Rules based: High Degrees of Freedom	Generally better than computers	Moderate (50-60%)	Chess Go
Probabilistic: Limited Degrees of Freedom	Equal to or worse than collectives	Moderate/ Low (30-40%)	Admissions officers Poker
Probabilistic: High Degrees of Freedom	Collectives outperform experts	Low (<20%)	Stock market Economy

For rules-based systems with limited degrees of freedom, computers consistently outperform individual humans; humans perform well, but computers are better and often cheaper, says Mauboussin. Humans underperform computers because humans are influenced by suggestion, recent experience, and how information is framed. Also, humans fail to weigh variables well. Thus, while experts tend to agree in this domain, computers outperform experts, as illustrated by the EKG-reading example.

In the next domain–rules-based systems with high degrees of freedom–experts tend to add the most value. However, as computing power continues to increase, eventually computers will outperform experts even here, as illustrated by Chess and Go. Eventually, games like Chess and Go are “solvable.” Once the computer can check every single possible move within a reasonable amount of time–which is inevitable as long as computing power continues to increase–no human will be able to match such a computer.

In probabilistic domains with limited degrees of freedom, experts are equal to or worse than collectives. Overall, the value of experts declines compared to rules-based domains.

(Image by Marrishuanna)

In probabilistic domains with high degrees of freedom, experts do worse than collectives. For instance, stock market prices aggregate many guesses from individual investors. Stock market prices typically are more accurate than experts.

 

THE HOT HAND IN INVESTING

Sports fans and athletes believe in the hot hand in basketball. A player on a streak is thought to be “hot,” or more likely to make his or her shots. However, statistical analysis of streaks shows that the hot hand does not exist.

(Illustration by lbreakstock)

Long success streaks happen to the most skillful players in basketball, baseball, and other sports. To illustrate this, Mauboussin asks us to consider two basketball players, Sally Swish and Allen Airball. Sally makes 60 percent of her shot attempts, while Allen only makes 30 percent of his shot attempts.

What are the probabilities that Sally and Allen make five shots in a row? For Sally, the likelihood is (0.6)^5, or 7.8 percent. Sally will hit five in a row about every thirteen sequences. For Allen, the likelihood is (0.3)^5, or 0.24 percent. Allen will hit five straight once every 412 sequences. Sally will have far more streaks than Allen.

In sum, long streaks in sports or in money management indicate extraordinary luck imposed on great skill.

 

TIME IS ON MY SIDE

The longer you’re willing to hold a stock, the more attractive the investment. For the average stock, the chance that it will be higher is (almost) 100 percent for one decade, 72 percent for one year, 56 percent for one month, and 51 percent for one day.

The problem isloss aversion. We feel the pain of a loss 2 to 2.5 times more than the pleasure of an equivalent gain. If we check a stock price daily, there’s nearly a 50 percent chance of seeing a loss. So checking stock prices daily is a losing proposition. By contrast, if we only check the price once a year or once every few years, then investing in a stock is much more attractive.

A fund with a high turnover ratio is much more short-term oriented than a fund with a low turnover ratio. Unfortunately, most institutional investors have a much shorter time horizon than what is needed for the typical good strategy to pay off. If portfolio managers lag over shorter periods of time, they may lose their jobs even if their strategy works quite well over the long term.

 

THE LOW DOWN ON THE TOP BRASS

(Illustration by Travelling-light)

It’s difficult to judge leadership, but Mauboussin identifies four things worth considering:

• Learning
• Teaching
• Self-awareness
• Capital allocation

Mauboussin asserts:

A consistent thirst to learn marks a great leader. On one level, this is about intellectual curiosity–a constant desire to build mental models that can help in decision making. A quality manager can absorb and weigh contradictory ideas and information as well as think probabilistically…

Another critical facet of learning is a true desire to understand what’s going on in the organization and to confront the facts with brutal honesty. The only way to understand what’s going on is to get out there, visit employees and customers, and ask questions and listen to responses. In almost all organizations, there is much more information at the edge of the network–the employees in the trenches dealing with the day-to-day issues–than in the middle of the network, where the CEO sits. CEOs who surround themselves with managers seeking to please, rather than prod, are unlikely to make great decisions.

A final dimension of learning is creating an environment where everyone in the organization feels they can voice their thoughts and opinions without the risk of being rebuffed, ignored, or humiliated. The idea here is not that management should entertain all half-baked ideas but rather that management should encourage and reward intellectual risk taking.

Teaching involves communicating a clear vision to the organization. Mauboussin points out that teaching comes most naturally to those leaders who are passionate. Passion is a key driver of success.

Self-awareness implies a balance between confidence and humility. We all have strengths and weaknesses. Self-aware leaders know their weaknesses and find colleagues who are strong in those areas.

Finally, capital allocation is a vital leadership skill. Regrettably, many consultants and investment bankers give poor advice on this topic. Most acquisitions destroy value for the acquirer, regardless of whether they are guided by professional advice.

Mauboussin quotes Warren Buffett:

The heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.

Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.

The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business. CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie and I have frequently observed the consequences of such “help.” On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it.

In the end, plenty of unintelligent capital allocation takes place in corporate America. (That’s why you hear so much about “restructuring.”)

 

SIX PSYCHOLOGICAL TENDENCIES

(Image by Andreykuzmin)

The psychologist Robert Cialdini, in his bookInfluence: The Psychology of Persuasion, mentions six psychological tendencies that cause people to comply with requests:

• Reciprocation. There is no human society where people do not feel the obligation to reciprocate favors or gifts. That’s why charitable organizations send free address labels and why real estate companies offer free house appraisals. Sam Walton was smart to forbid all of his employees from accepting gifts from suppliers, etc.
• Commitment and consistency. Once we’ve made a decision, and especially if we’ve publicly committed to that decision, we’re highly unlikely to change. Consistency allows us to stop thinking and also to avoid further action.
• Social validation. One of the chief ways we make decisions is by observing the decisions of others. In an experiment by Solomon Asch, eight people in a room are shown three lines of clearly unequal lengths. Then they are shown a fourth line that has the same length as one of the three lines. They are asked to match the fourth line to the one with equal length. The catch is that only one of the eight people in the room is the actual subject of the experiment. The other seven people are shills who have been instructed to choose an obviously incorrect answer. About 33 percent of the time, the subject of the experiment ignores the obviously right answer and goes along with the group instead.
• Liking. We all prefer to say yes to people we like–people who are similar to us, who compliment us, who cooperate with us, and who we find attractive.
• Authority. Stanley Milgram wanted to understand why many seemingly decent people–including believing Lutherans and Catholics–went along with the great evils perpetrated by the Nazis. Milgram did a famous experiment. A person in a white lab coat stands behind the subject of the experiment. The subject is asked to give increasingly severe electric shocks to a “learner” in another room whenever the learner gives an incorrect answer to a question. (Unknown to the subject, the learner in the other room is an actor and the electric shocks are not really given.) Roughly 60 percent of the time, the subject of the experiment gives a fatal shock of 450 volts to the learner. This is a terrifying result. See:https://en.wikipedia.org/wiki/Milgram_experiment
• Scarcity. Items or data that are scarce or perceived to be scarce automatically are viewed as more attractive. That’s why companies frequently offer services or products for a limited time only.

These innate psychological tendencies are especially powerful when they operate in combination. Charlie Munger calls this lollapalooza effects.

Mauboussin writes that investors are often influenced by commitment and consistency, social validation, and scarcity.

Psychologists discovered that after bettors at a racetrack put down their money, they are more confident in the prospects of their horses winning than immediately before they placed their bets. After making a decision, we feel both internal and external pressure to remain consistent to that view even if subsequent evidence questions the validity of the initial decision.

So an investor who has taken a position in a particular stock, recommended it publicly, or encouraged colleagues to participate, will feel the need to stick with the call. Related to this tendency is the confirmation trap: postdecision openness to confirming data coupled with disavowal or denial of disconfirming data. One useful technique to mitigate consistency is to think about the world in ranges of values with associated probabilities instead of as a series of single points. Acknowledging multiple scenarios provides psychological shelter to change views when appropriate.

There is a large body of work about the role of social validation in investing. Investing is an inherently social activity, and investors periodically act in concert…

Finally, scarcity has an important role in investing (and certainly plays a large role in the minds of corporate executives). Investors in particular seek informational scarcity. The challenge is to distinguish between what is truly scarce information and what is not. One means to do this is to reverse-engineer market expectations–in other words, figure out what the market already thinks.

 

EMOTION AND INTUITION IN DECISION MAKING

(Photo by Marek Uliasz)

Humans need to be able to experience emotions in order to make good decisions. Mauboussin writes about an experiment conducted by Antonio Damasio:

…In one experiment, he harnessed subjects to a skin-conductance-response machine and asked them to flip over cards from one of four decks; two of the decks generated gains (in play money) and the other two were losers. As the subjects turned cards, Damasio asked them what they thought was going on. After about ten turns, the subjects started showing physical reactions when they reached for a losing deck. About fifty cards into the experiment, the subjects articulated a hunch that two of the four decks were riskier. And it took another thirty cards for the subjects to explain why their hunch was right.

This experiment provided two remarkable decision-making lessons. First, the unconscious knew what was going on before the conscious did. Second, even the subjects who never articulated what was going on had unconscious physical reactions that guided their decisions.

 

BEWARE OF BEHAVIORAL FINANCE

Individual agents can behave irrationally but the market can still be rational.

…Collective behavior addresses the potentially irrational actions of groups. Individual behavior dwells on the fact that we all consistently fall into psychological traps, including overconfidence, anchoring and adjustment, improper framing, irrational commitment escalation, and the confirmation trap.

Here’s my main point: markets can still be rational when investors are individually irrational. Sufficient investor diversity is the essential feature in efficient price formation. Provided the decision rules of investors are diverse–even if they are suboptimal–errors tend to cancel out and markets arrive at appropriate prices. Similarly, if these decision rules lose diversity, markets become fragile and susceptible to inefficiency.

Mauboussin continues:

In case after case, the collective outperforms the individual. A full ecology of investors is generally sufficient to assure that there is no systematic way to beat the market. Diversity is the default assumption, and diversity breakdowns are the notable (and potentially profitable) exceptions.

(Illustration by Trueffelpix)

Mauboussin writes about an interesting example of how the collective can outperform individuals (including experts).

On January 17, 1966, a B-52 bomber and a refueling plane collided in midair while crossing the Spanish coastline. The bomber was carrying four nuclear bombs. Three were immediately recovered. But the fourth was lost and its recovery became a national security priority.

