1. He can compromise by paying a higher price than he’d like to
2. He can compromise by buying a lesser quality business than he’d like to
3. He can compromise by not buying anything when he’d rather own something
You could use these 3 compromises as a test of what kind of investor you are.
A growth investor – like Phil Fisher – compromises by paying a higher price than he’d like. He won’t compromise on quality. So, he has to compromise on price. A value investor – like Ben Graham – compromises by purchasing a lower quality business than he’d like. He won’t compromise on price. So, he has to comprise on quality. Finally, a focus investor – like me – compromises by not owning any stock when he’d much rather be 100% invested.”
I get a lot of emails from people saying that my strategy has changed – I’ve become more of a growth investor and less of a value investor – over time.
It’s true that the investments I’ve made in recent years have definitely changed.
But, my philosophy has changed less than it would appear from my stock picks. I concentrate heavily and go where I see opportunities I consider “nearly certain” rather than being the highest return opportunities based on pure probabilities.
There is, however, one area where my philosophy really has changed:
I’m convinced that I should simply hold stocks indefinitely.
Why?
Let’s start with two spin-offs I bought. One spin-off happened 2 years ago. The other spin-off happened a little over 10 years ago.
First, the 2-year-old spin-off. I have 25% of my portfolio in BWX Technologies (BWXT). I bought that as part of a spin-off from Babcock & Wilcox. The stock has returned more than 30% a year in the two years since the spin-off. It now trades at a P/E of 26. Normally, this is when a value investor would sell the stock. However, I think the company can grow earnings per share by 10% a year for the next several years. I also think a company of this quality should always trade at a P/E no less than 25. So, with no new ideas that seem more likely to deliver returns of 10% a year or better – I have no intention of selling BWXT. With the catalyst from the spin-off gone and the P/E above 25 – no value investor would keep holding this stock. But I intend to. Does that mean I’m not a value investor?
It might mean that. But, it also may just mean I learned from the last spin-off I liked a lot.
About ten years ago, I picked a spin-off called Hanesbrands (HBI). Here’s a quote from a roundtable discussion I did back in 2006 (share prices are not adjusted for subsequent splits):
“However, there are many situations (and here is usually where you find some bargains) where the EV/EBIT measure is not the most useful. When I can predict a high free cash flow margin with confidence, I use a very long-term discounted cash flows calculation. For instance, this is what I would do with Hanes Brands which was recently spun-off from Sara Lee. On an EV/EBIT basis, it may not look cheap. But, looking truly long-term, I’m convinced the intrinsic value of each share is much closer to the $45 – $65 range than the roughly $23 a share at which it now trades. But, that’s a special case – Hanes is a special business.”
I gave that quote back in October of 2006. Hanesbrands stock has compounded at 12% a year in the 10 years since I made that comment (it’s compounded at 15% a year since the actual spin-off date).
“The stocks I pick don’t benefit much from well-timed sales. There’s usually little harm in holding on to them much, much longer than I do.
So, I’ve decided to hold the stocks I own indefinitely. When I find a really, really good stock idea – which might happen once a year – I will need to sell pieces of the stocks I already own to raise cash for that purpose. I’ll do that. So, if I’m fully invested and want to put 20% of my money into a new stock – I’ll have to sell 20% of each stock I now own. But, I’m not going to eliminate my entire position in a stock anymore. Those decisions to completely exit a specific stock haven’t added value for me. So, I’m not going to try to make them anymore.
From now on, I’m going to be a collector of stocks.”
Focused Compounding includes a “Library” with 27 stock reports. I co-wrote those stock reports with Quan Hoang between 2013 and 2016. Although Quan and I no longer work together, he agreed to put his thoughts on that experience in writing for our community members to read. I think reading Quan’s “Reflections” will help you put each of those 27 reports in better context.
Quan’s Reflections
Geoff asked me to write a reflection on my experience writing The Avid Hog (a newsletter we later renamed Singular Diligence). So in this post, I’ll share my experience and show why I believe stronger than ever that long-term investing is the best path to wealth.
Geoff and I started our venture in 2012. Initially we had been hired to start the research arm for a financial company. Right after my college graduation, I flew to Plano and was eager to work in person with him, who to me is like Ben Graham (or Phil Fisher) to Warren Buffett. However, due to some disagreement with our employer over the product we were developing, Geoff decided to quit. That night by a pond near both our apartments, Geoff told me that he was about to turn 28 and he did not like doing the job that he didn’t like just to find several years later too late to switch. He asked if I wanted to quit and partner with him. That was exactly my plan when I knew he quit because learning from him was the only reason I went to Plano.
So we start our venture without a clear direction. We just wanted to write a newsletter. I imagined that would be the best learning process for me. I would do in-depth research every day and my knowledge would compound. If I did a good job, the newsletter would bring in cash flow for me to invest and I could be financially independent. Even if the newsletter did not make money, I would still learn a lot. I was young and determined to become a great investor. I didn’t see any job that could truly train me as an investor (and I still don’t see today.) That’s also the reason why there are so few good investors. Most students are obsessed with getting a job. Investment banks would train you to be a next-quarter forecaster, not an investor. Most investment funds don’t have the right investment framework and spend most of their time watching the wrong kind of information. In general, once one gets a job (finance-related or not), he will enter a rat race, leaving them no time to seriously practice value investing. I didn’t like that path. I was young and I was willing to invest my time.
From that day on, I would go to Geoff’s apartment each day. We started by writing blog posts regularly to connect with our audience. That was the bad part of each day. I don’t like writing and I always struggle to find ideas …
Give each stock your absolute undivided attention – focus like you’ve never focused before (it’s fine if you can only do this for like 45 minutes at a time).
“I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches–representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did and you’d be forced to load up on what you’d really thought about. So you would do so much better.”- Warren Buffett
Many Buffett and Munger pupils preach following the “punch card mindset,” yet very few actually do. I really think applying this filter has made all the difference for me in my evolutionary process as an investor, and I’m quite confident it will dramatically improve your results as well; especially if you are striving to be a focused investor like Geoff and myself. What does following the punch card mindset mean to me? It means doing the due-diligence required to get to a level of certainty that you are willing to put 20%+ of your net worth in a single idea. It means not succumbing to the daily irrational swings of Mr. Market, and being able to stick to your original thesis if nothing fundamentally has materially changed within the business. It means not laying out capital unless you feel like the odds are so heavily in your favor that heads, you’ll make money, or tails, you can at least break even or not lose that much. It is easy to talk the talk, but actually putting it into practice can be much more challenging, as It should be. After all, why should It be easy to become rich? You need to be okay with the fact that not every stock you look at will be a punch card worthy investment. Logically speaking there would be no such thing as the punch card mindset if so. Success in investing to me is saying no a lot more than you say yes. The best part about investing though is even if you say “no” to an idea, the amount of work you did to get to that decision can be extremely useful to you. Everything in investing is all cumulative. All knowledge stores up like compound interest. So even if you feel like you are not getting anywhere because you are not finding any actionable ideas, trust me, you are. Just keep your head down and keep chugging along.
“The most important three words in investing may be: “I don’t know.” Having strong viewpoints on a lot of securities, and acting on them, is a sure-fire way to poor returns in my opinion. In my view, it’s easier to adopt this “I don’t know” ethos by focusing on the business first and valuation second, as opposed to the other way around. I’ve found that when valuation is the overriding driver of interest, I’m prone to get involved in challenging businesses or complicated ideas and liable to confuse a …
The other day, someone I talk stocks with on Skype asked how I normally go about starting my initial research into a stock. What documents do I gather?
Here’s what I said:
“Basically, I start by finding the longest series of financial data I can (GuruFocus, Morningstar, whatever) and then look at that along with reading the newest 10-K and the oldest 10-K in detail. So, 10-year+ financial data summary, 20 year old 10-K (or whatever), this year’s 10-K, and then the investor presentation if they have one, and the going public/spin-off documents if that’s online. Also, I read the latest proxy statement and the latest 10-Q as needed for info on management, share ownership, the balance sheet etc.”
I also check the very long-term performance of the stock. So, I will chart the stock – at someplace like Google Finance – against the market over a period of 20, 30, or 40 years.