Assistant Security of Defense Jack Howard called a young naval officer, John Craven, to find the bomb. Craven assembled a diverse group of experts and asked them to place bets on where the bomb was. Shortly thereafter, using the probabilities that resulted from all the bets, the bomb was located. The collective intelligence in this example was superior to the intelligence of any individual expert.

 

IMPORTANCE OF A DECISION JOURNAL

In investing and in general, it’s wise to keep a journal of our decisions and the reasoning behind them.

(Photo by Leerobin)

We all suffer from hindsight bias. We are unable to recall what we actually thought before making a decision or judgment.

• If we decide to do something and it works out, we tend to underestimate the uncertainty that was present when we made the decision. “I knew I made the right decision.”
• If we decide to do something and it doesn’t work, we tend to overestimate the uncertainty that was present when we made the decision. “I suspected that it wouldn’t work.”
• If we judge that event X will happen, and then it does, we underestimate the uncertainty that was present when we made the judgment. “I knew that would happen.”
• If we judge that event X will happen, and it doesn’t, we overestimate the uncertainty that was present when we made the judgment. “I was fully aware that it was unlikely.”

See:https://en.wikipedia.org/wiki/Hindsight_bias

As Mauboussin notes, keeping a decision journal gives us a valuable source of objective feedback. Otherwise, we won’t recall with any accuracy the uncertainty we faced or the reasoning we used.

 

RIGHT FROM THE GUT

Robert Olsen has singled out five conditions that are present in the context of naturalistic decision making.

• Ill-structured and complex problems. No obvious best procedure exists to solve a problem.
• Information is incomplete, ambiguous, and changing. Because stock picking relates to future financial performance, there is no way to consider all information.
• Ill-defined, shifting, and competing goals. Although long-term goals may be clearer, goals can change over shorter horizons.
• Stress because of time constraints, high stakes, or both. Stress is clearly a feature of investing.
• Decisions may involve multiple participants.

Mauboussin describes three key characteristics of naturalistic decision makers. First, they rely heavily on mental imagery and simulation in order to assess a situation and possible alternatives. Second, they excel at pattern matching. (For instance, chess masters can glance at a board and quickly recognize a pattern.)

(Photo by lbreakstock)

Third, naturalistic decision makers reason through analogy. They can see how seemingly different situations are in fact similar.

 

WEIGHTED WATCHER

Mauboussin describes how we develop a “degree of belief” in a specific hypothesis:

Our degree of belief in a particular hypothesis typically integrates two kinds of evidence: the strength, or extremeness, of the evidence and the weight, or predictive validity. For instance, say you want to test the hypothesis that a coin in biased in favor of heads. The proportion of heads in the sample reflects the strength, while the sample size determines the weight.

Probability theory describes rules for how to combine strength and weight correctly. But substantial experimental data show that people do not follow the theory. Specifically, the strength of evidence seems to dominate the weight of evidence in people’s minds.

This bias leads to a distinctive pattern of over- and underconfidence. When the strength of evidence is high and the weight is low–which accurately describes the outcome of many Wall Street-sponsored surveys–people tend to be overconfident. In contrast, when the strength is low and the evidence is high, people tend to be underconfident.

(Photo by Michele Lombardo)

Does survey-based research lead to superior stock selection? Mauboussin responds that the answer is ambiguous. First, the market adjusts to new information rapidly. It’s difficult to gain an informational edge, especially when it comes to what is happening now or what will happen in the near future. In contrast, it’s possible to gain an informational edge if you focus on the longer term. That’s because many investors don’t focus there.

The second issue is that understanding the fundamentals about a company or industry is very different from understanding the expectations built into a stock price. The question is not just whether the information is new to you, but whether the information is also new to the market. In the vast majority of cases, the information is already reflected in the current stock price.

Mauboussin sums it up:

Seeking new information is a worthy goal for an investor. My fear is that much of what passes as incremental information adds little or no value, because investors don’t properly weight new information, rely on unsound samples, and fail to recognize what the market already knows. In contrast, I find that thoughtful discussions about a firm’s or an industry’s medium- to long-term competitive outlook extremely rare.

 

WHY INNOVATION IS INEVITABLE

(Image: Innovation concept, by Daniil Peshkov)

Mauboussin quotes Andrew Hargadon’sHow Breakthroughs Happen:

All innovations represent some break from the past–the lightbulb replaced the gas lamp, the automobile replaced the horse and cart, the steamship replaced the sailing ship. By the same token, however, all innovations are built from pieces of the past–Edison’s system drew its organizing principles from the gas industry, the early automobiles were built by cart makers, and the first steam ships added steam engines to existing sailing ships.

Mauboussin adds:

Investors need to appreciate the innovation process for a couple of reasons. First, our overall level of material well-being relies heavily on innovation. Second, innovation lies at the root of creative destruction–the process by which new technologies and businesses supersede others. More rapid innovation means more rapid success and failure for companies.

Mauboussin draws attention to three interrelated factors that continue to drive innovation at an accelerating rate:

• Scientific advances
• Information storage capacity
• Gains in computing power

 

ACCELERATING RATE OF INDUSTRY CHANGE

(Photo: Drosophila Melanogaster, by Tomatito26)

Mauboussin mentions the common fruit fly,Drosophila melanogaster, which geneticists and other scientists like to study because its life cycle is only two weeks.

Why should businesspeople care aboutDrosophila? A sound body of evidence now suggests that the average speed of evolution is accelerating in the business world. Just as scientists have learned a great deal about evolutionary change from fruit flies, investors can benefit from understanding the sources and implications of accelerated business evolution.

The most direct consequence of more rapid business evolution is that the time an average company can sustain a competitive advantage–that is, generate an economic return in excess of its cost of capital–is shorter than it was in the past. This trend has potentially important implications for investors in areas such as valuation, portfolio turnover, and diversification.

Mauboussin refers to research by Robert Wiggins and Timothy Ruefli on the sustainability of economic returns. They put forth four hypotheses. The first three were supported by the data, while the fourth one was not:

• Periods of persistent superior economic performance are decreasing in duration over time.
• Hypercompetition is not limited to high-technology industries but will occur through most industries.
• Over time, firms increasingly seek to sustain competitive advantage by concatenating a series of short-term competitive advantages.
• Industry concentration, large market share, or both are negatively correlated with chance of loss of persistent superior economic performance in an industry.

Mauboussin points out that faster product and process life cycles means that historical multiples are less useful for comparison. Also, the terminal valuation in discounted cash-flow models in many cases has to be adjusted to reflect shorter periods of sustainable competitive advantage.

(Image by Marek Uliasz)

Furthermore, while portfolio turnover on average is too high, portfolio turnover could be increased for those investors who have historically had a portfolio turnover of 20 percent (implying a holding period of 5 years). Similarly, shorter periods of competitive advantage imply that some portfolios should be more diversified. Lastly, faster business evolution means that investors must spend more time understanding the dynamics of organizational change.

 

HOW TO BALANCE THE LONG TERM WITH THE SHORT TERM

(Photo by Michael Maggs, via Wikimedia Commons)

Mauboussin notes the lessons emphasized by chess master Bruce Pandolfini:

• Don’t look too far ahead. Most people believe that great players strategize by thinking far into the future, by thinking 10 or 15 moves ahead. That’s just not true. Chess players look only as far into the future as they need to, and that usually means looking just a few moves ahead. Thinking too far ahead is a waste of time: The information is uncertain.
• Develop options and continuously revise them based on the changing conditions: Great players consider their next move without playing it. You should never play the first good move that comes into your head. Put that move on your list, and then ask yourself if there’s an even better move. If you see a good idea, look for a better one–that’s my motto. Good thinking is a matter of making comparisons.
• Know your competition: Being good at chess also requires being good at reading people. Few people think of chess as an intimate, personal game. But that’s what it is. Players learn a lot about their opponents, and exceptional chess players learn to interpret every gesture that their opponents make.
• Seek small advantages: You play for seemingly insignificant advantages–advantages that your opponent doesn’t notice or that he dismisses, thinking, “Big deal, you can have that.” It could be slightly better development, or a slightly safer king’s position. Slightly, slightly, slightly. None of those “slightlys” mean anything on their own, but add up seven or eight of them, and you have control.

Mauboussin argues that companies should adopt simple, flexible long-term decision rules. This is the “strategy as simple rules” approach, which helps us from getting caught in the short term versus long term debate.

Moreover, simple decision rules help us to be consistent. Otherwise we will often reach different conclusions from the same data based on moods, suggestion, recency bias, availability bias, framing effects, etc.

 

FITNESS LANDSCAPES AND COMPETITIVE ADVANTAGE

(Image: Fitness Landscape, by Randy Olsen, via Wikimedia Commons)

Mauboussin:

What does a fitness landscape look like? Envision a large grid, with each point representing a different strategy that a species (or a company) can pursue. Further imagine that the height of each point depicts fitness. Peaks represent high fitness, and valleys represent low fitness. From a company’s perspective, fitness equals value-creation potential. Each company operates in a landscape full of high-return peaks and value-destructive valleys. The topology of the landscape depends on the industry characteristics.

As Darwin noted, improving fitness is not about strength or smarts, but rather about becoming more and more suited to your environment–in a word, adaptability. Better fitness requires generating options and “choosing” the “best” ones. In nature, recombination and mutation generate species diversity, and natural selection assures that the most suitable options survive. For companies, adaptability is about formulating and executing value-creating strategies with a goal of generating the highest possible long-term returns.

Since a fitness landscape can have lots of peaks and valleys, even if a species reaches a peak (a local optimum), it may not be at the highest peak (a global optimum). To get a higher altitude, a species may have to reduce its fitness in the near term to improve its fitness in the long term. We can say the same about companies…

Mauboussin remarks that there are three types of fitness landscape:

• Stable. These are industries where the fitness landscape is reasonably stable. In many cases, the landscape is relatively flat, and companies generate excess economic returns only when cyclical forces are favorable. Examples include electric and telephone utilities, commodity producers (energy, paper, metals), capital goods, consumer nondurables, and real estate investment trusts. Companies within these sectors primarily improve their fitness at the expense of their competitors. These are businesses that tend to have structural predictability (i.e., you’ll know what they look like in the future) at the expense of limited opportunities for growth and new businesses.
• Coarse. The fitness landscape is in flux for these industries, but the changes are not so rapid as to lack predictability. The landscape here is rougher. Some companies deliver much better economic performance than do others. Financial services, retail, health care, and more established parts of technology are illustrations. These industries run a clear risk of being unseated (losing fitness) by a disruptive technology.
• Roiling. This group contains businesses that are very dynamic, with evolving business models, substantial uncertainty, and ever-changing product offerings. The peaks and valleys are constantly changing, ever spastic. Included in this type are many software companies, the genomics industry, fashion-related sectors, and most start-ups. Economic returns in this group can be (or can promise to be) significant but are generally fleeting.

Mauboussin indicates that innovation, deregulation, and globalization are probably causing the global fitness landscape to become even more contorted.

Companies can make short, incremental jumps towards a local maximum. Or they can make long, discontinuous jumps that may lead to a higher peak or a lower valley. Long jumps include investing in new potential products or making meaningful acquisitions in unrelated fields. The proper balance between short jumps and long jumps depends on a company’s fitness landscape.

Mauboussin adds that the financial tool for valuing a given business depends on the fitness landscape that the business is in. A business in a stable landscape can be valued using discounted cash-flow (DCF). A business in a course landscape can be valued using DCF plus strategic options. A business in a roiling landscape can be valued using strategic options.

 

THE FOLLY OF USING AVERAGE P/E’S

Bradford Cornell:

For past averages to be meaningful, the data being averaged have to be drawn from the same population. If this is not the case–if the data come from populations that are different–the data are said to be nonstationary. When data are nonstationary, projecting past averages typically produces nonsensical results.

Nonstationarity is a key concept in time-series analysis, such as the study of past data in business and finance. If the underlying population changes, then the data are nonstationary and you can’t compare past averages to today’s population.

(Image: Time Series, by Mike Toews via Wikimedia Commons)

Mauboussin gives three reasons why past P/E data are nonstationary:

• Inflation and taxes
• Changes in the composition of the economy
• Shifts in the equity-risk premium

Higher taxes mean lower multiples, all else equal. And higher inflation also means lower multiples. Similarly, low taxes and low inflation both cause P/E ratios to be higher.

The more companies rely on intangible capital rather than tangible capital, the higher the cash-flow-to-net-income ratio. Overall, the economy is relying increasingly on intangible capital. Higher cash-flow-to-net-income ratios, and higher returns on capital, mean higher P/E ratios.

 

MEAN REVERSION AND TURNAROUNDS

Growth alone does not create value. Growth creates value only if the return on invested capital exceeds the cost of capital. Growth actually destroys value if the return on invested capital is less than the cost of capital.

(Illustration by Teguh Jati Prasetyo)

Over time, a company’s return on capital moves towards its cost of capital. High returns bring competition and new capital, which drives the return on capital toward the cost of capital. Similarly, capital exits low-return industries, which lifts the return on capital toward the cost of capital.

Mauboussin reminds us that a good business is not necessarily a good investment, just as a bad business is not necessarily a bad investment. What matters is the expectations embedded in the current price. If expectations are overly low for a bad business, it can represent a good investment. If expectations are too high for a good business, it may be a poor investment.

On the other hand, some cheap stocks deserve to be cheap and aren’t good investments. And some expensive-looking stocks trading at high multiples may still be good investments if high growth and high return on capital can persist long enough into the future.

 

CONSIDERING COOPERATION AND COMPETITION THROUGH GAME THEORY

(Illustration: Concept of Prisoner’s Dilemma, by CXJ Jensen via Wikimedia Commons)

Mauboussin quotes Robert Axelrod’sThe Complexity of Cooperation:

What the Prisoner’s Dilemma captures so well is the tension between the advantages of selfishness in the short run versus the need to elicit cooperation from the other player to be successful over the longer run. The very simplicity of the Prisoner’s Dilemma is highly valuable in helping us to discover and appreciate the deep consequences of the fundamental processes involved in dealing with this tension.

The Prisoner’s Dilemma shows that the rational response for an individual company is not necessarily optimal for the industry as a whole.

If the Prisoner’s Dilemma game is going to be repeated many times, then the best strategy is tit-for-tat. Whatever your competitor’s latest move was, copy that for your next move. So if your competitor deviates one time and then cooperates, you deviate one time and then cooperate. Tit-for-tat is both the simplest strategy and also the most effective.

When it comes to market pricing and capacity decisions, competitive markets need not be zero sum. A tit-for-tat strategy is often optimal, and by definition it includes a policing component if your competitor deviates.

 

THE WISDOM AND WHIM OF THE COLLECTIVE

Mauboussin quotes Robert D. Hanson’sDecision Markets:

[Decision markets] pool the information that is known to diverse individuals into a common resource, and have many advantages over standard institutions for information aggregation, such as news media, peer review, trials, and opinion polls. Speculative markets are decentralized and relatively egalitarian, and can offer direct, concise, timely, and precise estimates in answer to questions we pose.

Mauboussin then writes about bees and ants, ending with this comment:

What makes the behavior of social insects like bees and ants so amazing is that there is no central authority, no one directing traffic. Yet the aggregation of simple individuals generates complex, adaptive, and robust results. Colonies forage efficiently, have life cycles, and change behavior as circumstances warrant. These decentralized individuals collectively solve very hard problems, and they do it in a way that is very counterintuitive to the human predilection to command-and-control solutions.

(Illustration: Swarm Intelligence, by Farbentek)

Mauboussin again:

Why do decision markets work so well? First, individuals in these markets think they have some edge, so they self-select to participate. Second, traders have an incentive to be right–they can take money from less insightful traders. Third, these markets provide continuous, real-time forecasts–a valuable form of feedback. The result is that decision markets aggregate information across traders, allowing them to solve hard problems more effectively than any individual can.

 

VOX POPULI

(Painting: Sir Francis Galton, by Charles Wellington Furse, via Wikimedia Commons)

Mauboussin tells of an experiment by Francis Galton:

Victorian polymath Francis Galton was one of the first to thoroughly document this group-aggregation ability. In a 1907Nature article, “Vox Populi,” Galton describes a contest to guess the weight of an ox at the West of England Fat Stock and Poultry Exhibition in Plymouth. He collected 787 participants who each paid a sixpenny fee to participate. (A small cost to deter practical joking.) According to Galton, some of the competitors were butchers and farmers, likely expert at guessing the weight. He surmised that many others, though, were guided by “such information as they might pick up” or “by their own fancies.”

Galton calculated the median estimate–the vox populi–as well as the mean. He found that the median guess was within 0.8 percent of the correct weight, and that the mean of the guesses was within 0.01 percent. To give a sense of how the answer emerged, Galton showed the full distribution of answers. Simply stated, the errors cancel out and the result is distilled information.

Subsequently, we have seen the vox populi results replicated over and over. Examples include solving a complicated maze, guessing the number of jellybeans in a jar, and finding missing bombs. In each case, the necessary conditions for information aggregation to work include an aggregation mechanism, an incentive to answer correctly, and group heterogeneity.

 

COMPLEX ADAPTIVE SYSTEMS

(Illustration by Acadac, via Wikimedia Commons)

Complex adaptive systems exhibit a number of essential properties and mechanisms, writes Mauboussin:

• Aggregation. Aggregation is the emergence of complex, large-scale behavior from the collective interactions of many less-complex agents.
• Adaptive decision rules. Agents within a complex adaptive system take information from the environment, combine it with their own interaction with the environment, and derive decision rules. In turn, various decision rules compete with one another based on their fitness, with the most effective rules surviving.
• Nonlinearity. In a linear model, the whole equals the sum of the parts. In nonlinear systems, the aggregate behavior is more complicated than would be predicted by totaling the parts.
• Feedback loops. A feedback system is one in which the output of one iteration becomes the input of the next iteration. Feedback loops can amplify or dampen an effect.

Governments, many corporations, and capital markets are all examples of complex adaptive systems.

Humans have a strong drive to invent a cause for every effect. This has been biologically advantageous for the vast majority of human history. In the past, if we heard a rustling in the grass, we immediately sought safety. There was always some cause for the noise. It virtually never made sense to wait around to see if it was a predator or not.

However, in complex adaptive systems like the stock market, typically there is no simple cause and effect relationship that explains what happens.

For many big moves in the stock market, there is no identifiable cause. But people have such a strong need identify a cause that they make up causes. The press delivers to people what they want: explanations for big moves in the stock market. Usually these explanations are simply made up. They’re false.

 

THE FUTURE OF CONSILIENCE IN INVESTING

(Painting: Galileo Galilei, by Justus Sustermans, via Wikimedia Commons)

Mauboussin, following Charlie Munger, argues that cross-disciplinary research is likely to produce the deepest insights into the workings of companies and markets. Here are some examples:

• Decision making and neuroscience. Prospect theory–invented by Daniel Kahneman and Amos Tversky–describes how people suffer from cognitive biases when they make decisions under uncertainty. Prospect theory is extremely well-supported by countless experiments. But prospect theory still doesn’t explain why people make the decisions they do. Neuroscience will help with this.
• Statistical properties of markets–from description to prediction? Stock price changes are not normally distributed–along a bell-shaped curve–but rather follow a power law. The statistical distribution has fat tails, which means there are more extreme moves than would occur under a normal distribution. Once again, a more accurate description is progress. But the next step involves a greater ability to explain and predict the phenomena in question.
• Agent-based models. Individual differences are important in market outcomes. Feedback mechanisms are also central.
• Network theory and information flows. Network research involves epidemiology, psychology, sociology, diffusion theory, and competitive strategy. Much progress can be made.
• Growth and size distribution. There are very few large firms and many small ones. And all large firms experience significantly slower growth once they reach a certain size.
• Flight simulator for the mind? One of the biggest challenges in investing is that long-term investors don’t get nearly enough feedback. Statistically meaningful feedback for investors typically takes decades to produce.

 

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.

October 15, 2023

John Maynard Keynes is one of the greatest economists of all time. But when he tried to invest on the basis of macroeconomic predictions, he failed. Twice. When he embraced focused value investing, he was wildly successful.

It is well known that Warren Buffett and Charlie Munger are two of the greatest value investors, and that they both favor a focused approach. What is not as well known is that the world’s most famous economist, John Maynard Keynes, independently embraced a value investing approach similar to that used by Buffett and Munger.

The story of Keynes’ evolution as an investor has been told many times. One book in particular – Justyn Walsh’s Keynes and the Market (Wiley, 2008) – does a great job.

Keynes did very well over decades as a focused value investor. His best advice:

• Buy shares when they are cheap in relation to probable intrinsic value;
• Ignore macro and market predictions, and stay focused on a few individual businesses that you understand and whose management you believe in;
• Hold those businesses for many years as long as the investment theses are intact;
• Try to have negatively correlated investments (for example, the stock of a gold miner, says Keynes).

Now for a brief summary of the book.