So, here’s a full list of my usual sources:
1. Check long-term stock performance (what is the compound annual return in the stock over 20, 30, or 40 years?)
2. Find the longest series of historical financial data possible (search for a Value Line sheet, a GuruFocus page, or go to Morningstar or QuickFS.net to see the long-term financial results)
3. Read, highlight, and take notes on the latest 10-K (so 2016)
4. Read, highlight, and take notes on the oldest 10-K (On EDGAR, this is usually around the year 1995)
5. Read, highlight, and take notes on the company’s own investor presentation
6. Read, highlight, and take notes on the IPO or spin-off documents (On EDGAR, this will be something like an S-1 or 424B1)
7. Read, highlight, and take notes on the latest proxy statement (On EDGAR, this will be something like a DEF14A)
8. Read, highlight, and take notes on the latest 10-Q.
Why Check the Long-Term Stock Performance?
This is something a lot of value investors wouldn’t think of. But, I find it very useful. Any time you are looking at a stock’s performance your choice of start date and end date are important. The good news is that your start date will be fairly arbitrary if you just look as far back as possible. So, if the stock has 27 years of history as a public company – and you look back 27 years – you probably aren’t picking a price near an unusual low point in the stock’s history. In fact, you’re probably picking the IPO price, which will rarely have seemed a “value” price at the time. The other good news is that – as a value investor – you’re probably attracted to stocks that seem cheap now. They trade at low or at least reasonable multiples of earnings, EBITDA, sales, tangible book value, etc. This means that any stock you are looking at as a possible purchase is unlikely to be benefiting right now from a particularly good choice of an end point.
“Go Where There Are Network Effects” – Zero to One book, Peter Thiel
A business that has a strong and enduring Network Effect can be a great business to invest in. It is one of my favorite tools in my mental-model toolbox, and is one that I look for and think about often. The best part about a business that has a strong network effect is just like compound interest, it only gets better as the numbers get bigger. The simplest way to describe a network effect is when a product or service becomes more valuable as more people use it. For example, companies like Airbnb, Facebook, Microsoft, PayPal, eBay, Match Group and Twitter all have strong network effects. If a business can profit on this effect the rewards can be quite enormous. It can be a great starting point for investors seeking to find a business that has a wide and deep moat and a long runway for many years ahead.
People use Airbnb because they know there is a variety of different options to choose from when it comes to renting a place to stay, and “Hosts” list their houses on Airbnb because they know there’s an endless amount of people who are looking to rent instead of staying in a hotel.
People sign up and use Facebook because their friends and peers are signed up and use the website as well.
People continue to play video games on Xbox live because they know other people are gaming and competing on Xbox live.
PayPal is convenient because it is so popular, which encourages companies to accept payments from it.
Buyers use eBay because they know there will be a lot of sellers selling items, and sellers use eBay because they know there will be a lot of buyers buying items.
People swipe on Tinder because they know other people are swiping on Tinder.
People use Twitter because no one wants to miss Donald Trump’s tweets…. (I’m half-kidding here)
You get the point, right? Network effects can become significant after a certain number of users have been reached: this is the “Critical Mass” point. When the critical mass point has been achieved, the value obtained from this network effect can be greater than or equal to the price paid for the effect. What does that mean? It’s the point at which a growing company becomes more efficient, and no longer needs additional investment to remain economically sustainable. Charlie Munger always talks about learning the “big ideas” across many different disciplines, and critical mass comes from Nuclear Physics; where critical mass is defined as the smallest mass that can sustain a nuclear reaction at a constant level. When bringing this phenomenon into the investing world, it is about when a business becomes self-sustaining. Aiming to hit this critical mass point is the challenging part of business. This is why most tech companies are so focused on user growth and are often valued by user-progression, as opposed to traditional valuation …
Car-Mart (CRMT) now trades for $35 a share. I picked the stock for my old newsletter, The Avid Hog (you can read all 27 past issues of that newsletter here), when it was trading at $38 a share back in June of 2014. So, it’s now three years later. And the stock is now 8% cheaper. Do I like Car-Mart more today than I did in 2014?
No.
Ideally, a stock should be:
Cheap
Good
Safe
I’m not sure Car-Mart meets all 3 of those criteria. And I am sure it has a harder time meeting those 3 criteria today than it did back in June of 2014. But, let’s start with the criterion that Car-Mart clearly passes.