 

INTELLECTUAL BEGINNINGS

Keynes was born in 1883 in the university town of Cambridge, where his father was an economics fellow and his mother was one of its first female graduates. After attending Eton, in 1902 Keynes won a scholarship to King’s College at Cambridge. There, he became a member of a secret society known as “the Apostles,” which included E. M. Forster, Bertrand Russell, and Wittgenstein. The group was based on principles expressed in G. E. Moore’s Principia Ethica. Moore believed the following:

By far the most valuable things, which we know or can imagine, are certain states of consciousness, which may be roughly described as the pleasures of human intercourse and the enjoyment of beautiful objects.

Upon graduation, Keynes decided to become a Civil Servant, and ended up as a junior clerk in the India Office in 1906. Keynes was also part of the Bloomsbury group, which included artists, writers, and philosophers who met at the house of Virginia Woolf and her siblings. Walsh quotes a Bloomsbury:

We found ourselves living in the springtime of a conscious revolt against the social, political, moral, intellectual, and artistic institutions, beliefs, and standards of our fathers and grandfathers.

 

WORLD WAR I – PEACE TERMS

Keynes strongly disagreed with the proposed peace terms following the conclusion of World War I. He wrote The Economic Consequences of the Peace, which was translated into eleven languages. Keynes predicted that the vengeful demands of France (and others) against their enemies would inevitably lead to another world war far worse than the first one. Unfortunately, Keynes was ignored and his prediction turned out to be roughly correct.

 

KEYNES THE SPECULATOR

After resigning from Treasury, Keynes needed a source of income. Given his background in economics and government, he decided that he could make money by speculating on currencies (and later commodities). After a couple of large ups and downs, Keynes ended up losing more than 80% of his net worth in 1928 to 1929 – from 44,000 pounds to 8,000 pounds. His speculative bets on rubber, corn, cotton, and tin declined massively in 1928. Eventually he realized that value investing was a much better way to succeed as an investor.

Keynes made a clear distinction between speculation and value investing. He described speculation as like the newspaper competitions where one had to pick out the faces that the average would pick as the prettiest:

It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice fourth, fifth and higher degrees.

 

KEYNES THE ECONOMIST

Another famous economist, Irving Fisher, who had also done well in business, made his famous prediction in mid-October 1929:

Stock prices have reached what looks like a permanently high plateau…. I expect to see the stock market a good deal higher… within a few months.

After the initial crash that began in late October 1929, Fisher continued to predict a recovery.

Keynes, on the other hand, was quick to recognize both the deep problems posed by the economic downturn and the necessity for aggressive fiscal policy (contrary to the teachings of classical economics). Keynes said:

The fact is – a fact not yet recognized by the great public – that we are now in the depths of a very severe international slump, a slump which will take its place in history amongst the most acute ever experienced. It will require not merely passive movements of bank rates to lift us out of a depression of this order, but a very active and determined policy.

Keynes argued that the economy was at an underemployment equilibrium, with a large amount of wasted resources. Only aggressive fiscal policy could increase aggregate demand, thereby bringing the economy back to a healthy equilibrium. Classical economists at the time – who disagreed forcefully with Keynes – thought that the economy was like a household: when income declines, one must spend less until the situation corrects itself. Keynes referred to the classical economists as “liquidationists,” because their position implied that everything should be liquidated (at severely depressed and irrational prices) until the economy corrected itself.

Franklin Delano Roosevelt seemed to agree with Keynes. Roosevelt said “this Nation asks for action, and action now.” Roosevelt argued that, if necessary, he would seek “broad Executive power… as great as the power that would be given to me if we were in fact invaded by a foreign foe.”

In The General Theory of Employment, Interest and Money, Keynes disagreed with the conventional doctrine that free markets always produce optimal results. Much later, even Keynes’ opponents agreed with him and admitted that “we are all Keynesians now.”

In the 1970’s, however, when stagflation (slow growth and rising prices) reared its ugly head, neoclassical economics was revived and Keynesian economics became less popular. But by the late 1970’s, another part of Keynes’ views – “animal spirits” – became important in the new field of behavioral economics.

 

KEYNES THE VALUE INVESTOR

Keynes held that there is an irreducible uncertainty regarding most of the future. In the face of great uncertainty, “animals spirits” – or “the spontaneous urge to action rather than inaction” – leads people to make decisions and move forward.

Because the future is so uncertain, many investors extrapolate the recent past into the future, which often causes them to make investment mistakes. Moreover, many investors overweight the near term, leading to stock price volatility far in excess of the long-term earnings and dividends produced by the underlying companies. Keynes remarked:

Day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market.

Keynes lamented the largely random daily price fluctuations upon which so many investors uselessly focus. Of these fluctuating daily prices, Keynes said that they gave:

… a frequent opportunity to the individual… to revise his commitments. It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and 11 in the morning and reconsider whether he should return to it later in the week.

Warren Buffett has often quoted this statement by Keynes. Indeed, in discussing speculators as opposed to long-term value investors, Keynes sounds a lot like Ben Graham and Warren Buffett. Keynes:

It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.

Keynes also noted:

… it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.

Because many fund managers are judged over shorter periods of time – even a few months – they typically worry more about not underperforming than they do about outperforming. With so many investors – both professional and non-professional – focused on short-term price performance, it’s no surprise that the stock market often overreacts to new information – especially if it’s negative. (The stock market can often underreact to positive information.) Nor is it a surprise that the typical stock price moves around far more than the company’s underlying intrinsic value – asset value or earnings power.

In a nutshell, investor psychology can cause a stock to be priced almost anywhere in the short term, regardless of the intrinsic value of the underlying company. Keynes held that value investors should usually simply ignore these random fluctuations and stay focused on the individual businesses in which they have invested. As Ben Graham, the father of value investing, said in The Intelligent Investor:

Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.

Graham also wrote:

The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks. Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels. Thus we have what appear to be two major sources of undervaluation: (1) currently disappointing results and (2) protracted neglect or unpopularity.

Or as Buffett said:

Fear is the foe of the faddist, but the friend of the fundamentalist.

Buffett later observed that Keynes “began as a market-timer… and converted, after much thought, to value investing.” Whereas the speculator attempts to predict price swings, the value investor patiently waits until irrational price swings have made a stock unusually cheap with respect to probable future earnings. Keynes:

… I am generally trying to look a long way ahead and am prepared to ignore immediate fluctuations, if I am satisfied that the assets and earnings power are there.

 

MARGIN OF SAFETY

Ben Graham, the father of value investing and Warren Buffett’s teacher and mentor, wrote the following in Chapter 20 of The Intelligent Investor:

In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, ‘This too will pass.’ Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.

Keynes used the phrase “safety first” instead of “margin of safety.” Moreover, he had a similar definition of intrinsic value: an estimate based on the probable earnings power of the assets. Keynes realized that a lower price paid relative to intrinsic value simultaneously reduces risk and increases probable profit. The notion that a larger margin of safety means larger profits in general is directly opposed to what is still taught in modern finance: higher investment returns are only achievable through higher risk.

Moreover, Keynes emphasized the importance of non-quantitative factors relevant to investing. Keynes is similar to Graham, Buffett, and Munger in this regard. Munger:

… practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and (2) doesn’t mix in the hard-to-measure stuff that may be more important.

Or as Ben Graham stated:

… the combination of precise formulas with highly imprecise assumptions can be used to establish, or rather to justify, practically any value one wishes… in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw therefrom.

 

UNCERTAINTY AND PESSIMISM CREATE BARGAINS

The value investor often gains an advantage by having a 3- to 5-year investment time horizon. Because the future is always uncertain, and because so many investors are focused on the next 6 months, numerous bargains become available for long-term investors. As Keynes mentioned:

Very few American investors buy any stock for the sake of something which is going to happen more than six months hence, even though its probability is exceedingly high; and it is out of taking advantage of this psychological peculiarity that most money is made.

Pessimism also creates bargains. During the 1973-1974 bear market, many stocks became ridiculously cheap relative to asset value or earnings power. Buffett has explained the case of The Washington Post Company:

In ’74 you could have bought The Washington Post when the whole company was valued at $80 million. Now at that time the company was debt free, it owned The Washington Post newspaper, it owned Newsweek, it owned the CBS stations in Washington, D.C. and Jacksonville, Florida, the ABC station in Miami, the CBS station in Hartford/New Haven, a half interest in 800,000 acres of timberland in Canada, plus a 200,000-ton-a-year mill up there, a third of the International Herald Tribune, and probably some other things I forgot. If you asked any one of thousands of investment analysts or media specialists about how much those properties were worth, they would have said, if they added them up, they would have come up with $400, $500, $600 million.

 

MARKET LEADERS OR HIGHER QUALITY COMPANIES

Keynes had a policy of buying the best within each chosen investment category:

It is generally a good rule for an investor, having settled on the class of security he prefers – … bank shares or oil shares, or investment trusts, or industrials, or debentures, preferred or ordinary, whatever it may be – to buy only the best within that category.

Buffett, partly through the influence of Charlie Munger, evolved from an investor in quantitatively cheap stocks to an investor in higher quality companies. Munger explains the logic:

Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6 percent on capital over 40 years and you hold if for… 40 years, you’re not going to make much different than 6 percent return – even if you originally buy it at a huge discount. Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

 

FOCUSED AND PATIENT

Keynes was a “focused” value investor in the sense of believing in a highly concentrated portfolio. This is similar to Buffett and Munger (especially when they were managing smaller amounts of money).

Keynes was criticized for taking large positions in his best ideas. Here is one of his responses:

Sorry to have gone too large in Elder Dempster… I was… suffering from my chronic delusion that one good share is safer than ten bad ones, and I am always forgetting that hardly anyone else shares this particular delusion.

If you can understand specific businesses – which is easier to do if you focus on tiny microcap companies – Keynes, Buffett, and Munger all believed that you should take large positions in your best ideas. Keynes called these opportunities “ultra favourites” or “stunners,” while Buffett called them “superstars” and “grand-slam home runs.” As Keynes concluded late in his career:

… it is out of these big units of the small number of securities about which one feels absolutely happy that all one’s profits are made… Out of the ordinary mixed bag of investments nobody ever makes anything.

One way that the best ideas of Keynes, Buffett, and Munger become even larger positions in their portfolios over time is if the investment theses are essentially correct, which eventually leads the stocks to move much higher. Many investors ask: if your best idea becomes an even larger part of the portfolio, shouldn’t you rebalance? Here is Buffett’s response:

To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.

The decision about whether to hold a stock should depend only upon your current investment thesis about the company. It doesn’t matter what you paid for it, or whether the stock has increased or decreased recently. What matters is how much free cash flow you think the company will produce over time, and how cheap the stock is now relative to that future free cash flow. What also matters is how cheap the stock is relative to your other ideas.

Keynes again on concentration:

To suppose that safety-first consists in having a small gamble in a large number of different directions…, as compared with a substantial stake in a company where one’s information is adequate, strikes me as a travesty of investment policy.

As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.

Conducting research on a relatively short list of candidates and then concentrating your portfolio on the best ideas, is a form of specialization. Often the stocks in a specific sector will get very cheap when that sector is out of favor. If you’re willing to invest the time to understand the stocks in that sector, you may be able to gain an edge.

Moreover, if you’re an individual investor, it makes sense to focus on tiny microcap companies, which are generally easier to understand and can get extremely cheap because most investors completely ignore them.

Ben Graham often pointed out that patience and courage are essential for contrarian value investing. Cheap stocks are usually neglected or hated because they have terrible short-term problems affecting their earnings and cash flows. Similarly, Keynes held that huge short-term price fluctuations are often irrational with respect to long-term earnings and dividends. Keynes:

… the modern organization of the capital market requires for the holder of quoted equities much more nerve, patience, and fortitude than from the holder of wealth in other forms.

 

SUMMARY

Keynes’ experiences on the stock market read like some sort of morality play – an ambitious young man, laboring under the ancient sin of hubris, loses almost everything in his furious pursuit of wealth; suitably humbled, our protagonist, now wiser for the experience, applies his considerable intellect to the situation and discovers what he believes to be the one true path to stock market success.

Keynes realized that focused value investing is the best way to compound wealth over time. Ignore market and macro predictions, and focus on a few businesses that you can understand and in whose management you believe.

In 1938, in a memorandum written for King’s College Estates Committee, Keynes gave a concise summary of his investment philosophy:

• A careful selection of a few investments (or a few types of investment) having regard to their cheapness in relation to their probable actual and potential intrinsic value over a period of years ahead and in relation to alternative investments at the time;
• A steadfast holding of these in fairly large units through thick and thin, perhaps for several years, until either they have fulfilled their promise or it is evident that they were purchased on a mistake;
• A balanced investment position, i.e., a variety of risks in spite of individual holdings being large, and if possible opposed risks (e.g., a holding of gold shares amongst other equities, since they are likely to move in opposite directions when there are general fluctuations).

Walsh writes that Keynes followed six key investment rules:

1. Focus on the estimated intrinsic value of a stock – as represented by the projected earnings of the particular security – rather than attempt to divine market trends.
2. Ensure that a sufficiently large margin of safety – the difference between a stock’s assessed intrinsic value and price – exists in respect of purchased stocks.
3. Apply independent judgment in valuing stocks, which may often imply a contrarian investment policy.
4. Limit transaction costs and ignore the distractions of constant price quotation by maintaining a steadfast holding of stocks.
5. Practice a policy of portfolio concentration by committing relatively large sums of capital to stock market “stunners.”
6. Maintain the appropriate temperament by balancing “equanimity and patience” with the ability to act decisively.

The importance of temperament and the ability to maintain inner peace should not be overlooked. As Buffett points out:

Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ… Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

Walsh summarizes Keynes’ performance as a value investor:

Taking 1931 as the base year – admittedly a relatively low point in the Fund’s fortunes, but also on the assumption that Keynes’ value investment style began around this time – the Chest Fund recorded a roughly tenfold increase in value in the fifteen years to 1945, compared with a virtual nil return for the Standard & Poor’s 500 Average and a mere doubling of the London industrial index over the same period.

What’s even more impressive is that this performance does not include the income generated by the Chest Fund, all of which was spent on college building works and repayment of loans.

One small mistake Keynes made was holding his “stunners” even when they were overvalued. Keynes made this mistake because he was an optimist. (Buffett made a similar mistake in the late 1990’s.) Here is Keynes (sounding like Buffett) on the future:

There is nothing to be afraid of. On the contrary. The future holds in store for us far more wealth and economic freedom and possibilities of personal life than the past has ever offered.

 

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.

September 24, 2023

Peter Bevelin is the author of the great book, Seeking Wisdom: From Darwin to Munger. I wrote about this book here: https://boolefund.com/seeking-wisdom/

Bevelin also wrote a shorter book, A Few Lessons from Sherlock Holmes. I’m a huge fan of Sherlock Holmes. Robert Hagstrom has written an excellent book on Holmes calledThe Detective and the Investor. Here’s my summary of Hagstrom’s book: https://boolefund.com/invest-like-sherlock-holmes/

I highly recommend Hagstrom’s book. But if you’re pressed for time, Bevelin’sA Few Lessons from Sherlock Holmes is worth reading.

Belevin’s book is a collection of quotations. Most of the quotes are from Holmes, but there are also quotes from others, including:

• • Joseph Bell, a Scottish professor of clinical surgery who was Arthur Conan Doyle’s inspiration for Sherlock Holmes
  • Dr. John Watson, Holmes’s assistant
  • Dr. John Evelyn Thorndike, a fictional detective and forensic scientist in stories by R. Austin Freeman
  • Claude Bernard, a French physiologist
  • Charles Darwin, the English naturalist
  • Thomas McRae, an American professor of medicine and colleague of Sir William Osler
  • Michel de Montaigne, a French statesman and philosopher
  • William Osler, a Canadian physician
  • Oliver Wendell Holmes, Sr., an American physician and author

Sherlock Holmes:

Life is infinitely stranger than anything which the mind of man could invent.

(Illustration of Sherlock Holmes by Sidney Paget, via Wikimedia Commons)

Here’s an outline for this blog post:

• • Some Lessons
  • On Solving a Case–Observation and Inference
  • Observation–Start with collecting facts and follow them where they lead
  • Deduction–What inferences can we draw from our observations and facts?
  • Test Our Theory–If it disagrees with the facts it is wrong
  • Some Other Tools

 

SOME LESSONS

Bevelin quotes the science writer Martin Gardner on Sherlock Holmes:

Like the scientist trying to solve a mystery of nature, Holmes first gathered all the evidence he could that was relevant to his problem. At times, he performed experiments to obtain fresh data. He then surveyed the total evidence in the light of his vast knowledge of crime, and/or sciences relevant to crime, to arrive at the most probable hypothesis. Deductions were made from the hypothesis; then the theory was further tested against new evidence, revised if need be, until finally the truth emerged with a probability approaching certainty.

Bevelin quotes Holmes on the qualities needed to be a good detective:

He has the power of observation and that of deduction. He is only wanting in knowledge, and that may come in time.

It’s important to take a broad view. Holmes:

One’s ideas must be as broad as Nature if they are to interpret Nature.

However, focus only on what is useful. Bevelin quotes Dr. Joseph Bell:

He [Doyle] created a shrewd, quick-sighted, inquisitive man… with plenty of spare time, a retentive memory, and perhaps with the best gift of all–the power of unloading the mind of all burden of trying to remember unnecessary details.

Knowledge of human nature is obviously important. Holmes:

Human nature is a strange mixture, Watson. You see that even a villain and murderer can inspire such affection that his brother turns to suicide when he learns his neck is forfeited.

Holmes again:

Jealousy is a strange transformer of characters.

Bevelin writes that the most learned are not the wisest. Knowledge doesn’t automatically make us wise. Bevelin quotes Montaigne:

Judgment can do without knowledge but not knowledge without judgment.

Learning is lifelong. Holmes:

Like all other arts, the Science of Deduction and Analysis is one which can only be acquired by long and patient study, nor is life long enough to allow any mortal to attain the highest possible perfection in it.

 

ON SOLVING A CASE–Observation and Inference

Bevelin quotes Dr. John Evelyn Thorndyke, a fictional detective in stories by R. Austin Freeman:

…I make it a rule, in all cases, to proceed on the strictly classical lines on inductive inquiry–collect facts, make hypotheses, test them and seek for verification. And I always endeavour to keep a perfectly open mind.

Holmes:

We approached the case… with an absolutely blank mind, which is always an advantage. We had formed no theories. We were there simply to observe and to draw inferences from our observations.

Appearances can be deceiving. If someone is likeable, that can cloud one’s judgment. If someone is not likeable, that also can be misleading. Holmes:

It is of the first importance… not to allow your judgment to be biased by personal qualities… The emotional qualities are antagonistic to clear reasoning. I can assure you that the most winning woman I ever knew was hanged for poisoning three little children for their insurance-money, and the most repellant man of my acquaintence is a philanthropist who has spent nearly a quarter of a million on the London poor.

Holmes talking to Watson:

You remember that terrible murderer, Bert Stevens, who wanted us to get him off in ’87? Was there ever a more mild-mannered, Sunday-school young man?

 

OBSERVATION–Start with collecting facts and follow them where they lead

Bevelin quotes Thomas McCrae, an American professor of medicine and colleague of Sir William Osler:

More is missed by not looking than not knowing.

That said, to conduct an investigation one must have a working hypothesis. Bevelin quotes the French physiologist Claude Bernard:

A hypothesis is… the obligatory starting point of all experimental reasoning. Without it no investigation would be possible, and one would learn nothing: one could only pile up barren observations. To experiment without a preconceived idea is to wander aimlessly.

(Charles Darwin, Photo by Maull and Polyblank (1855), via Wikimedia Commons)

Bevelin also quotes Charles Darwin:

About thirty years ago there was much talk that geologists ought only to observe and not theorise; and I well remember someone saying that at this rate a man might as well go into a gravel-pit and count the pebbles and describe the colors. How odd it is that anyone should not see that all observation must be for or against some view if it is to be of any service!

Holmes:

Let us take that as a working hypothesis and see what it leads us to.

It’s crucial to make sure one has the facts clearly in mind. Bevelin quotes the French statesman and philosopher Montaigne:

I realize that if you ask people to account for “facts,” they usually spend more time finding reasons for them than finding out whether they are true…

Deception, writes Bevelin, has many faces. Montaigne again:

If falsehood, like truth, had only one face, we would be in better shape. For we would take as certain the opposite of what the liar said. But the reverse of truth has a hundred thousand shapes and a limitless field.

Consider why someone might be lying. Holmes:

Why are they lying, and what is the truth which they are trying so hard to conceal? Let us try, Watson, you and I, if we can get behind the lie and reconstruct the truth.

It’s often not clear–especially near the beginning of an investigation–what’s relevant and what’s not. Nonetheless, it’s vital to try to focus on what’s relevant because otherwise one can get bogged down by unnecessary detail. Holmes:

The principal difficulty in your case… lay in the fact of their being too much evidence. What was vital was overlaid and hidden by what was irrelevant. Of all the facts which were presented to us we had to pick just those which we deemed to be essential, and then piece them together in order, so as to reconstruct this very remarkable chain of events.

Holmes again:

It is of the highest importance in the art of detection to be able to recognize out of a number of facts which are incidental and which are vital. Otherwise your energy and attention must be dissipated instead of being concentrated.