Receivables Per Share: The Right Way to Value Car-Mart?
Buy and hold investors value a business on its future cash earning power.
So, the correct way to value a business is usually to begin by finding the key determinant – the ultimate source – of a company’s future cash earnings and multiply that number by a second figure. For a timber producer, you’d use the acres of timberland. You might look at a company owning 500,000 acres of timberland and see that buyers normally pay $600 an acre for such land. Based on that, you’d say the business is worth $300 million. If this corporation currently had $120 million in debt on its books, you’d then say all the common stock combined was only worth $180 million. If there were 9 million shares outstanding, you’d say each share of stock was worth $20 a share. In this way, you’ve done an entire calculation for a single share of stock based on something that is:
Constant
Calculable
and consequential
The amount of timberland a company owns varies much less from year-to-year than reported earnings. It’s a “constant” figure. It’s also a very easily “calculable” number. The company states the number of acres it owns in the 10-K each year. Finally, the quality and quantity of acres of timberland owned is clearly the most “consequential” number there is for such a business. Different owners, different managers, different ways of running the business could squeeze a little more profit or a little less profit from the business from year-to-year. But, how much land the company owns and where it owns that land can’t be changed. Clearly, the quality and quantity of acres of timberland owned is the key determinant – the ultimate source – of this company’s future cash earnings.
What is the ultimate source of Car-Mart’s future cash earnings?
What one number can we find that is: 1) constant, 2) calculable, and 3) consequential? We need to find the “essential earnings engine” for Car-Mart.
It’s receivables per share.
Here’s how I explained the right way to value Car-Mart, back in 2014:
“Car-Mart’s value over time should mirror its per share loan balance. This loan balance is what creates value for Car-Mart. So, it is receivables – net of the provision for …
I picked Grainger (GWW) for a newsletter I used to write. The pick was made in April of 2016. Grainger traded at $229 a share when I picked it. Today, the stock trades for $188 a share. That’s one reason to look at the stock now.
Reason #1 for considering GWW:
I picked the stock when the price was 22% higher than it is now.
There’s another. Over the last twelve months, here’s how Grainger’s stock performed versus the shares of is two closest peers.
Grainger: (16%)
Fastenal (FAST): (2%)
MSC Industrial (MSM): +19%
I picked MSC Industrial for the newsletter too. Last year, one of the questions I had to ask myself was which stock I liked better: Grainger or MSC Industrial? Back then, it was a tough question. Today, it should be a lot easier to answer.
Reason #2 for considering GWW:
Grainger is now 14% cheaper relative to Fastenal and 29% cheaper relative to MSC Industrial than it was a year ago.
So, is Mr. Market right? Does Grainger really deserve a downward re-valuation of 14% versus Fastenal and 29% versus MSC?
Before we can answer that question, we need to know why I picked Grainger in the first place.
Reason for Picking Grainger in the First Place
I thought Grainger was a Growth At a Reasonable Price (GARP) stock. Here’s what I wrote a year ago:
“…Grainger can grow sales by at least 5% a year. Profit growth should be more than 5% and less than 8% a year. At that pace of growth in sales, Grainger would return two-thirds of its earnings each year. So, if you bought Grainger at around a P/E of 16 or 17, the company would pay out 4% of your purchase price each year in buybacks and dividends while companywide profit would grow 5% to 8% a year. Your return in the stock would be in the 9% to 12% a year range. This is far better than you’ll get long-term in the S&P 500. So, Grainger is a ‘growth at a reasonable price’ stock even when priced as high as 17 times earnings and when growing sales as slowly as 5% a year. The combination of margin expansion and share buybacks mean the company could grow sales as slow as 5% a year and yet grow earnings per share at close to 10% a year. The ‘growth’ in ‘growth at a reasonable price’ that an investor should care about is only earnings growth and only in per share terms. It doesn’t matter whether companywide sales grow 10% a year or 5% a year if EPS growth is 10% a year in both scenarios, the stock is no more or less valuable due to the difference in sales growth. Companywide sales growth doesn’t benefit shareholders. Only growth in earnings per share makes any difference to an investor. So, by that measure, a stock with a P/E of 15 or 20 …