Bevelin quotes the Canadian physician William Osler:

The value of experience is not in seeing much, but in seeing wisely.

Observation is a skill one must develop. Most of us are not observant. Holmes:

The world is full of obvious things which nobody by any chance ever observes.

(Illustration of Sherlock Holmes by Sidney Paget (1891), via Wikimedia Commons)

Holmes again:

I see no more than you, but I have trained myself to notice what I see.

Small things can have the greatest importance. Several quotes from Holmes:

• • The smallest point may be the most essential.
  • It has long been an axiom of mine that the little things are infinitely the most important.
  • What seems strange to you is only so because you do not follow my train of thought or observe the small facts upon which large inferences may depend.
  • It is just these very simple things which are extremely liable to be overlooked.
  • Never trust general impressions, my boy, but concentrate yourself upon details.

Belevin also quotes Dr. Joseph Bell:

I always impressed over and over again upon all my scholars–Conan Doyle among them–the vast importance of little distinctions, the endless significance of trifles.

Belevin points out that it’s easy to overlook relevant facts. It’s important always to ask if one has overlooked something.

 

DEDUCTION–What inferences can we draw from our observations and facts?

Most people reason forward, predicting what will happen next. But few people reason backward, inferring the causes of the effects one has observed. Holmes:

Most people, if you describe a chain of events to them, will tell you what the result would be. They can put those events together in their minds, and argue from them that something will come to pass. There are few people, however, who, if you told them a result, would be able to evolve from their own inner consciousness what the steps were which led up to that result. This power is what I mean when I talk of reasoning backward, or analytically.

Often the solution is simple. Holmes:

The case has been an interesting one… because it serves to show very clearly how simple the explanation may be of an affair which at first sight seems to be almost inexplicable.

History frequently repeats. Holmes:

They lay all the evidence before me, and I am generally able, by the help of my knowledge of the history of crime, to set them straight. There is a strong family resemblance about misdeeds, and if you have all the details of a thousand at your finger ends, it is odd if you can’t unravel the thousand and first.

Holmes:

There is nothing new under the sun. It has all been done before.

That said, some cases are unique and different to an extent. But bizarre cases tend to be easier to solve. Holmes:

As a rule… the more bizarre a thing is the less mysterious it proves to be. It is your commonplace, featureless crimes which are really puzzling, just as a commonplace face is the most difficult to identify.

(Illustration of Sherlock Holmes by Sidney Paget, via Wikimedia Commons)

Holmes again:

It is a mistake to confound strangeness with mystery. The most commonplace crime is often the most mysterious, because it presents no new or special features from which deductions may be drawn.

If something we expect to see doesn’t happen, that in itself can be a clue. There was one case of a race horse stolen during the night. When Holmes gathered evidence, he learned that the dog didn’t bark. This means the midnight visitor must have been someone the dog knew well.

Moreover, many seemingly isolated facts could provide a solution if they are taken together. Holmes:

You see all these isolated facts, together with many minor ones, all pointed in the same direction.

After enough facts have been gathered, then one can consider each possible hypothesis one at a time. In practice, there are many iterations: new facts are discovered along the way, and new hypotheses are constructed. By carefully excluding each hypothesis that is not possible, eventually one can deduce the hypothesis that is true. Holmes:

That process… starts upon the supposition that when you have eliminated all which is impossible, then whatever remains, however improbable, must be the truth. It may well be that several explanations remain, in which case one tries test after test until one or other of them has a convincing amount of support.

 

TEST OUR THEORY–If it disagrees with the facts it is wrong

What seems obvious can be very misleading. Holmes:

There is nothing more deceptive than an obvious fact.

“Truth is stranger than fiction,” said Mark Twain. Holmes:

Life is infinitely stranger than anything which the mind of many could invent.

Holmes again:

One should always look for a possible alternative and provide against it. It is the first rule of criminal investigation.

(Illustration of Sherlock Holmes by Sidney Paget, via Wikimedia Commons)

It’s vital to take time to think things through. Watson:

Sherlock Holmes was a man… who, when he had an unsolved problem upon his mind, would go for days, and even for a week, without rest, turning it over, rearranging his facts, looking at it from every point of view until he had either fathomed it or convinced himself that his data were insufficient.

Sometimes doing nothing–or something else–is best when one is waiting for more evidence. Holmes:

I gave my mind a thorough rest by plunging into a chemical analysis. One of our greatest statesmen has said that a change of work is the best rest. So it is.

 

SOME OTHER TOOLS

Bevelin observes the importance of putting oneself in another’s shoes. Holmes:

You’ll get results, Inspector, by always putting yourself in the other fellow’s place, and thinking what you would do yourself. It takes some imagination, but it pays.

Others may be of help. Holmes:

If you will find the facts, perhaps others may find the explanation.

Watson was a great help to Holmes. Watson:

I was a whetstone for his mind. I stimulated him. He liked to think aloud in my presence. His remarks could hardly be said to be made to me–many of them would have been as appropriately addressed to his bedstead–but nonetheless, having formed the habit, it had become in some way helpful that I should register and interject. If I irritated him by a certain methodical slowness in my mentality, that irritation served only to make his own flame-like intuitions and impressions flash up the more vividly and swiftly. Such was my humble role in our alliance.

(Illustration of Sherlock Holmes and John Watson by Sidney Paget, via Wikimedia Commons)

Different lines of thought can approximate the truth. Bevelin quotes Dr. Joseph Bell:

There were two of us in the hunt, and when two men set out to find a golf ball in the rough, they expect to come across it where the straight lines marked in their minds’ eye to it, from their original positions, crossed. In the same way, when two men set out to investigate a crime mystery, it is where their researches intersect that we have a result.

Holmes makes the same point:

Now we will take another line of reasoning. When you follow two separate chains of thought, Watson, you will find some point of intersection which should approximate to the truth.

It’s essential to be open to contradictory evidence. Bevelin quotes Charles Darwin:

I have steadily endeavoured to keep my mind free so as to give up any hypothesis, however much beloved… as soon as facts are shown to be opposed to it.

Mistakes are inevitable. Holmes:

Because I made a blunder, my dear Watson–which is, I am afraid, a more common occurrence than anyone would think who only knew me through your memoirs.

Holmes remarks that every mortal makes mistakes. But the best are able to recognize their mistakes and take corrective action:

Should you care to add the case to your annals, my dear Watson… it can only be as an example of that temporary eclipse to which even the best-balanced mind may be exposed. Such slips are common to all mortals, and the greatest is he who can recognize and repair them.

Bevelin quotes the physician Oliver Wendell Holmes, Sr.:

The best part of our knowledge is that which teaches us where knowledge leaves off and ignorance begins.

(Oliver Wendell Holmes, Sr., via Wikimedia Commons)

In the investment world, the great investors Warren Buffett and Charlie Munger use the term circle of competence. Here’s Buffett:

What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

Buffett again:

What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.

Munger:

Knowing what you don’t know is more useful than being brilliant.

Finally, here’s Tom Watson, Sr., the founder of IBM:

I’m no genius. I’m smart in spots–but I stay around those spots.

 

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.

September 17, 2023

According to the Efficient Market Hypothesis (EMH), stock prices reflect all available information and are thus fairly valued. It’s impossible to get investment results better than the market except by luck.

However, Warren Buffett, arguably the greatest investor of all time and a value investor, has argued that he knows a group of value investors, all of whom have done better than the market over time. Buffett argues that there’s no way every investor in this group could have gotten lucky at the same time. Also, Buffett didn’t pick this group of investors after they already had produced superior performance. Rather, he identified them ahead of time. The only thing these investors had in common was that they believed in the value investing framework, according to which sometimes the price of a stock can be far below the intrinsic value of the business in question.

Buffett presented his argument in 1984. But the logic still holds today. The title of Buffett’s speech was The Superinvestors of Graham-and-Doddsville. The speech is still available as an essay here: https://www8.gsb.columbia.edu/articles/columbia-business/superinvestors

Despite the unassailable logic and evidence of Buffett’s argument, still today many academic economists and theorists continue to argue that the stock market is efficient and therefore impossible to beat except by luck. These academics therefore argue that investors such as Warren Buffett just got lucky.

Let’s examine Buffett’s essay.

Buffett first says to imagine a national coin-flipping contest. 225 million Americans (the population in 1984) get up at sunrise and bet one dollar on the flip of a coin. If they call correctly, they win a dollar from those who called incorrectly. Each day the losers drop out. And the winners bet again the following morning, putting cumulative winnings on the line.

After ten straight days, there will be approximately 220,000 Americans who correctly called ten coin tosses in a row. Each of these participants will have a little more than $1,000.

Buffett writes hilariously:

Now this group will probably start getting a little puffed up about this, human nature being what it is. They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping.

After another ten days of this daily contest, there will be approximately 215 flippers left who correctly called twenty coin tosses in a row. Each of these contestants will have turned a dollar into $1 million.

Buffett continues:

By then, this group will really lose their heads. They will probably write books on “How I turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning.” Worse yet, they’ll probably start jetting around the country attending seminars on efficient coin-flipping and tackling skeptical professors with, “If it can’t be done, why are there 215 of us?”

By then some business school professor will probably be rude enough to bring up the fact that if 225 million orangutans had engaged in a similar exercise, the results would be much the same – 215 egotistical orangutans with 20 straight winning flips.

But then Buffett says:

I would argue, however, that there are some important differences in the examples I am going to present. For one thing, if (a) you had taken 225 million orangutans distributed roughly as the U.S. population is; if (b) 215 winners were left after 20 days; and if (c) you found that 40 came from a particular zoo in Omaha, you would be pretty sure you were on to something. So you would probably go out and ask the zookeeper about what he’s feeding them, whether they had special exercises, what books they read, and who knows what else. That is, if you found any really extraordinary concentrations of success, you might want to see if you could identify concentrations of unusual characteristics that might be causal factors.

Scientific inquiry naturally follows such a pattern. If you were trying to analyze possible causes of a rare type of cancer – with, say, 1,500 cases a year in the United States – and you found that 400 of them occurred in some little mining town in Montana, you would get very interested in the water there, or the occupation of those afflicted, or other variables. You know it’s not random chance that 400 come from a small area. You would not necessarily know the causal factors, but you would know where to search.

Buffett adds:

I submit to you that there are ways of defining an origin other than geography. In addition to geographical origins, there can be what I call an intellectual origin. I think you will find that a disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville. A concentration of winners that simply cannot be explained by chance can be traced to this particular intellectual village.

Buffett then argues:

In this group of successful investors that I want to consider, there has been a common intellectual patriarch, Ben Graham. But the children who left the house of this intellectual patriarch have called their “flips” in very different ways. They have gone to different places and bought and sold different stocks and companies, yet they have had a combined record that simply cannot be explained by random chance…

The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between thevalueof a business and theprice of small pieces of that business in the market… Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of any interest to them. In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value.

As Ben Graham said:

Price is what you pay. Value is what you get.

The Efficient Market Hypothesis argues that the current value of any stock is already reflected in the price. Value investors, however, don’t believe that. Value investors believe that stock prices areusually correct – the market is usually efficient – butnot always.

Buffett speculates on why there have been so many academic studies of stock prices:

I always find it extraordinary that so many studies are made of price and volume behavior, the stuff of chartists. Can you imagine buying an entire business simply because the price of the business had been marked up substantially last week and the week before? Of course, the reason a lot of studies are made of these price and volume variables is that now, in the age of computers, there are almost endless data available about them. It isn’t necessarily because such studies have any utility; it’s simply that the data are there and academicians have worked hard to learn the mathematical skills needed to manipulate them. Once these skills are acquired, it seems sinful not to use them, even if the usage has no utility or negative utility. As a friend said, to a man with a hammer, everything looks like a nail.

Buffett then proceeds to discuss the group of value investors that he had selected decades before 1984. Why is it that the value investors whom Buffett had identified decades ago before ended up far outperforming the market? The one thing they had in common was that they distinguished between price and value, and they only bought when price was far below value. Other than that, these investors had very little in common. They bought very different stocks from one another and they also had different methods of portfolio construction, with some like Charlie Munger having very concentrated portfolios and others like Walter Schloss having very diversified portfolios.

Buffett shows the records for Walter Schloss, Tom Knapp, Warren Buffett (himself), Bill Ruane, Charlie Munger, Rick Guerin, Stan Perlmeter, and two others. For details on the track records of the value investors Buffett had previously identified, see here: https://www8.gsb.columbia.edu/articles/columbia-business/superinvestors

While discussing Rick Guerin, Buffett offered the following interesting comments:

One sidelight here: it is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately to people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find that you can talk to him for years and show him records, and it doesn’t make any difference. They just don’t seem able to grasp the concept, simple as it is. A fellow like Rick Guerin, who had no formal education in business, understands immediately the value approach to investing and he’s applying it five minutes later. I’ve never seen anyone who became a gradual convert over a ten-year period to this approach. It doesn’t seem to be a matter of IQ or academic training. It’s instant recognition, or it is nothing.

And when discussing Stan Perlmeter, Buffett says:

Perlmeter does not own what Walter Schloss owns. He does not own what Bill Ruane owns. These are records made independently. But every time Perlmeter buys a stock it’s because he’s getting more for his money than he’s paying. That’s the only thing he’s thinking about. He’s not looking at quarterly earnings projections, he’s not looking at next year’s earnings, he’s not thinking about what day of the week it is, he doesn’t care what investment research from any place says, he’s not interested in price momentum, volume, or anything. He’s simply asking: What is the business worth?

Buffett then comments on the nine track records he mentioned:

So these are nine records of “coin-flippers” from Graham-and-Doddsville. I haven’t selected them with hindsight from among thousands. It’s not like I am reciting to you the names of a bunch of lottery winners – people I had never heard of before they won the lottery. I selected these men years ago based upon their framework for investment decision-making. I knew what they had been taught and additionally I had some personal knowledge of their intellect, character, and temperament. It’s very important to understand that this group has assumed far less risk than average; note their record in years when the general market was weak. While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock. A few of them sometimes buy whole businesses far more often they simply buy small pieces of businesses. Their attitude, whether buying all or a tiny piece of a business, is the same. Some of them hold portfolios with dozens of stocks; others concentrate on a handful. But all exploit the difference between the market price of a business and its intrinsic value.

I’m convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.

Buffett then discusses risk versus reward. When you are practicing value investing, the lower the price is relative to probable intrinsic value, theless risk there is but simultaneously thegreater upside there is. As Buffett puts it, if you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expected reward is greater in the latter case.

Speaking of risk versus reward, Buffett gives an 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 the Post,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.

Buffett adds that you also want to be sure that the managers of the business are reasonably competent. But this is a very doable task.

Buffett concludes his essay by saying that people may wonder why he is writing it in the first place, given that it may create more competitors using value investing. Buffett observes that the secret has been out since 1934, when Ben Graham and David Dodd publishedSecurity Analysis, and yet there has been no trend towards value investing.

 

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.

August 27, 2023

I first wrote about Atlas Engineered Products (APEUF) on December 11, 2022, here: https://boolefund.com/case-study-atlas-engineered-products-apeuf/

Since then, the stock has increased 63%, from $0.54 to $0.88. However, the stock is still undervalued and it seems to have a sustainably high ROE (return on equity) of between 26% and 40%, which should allow the business and the stock to compound over time.

Atlas Engineered Products is a leading Canadian manufacturer of engineered wood products, including roof systems and roof trusses, floor systems and floor trusses, and wall panels.

Atlas’s specialist design team uses cutting edge design and engineering technology to ensure that their clients get consistent, accurate, top-quality products.

Atlas has acquired and improved 8 companies since going public in late 2017.

The market for roof systems and trusses, floor systems and trusses, and wall panels, is local because it is too expensive to transport such large items over a long distance. As a result, this market is extremely fragmented. There are hundreds of small regional operators with sales in the range of $3 to $15 million. Many of these operators need succession planning. Atlas thus has an opportunity to continue making acquisitions.

Atlas is providing an opportunity for many of these small operators for succession planning purposes.

At the same time, Atlas can profit from operational efficiences, technological advances, advantages of scale in procurement, and expanded product distribution. (Most small regional operators are unable or unwilling to invest in technology and automation.)

Atlas focuses on the higher added value and most scalable products. It quickly winds down or sells lower margin businesses.

The company aims to sell all of its products at all of its locations. In addition to the core product offering, Atlas is focused on complementary product lines chiefly related to engineered wood. The company also has an ongoing program of equipment upgrade and automation at all of its locations. Moreover, Atlas continues to expand its sales team.

Here is the company’s most recent investor presentation: https://www.atlasengineeredproducts.com/dist/assets/presentation/Investor-Deck-May-2023-Rev-2.3.8-compressed.pdf

Clients choose Atlas Engineered Products:

• • To save money: Atlas is cost effective and efficient, with national buying power and best-in-class design, production, and automation technology.
  • To save time: Offsite customized manufactured roof and floor trusses, and wall panels, can be installed onsite up to 5x’s faster than traditional stick frame construction.
  • For expanded product offerings: Roof, wall, and floor systems, and engineered wood products, offers customers a one-stop product delivery.
  • Atlas is environmentally friendly: it uses less energy to manufacture, and has fewer emissions and waste.

Here are the current multiples:

• • EV/EBITDA = 3.49
  • P/E = 9.16
  • P/B = 2.33
  • P/CF = 3.99
  • P/S = 1.24

Insider ownership is 18.7%, which is very good. TL/TA (total liabilities/total assets) is 41.5%, which is decent.

ROE is 26%, which is quite good. Normalized ROE is likely higher, although ROE would temporarily dip during a recession or slowdown (but Atlas would probably then have more good acquisition opportunities).

Over the longer term, demographics are a tailwind, as the Canadian government plans to admit 500,000 immigrants per year by 2025.

The Piotroski F_score is 7, which is good.

Intrinsic value scenarios:

• • Low case: During a recession and/or a bear market, the stock could fall 50% from $0.88 to $0.44.
  • Mid case: The current EV/EBITDA is 3.49, but in a normal environment it should be at least 6.0. That would mean the stock is worth $1.52, which is 72% above today’s $0.88.
  • High case: If the company can maintain its ROE of between 26% and 40%, while reinvesting most of its profits into both inorganic and organic growth, then Atlas’ profits and stock could continue to compound at a high rate over time.

Risks

The housing market is cyclical. Economies are slowing down as interest rates rise. There will likely be a recession (which would slow down organic growth but increase acquisitions) and/or a bear market.

 

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.

August 20, 2023

From the company’s website:

“Delta Apparel, Inc., along with its operating subsidiaries, DTG2Go, LLC, Salt Life, LLC, and M.J. Soffe, LLC, is a vertically-integrated, international apparel company that designs, manufactures, sources, and markets a diverse portfolio of core activewear and lifestyle apparel products under the primary brands of Salt Life®, Soffe®, and Delta… The Company specializes in selling casual and athletic products through a variety of distribution channels and tiers, including outdoor and sporting goods retailers, independent and specialty stores, better department stores and mid-tier retailers, mass merchants and e-retailers, the U.S. military, and through its business-to-business e-commerce sites. The Company’s products are also made available direct-to-consumer on its websites… as well as through its branded retail stores.”

I first wrote about Delta Apparel (DLA) here: https://boolefund.com/case-study-delta-apparel-dla/

At the time, the stock was at $30.01. We ended up selling most of our position at $28-29 (after having bought at $15.26).

Since then, the stock has declined over 75% to today’s $7.40. The company is in the process of reducing its inventory to pay off debt. This means the recent results have been poor and the next couple of quarters will also be rough.

Delta Apparel has two segments: Salt Life and the Delta Group.

Salt Life is a very popular brand in the Southeast U.S. Many people who love the outdoors, including the ocean, love the Salt Life brand. In 2022, Salt Life had sales of $60 million with operating income of $8.2 million. Also, the brand grew its number of stores at a healthy clip. There is much room for the Salt Life brand to grow. According to a writeup on Value Investors Club, the Salt Life brand could reach $500 million in sales, like Tommy Bahama.

Here is the writeup on Value Investors Club: https://valueinvestorsclub.com/idea/Delta_Apparel_/1415242928

The Delta Group includes two different businesses: a commoditized active wear business and a specialized digital printing business, DTG2GO. In a normal year, the active wear business generates $320 million in sales with an operating margin of 6-7%.

DTG2GO is a market leader in the direct-to-garment digital print and fulfillment industry, bringing technology to the supply chain of its customers. DTG2GO uses proprietary software to deliver on-demand, digitally printed apparel direct to consumers on behalf of the customer. DTG2GO has sales of $60 million with an operating margin of around 15%. DTG2GO does digital printing for companies including Fanatics and Redbubble. Fanatics, a $30 billion private company, stopped in-house printing and fulfillment, and has outsourced them to DTG2GO.

Important Note: Digital impressions are about 2% of total graphic impressions on clothing. There is huge room for growth here. Digital printing will allow almost any retailer to lower costs, reduce inventory, increase selection, and speed up delivery times.

Here are the normalized figures for Delta Apparel: EBITDA is $60 million, net income is $30 million, cash flow is $95 million, and revenue is $440 million.

The market cap is $51.9 million, while the enterprise value (EV) is $273.7 million.

Here are the multiples for Delta Apparel:

• • EV/EBITDA = 4.56
  • P/E = 1.73
  • P/B = 0.31
  • P/CF = 0.55
  • P/S = 0.12

Delta Apparel has a Piotroski F-Score of 6, which is decent. This will likely begin to improve some time next year, after the company has reduced its inventory and debt.

We measure debt levels by looking at total liabilities (TL) to total assets (TA). DLA has TL/TA of 64.7%, which is OK. The company is in the process of paying down its debt.

Insider ownership is important because that means that the people running the company have interests that are aligned with the interests of other shareholders. At DLA, insider ownership is approximately 16%. This is good.

• • Low case: The stock could decline 50% during a bear market or recession.
  • Mid case: The company should trade for a P/E of at least 10 based on normalized earnings of $30 million. That would be a market cap of $300 million, or a stock price of $42.86. That is 480% higher than today’s $7.40.
  • High case: Normalized earnings could reach $40 million. With a P/E of 12, that would be a market cap of $480 million, or a stock price of $68.57. That is over 825% higher than today’s $7.40.

 

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.

August 6, 2023

I first wrote up the idea of GNK in June 2020 here: https://boolefund.com/genco-shipping-gnk/

At the time, the stock at $6.94 a share was very cheap based on our five measures of cheapness:

• • EV/EBITDA = 4.60
  • P/E = 6.52
  • P/B = 0.34
  • P/CF = 2.07
  • P/S = 0.70

Now the stock is up to $13.94, but the stock is still very cheap.

The market cap is $610.8 million. Cash is $47.9 million, while debt is $153.5 million.

The company has a barbell approach to fleet composition: The minor bulk fleet provides stable cash flows, while the Capesize vessels provide meaningful upside and operating leverage if rates move higher.

The company’s strategy is to have net debt of zero, to pay regular dividends, and to make acquisitions at low prices using its stock.

The company continues to voluntarily pay down debt. The company has reduced its debt by $295.7 million since the start of 2021, a 66% reduction in debt.

As a result, the company’s cash breakeven rate has been reduced from $13,050 to $9,715, the lowest in the drybulk industry. This compares well to the $12,300 Q3 2023 TCE estimate to date based on fixtures for 61% of the quarter’s available days.

Meanwhile, the company has paid 16 consecutive quarterly dividends totaling $4.60 per share, which is 33% of its current stock price of $3.94.

Here are the current multiples:

• • EV/EBITDA = 3.78
  • P/E = 7.11
  • P/B = 0.62
  • P/CF = 4.73
  • P/S = 1.34

Insiders own 1.3% of the shares outstanding, which is worth about $7.9 million (at today’s stock price of $13.94). Insiders will obviously do well if they successfully lead the company forward.

Genco Shipping has a Piotroski F_Score of 7, which is decent.

TL/TA is 15.6%, which is excellent. This is a function of the company’s ongoing strategy to reach net debt of zero.

ROE is 8.9%, which is low. This is because rates are fairly low. When rates improve, ROE will improve.

Intrinsic value scenarios:

• • Low case: GNK could fall 50%, from today’s $13.94 to $6.97, if there’s a bear market and/or a recession.
  • Mid case: The company is worth an EV/EBITDA of at least 6. That would put fair value for the stock at $26.79, which is over 90% higher than today’s $13.94.
  • High case: The company may be worth an EV/EBITDA of 8. That would put fair value for the stock at $33.51, which is 140% higher than today’s $13.94.
  • Very high case: If rates improve significantly, EBITDA could increase at least 50%. If the company is worth an EV/EBITDA of at least 6, then the fair value for the stock would be $38.04, which is over 170% higher than today’s $13.94.

Risks

If there is a bear market and/or a recession, rates could collapse and the stock could drop 50% or more.

 

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.

July 30, 2023

Our investment in Global Ship Lease (GSL) has been one of our best ideas thus far.

Shipping is a terrible business. It is asset-intensive, with low returns on capital. There are short-lived booms and sustained busts. Also, the booms are impossible to predict with any precision.

However, if you can buy shipping stocks when they are significantly undervalued, you have good odds of earning high returns.

I first wrote up the idea of GSL in June 2020 here: https://boolefund.com/global-ship-lease-gsl/

At the time, the stock at $4.62 a share was extremely cheap based on our five measures of cheapness:

• • EV/EBITDA = 5.28
  • P/E = 1.93
  • P/NAV = 0.20
  • P/CF = 0.81
  • P/S = 0.29

These figures made Global Ship Lease one of the top ten cheapest companies out of over two thousand that we ranked.

We bought GSL stock in June 2020 at $4.57. Today the stock is at $21.58. The position is up over 370% so far, which makes it our best-performing idea.

But there still appears to be substantial upside for GSL.

Demand

70% of global containerized trade volume is in non-mainline routes–and these routes are growing faster than mainline routes. These routes are served by mid-sized and smaller containerships. This is where GSL focuses.

Supply

The supply of mid-sized and smaller container ships is constrained. The orderbook-to-fleet ratio for these ships is at 14.5%. It takes two to three years for shipyards to make a new ship. If all 25+ year-old ships were scrapped, then the annual growth rate for mid-sized and smaller ships would be about 1.1%.

GSL today

As of the end of Q1 2023, the total charter backlog is $2.1 billion, which is 2.5 years of contract coverage. GSL’s revenues, cash flows, and earnings are already set at high levels for the next 2.5 years.

Here are the current multiples for GSL:

• • EV/EBITDA = 3.23
  • P/E = 2.64
  • P/NAV = 0.35
  • P/CF = 1.88
  • P/S = 1.21

George Youroukos, Executive Chairman of the Board, recently acquired approximately $10 million of GSL’s stock. Youroukos clearly believes GSL’s stock is cheap. This brings Youroukos’ total position to 6.4% of GSL’s outstanding shares, worth over $50 million.

The Piotroski F_Score is 7, which is decent.

Cash is $162.2 million, while debt is $882.8 million. The company continues to pay down its debt and expects to have $757 million in debt by the end of 2023 and $588 million in debt by the end of 2024. Moreover, GSL has reduced its cost of debt from 7.56% in Q4 2018 to 4.53% in Q1 2023.

TL/TA (total liabilities/total assets) is 51.8%, which is pretty good.

ROE is 33.0%. The high ROE is due in large part to leverage. ROA is 13.7%, which is still decent.

The current dividend yield is 7.0%. Also, the company has bought back $33.8 million shares and has $6.2 million left to spend on buybacks. Because the stock is quite undervalued, the buybacks are very accretive for shareholders.

Here is GSL’s Q1 2023 earnings presentation: https://www.globalshiplease.com/static-files/a226750c-bb27-45e2-8017-a0183e07ad26

Intrinsic value scenarios:

• • Low case: If there is a bear market or recession, GSL could fall 50%, from today’s $21.58 to $10.79. This would be a major buying opportunity.
  • Mid case: Global Ship Lease has a P/E of 2.64, but should have a P/E of at least 6. That means the stock is worth approximately $49.05, which is about 127% higher than today’s $21.58.
  • High case: GSL should have a P/E of 8. That means the stock is worth about $65.40, which is over 200% higher than today’s $21.58.

Bottom Line

GSL is one of our best-performing stocks, up over 370% since we bought it in June of 2020. The Boole Microcap Fund continues to hold much of the position because GSL is still undervalued. If GSL hits $49.05, it will be up over 970% since we bought it. If GSL hits $65.40, it will be 1,330% since we bought it.

 

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.

July 23, 2023

Karora Resources (KRRGF) is a gold miner in Western Australia. I wrote up the idea of Karora Resources on November 21, 2021: https://boolefund.com/case-study-karora-resources-krrgf/

Since then, the company has increased its gold production, having just achieved a record 40,823 ounces in Q2 2023.

The market cap is $645.5 million, while enterprise value (EV) is $632.0 million.

Some time between 2024 and 2025, Karora will produce over 200,000 ounces of gold on an annual basis. Karora will also produce over 800 tons of nickel.

Revenue based on 200k ounces of gold and a gold price of $2,250 per ounce is $450 million. All-in sustaining cost (AISC) can be assumed to be $1,200 per ounce. So EBITDA for gold production would be approximately $210 million.

Revenue based on 800 tons of nickel production and a price per ton of nickel of $21,970 is $17.6 million. EBITDA for nickel production would be about $7 million.

Total revenue would be approximately $467.6 million. Total EBITDA would be $217 million. (Cash flow would be close to EBITDA.) And assuming the normalized profit margin is 17.4 percent, earnings would be about $81.4 million.

Here are the multiples based on these assumptions:

• • EV/EBITDA = 2.91
  • P/E = 7.93
  • P/NAV = 0.20
  • P/CF = 2.97
  • P/S = 1.38

• Karora Resources is exceptionally well-managed, led by CEO Paul Andre Huet and managing director of Australia Leigh Junk. The Karora team–despite numerous external headwinds–has met or exceeded every target it has set since its acquisition of HGO Mill in mid-2019.

Also, management owns 2% of the shares outstanding, which is worth about $13 million. That $13 million could become $26 million (or more) if Karora keeps executing.

Karora Resources has a Piotroski F_Score of 7, which is good.

Net debt is low: Cash is $68.9 million. Debt is $51.2 million. TL/TA is 37.2%, which is good.

Very importantly, Karora’s growth is internally funded by existing cash and cash flow. Karora is not relying on debt for growth.

Furthermore, Karora has massive exploration potential.

Intrinsic value scenarios:

• • Low case: Gold prices could fall. Also, there could be a market correction or a recession during which the stock could temporarily fall by 50% or more (from today’s $3.50 to $1.75). This would be a major buying opportunity.
  • Mid case: The P/E = 7.9 relative to 2024 production, assuming the gold price is around $2,250 per ounce. But the P/E should be at least 16 for a mid-tier, multi-asset gold producer in a top tier jurisdiction (Western Australia). This implies over 100% upside from today’s $3.50, or an intrinsic value of $7.09 per share. This does not factor in the company’s huge exploration potential.
  • High case: Gold prices could be much higher in an inflationary scenario. If gold prices reach $2,750, then with a net profit margin of 25%, earnings would reach $141.9 million. With a P/E of 16, KRRGF would be worth at least $12.98 per share. That is over 270% higher than today’s $3.50.

Note that Karora’s operations are in Western Australia, so there is very little political risk.

 

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.