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What Most Investors Are Trying to Do

John Huber, who writes the Base Hit Investing blog and also runs the excellent BHI Member site, did an interview over at Forbes.com. In that interview, Huber says:

“(My) strategy is very simply to make meaningful investments in good companies when their stocks are undervalued.

This is obviously what most investors are trying to do…”

Like John, I used to think that this is what most investors were trying to do. However, the thousands of email exchanges I’ve had over the 12 years I’ve been writing this blog have taught me that most investors are not trying to “make meaningful investments in good companies when their stocks are undervalued.”

Let’s break this statement down to see what I mean:

1.       Make meaningful investments

2.       In good companies

3.       When their stocks are undervalued

We have 3 key words there:

1.       Meaningful

2.       Good

3.       Undervalued

 

Make Meaningful Investments

What is a meaningful investment?

 

“Meaningful Investments” According to Me

My minimum position size is around 20%. My maximum position size is around 50%. I usually own 3-5 stocks. I often have some cash.

At the start of this quarter, my portfolio was more concentrated than usual. I had 50% of my portfolio in my top stock alone, 78% in my top 2 stocks combined, and 92% in my top 3 stocks combined.

 

“Meaningful Investments” According to Joel Greenblatt

Quote: “After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to reduce risk is small.”

Answer: A meaningful investment is 13% to 17% of your portfolio (1/8 = 12.5%; 1/6 = 16.67%).

 

“Meaningful Investments” According to Warren Buffett

Quote: “Charlie and I operated mostly with five positions. If I were running $50, $100, $200 million, I would have 80 percent in five positions, with 25 percent for the largest.”

Answer: A meaningful investment is 16% to 25% (80%/5 = 16%).

 

“Meaningful Investments” According to Charlie Munger

Quote: “If you are going to operate for 30 years and only own 3 securities but you had an expectancy of outperforming averages of say 4 points a year or something like that on each of those 3 securities, how much of a chance are you taking when you get a wildly worse result on the average? I’d work that out mathematically, and assuming you’d stay for 30 years, you’d have a more volatile record but the long-term expectancy was, in terms of disaster prevention, plenty good enough for 3 securities.”

Answer: A meaningful investment is 33% (1/3 = 33.33%).

 

So, the above value investors (jointly) define a “meaningful investment” to be in the range of 13% to 33% of your total portfolio.

Over the last 12 years, I’ve discussed position size with dozens of individual investors. Maybe five of them take “normal” positions of 13% to 33% of their portfolio. I would estimate that at least 85% of investors do not try to …

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Risk Habituation and Creeping Speculation

In response to an email a reader sent about some of my recent posts on the difference between investment and speculation, I entered lecture mode…

 

I am especially worried about the tendency among readers to speculate using the logic that value investors (like me) are sometimes wrong (like in WTW) and these “investments” turn out to be speculations. Therefore, how is buying at 8 times EBITDA in what has historically been a fairly predictable company different from buying at 16 times EBITDA in a company that hasn’t historically been predictable? Aren’t they both speculations since you are always ultimately going to make money or lose money based on how right you are about the future?

 

Are You Better Off Than You Were 8 Years Ago? – Are You a Better Investor?

I feel this is an issue with the length of the latest bull market. Whether or not stocks are very expensive (and I do find them expensive generally, but this point still stands if I’m wrong about that), most readers of the blog have seen mostly good results from the stocks they’ve chosen to hold over the last 8 years now. Eight years is a long time. Many people have not even been following the same investment strategy for more than 8 years.

Their current approach has never been battle tested.

So, now I hear a lot from people who are more into paying up for higher quality, holding longer, etc. There are ways of implementing a strategy like that which work. But, I think the experience of the “recent” past is what gets them thinking in these directions.

Although I’m “only” 32, I was investing seriously (in terms of how much time I spent thinking about the subject) in 1999-2002 and in 2007-2009. Now, most years are not like 1999-2002 or 2007-2009. But neither are they like the run from the second half of 2009 through to today (the end of 2017). That kind of run is rarely this smooth. And so, when you have not seen a period with P/E multiples of even good stocks contracting 30% or 50% or more – you are less worried about the distinction between investment and speculation.

When you look at something I own like BWX Technologies (BWXT), which has performed well both as a business and as a stock, you see that it is now trading at 31 times earnings. It’s a great business. But, even if it is always recognized as a great business by the market – it may yet be assigned a P/E of 20 instead of 31. Great businesses sometimes trade at a P/E of 20. So, right there, you have the potential for a 35% decline in the price of this stock.

I still own the stock. And I’ll keep owning it till I know for sure that whatever new stock I want to buy is better than holding on to this stock. But, what is always foremost in my mind when …

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You Don’t Need to Know What a Stock’s Worth to Know It’s Cheap

Someone emailed me asking what sources they needed to study to get better at valuing stocks.

My answer was that the ability to come up with accurate valuations for public companies is overrated.

Why? Because…

It’s rarely important to know how to value a company. What’s important is the ability to recognize when a company is clearly selling for less than it’s worth and then acting on that knowledge.

For example, in a write-up I did on my member site (Focused Compounding) explaining why I put 50% of my portfolio into NACCO (NC) when it completed the spin-off of Hamilton Beach (HBB), I said that:

“I think of each share of NACCO as an inflation adjusted stream of free cash flow. As I’ve shown, I think the stream has a ‘coupon’ of greater than $3.25 and I bought it at $32.50. So, the yield is 10% or more and that’s effectively a ‘real’ yield.

The average U.S. stock has a free cash flow yield in the 4% to 5% range and that yield is not as well protected against inflation.

It’s true that NACCO’s yield will eventually decline as coal power plants shut down (although, in recent years, the tons of coal supplied has risen rather than fallen). However, I think of my ‘margin of safety’ as being the fact that it isn’t 100% certain these plants will shut down and they haven’t shut down yet. Till they do, cash will build up on the balance sheet of NACCO (the parent company) or it will pay out dividends, buy back stock, or acquire businesses unrelated to coal mining (as it did in the past).”

It’s important to note that:

1) I never said that NACCO’s cash earning power is $3.25 a share. I said it’s at least $3.25.

2) I never said that the right multiple for NACCO is 10 times FCF. I just said that a normal stock trades for 20-25 times FCF (a 4% to 5% FCF yield) and NACCO trades for no more than 10 times FCF.

In fact, in that same article, I walk through ways of estimating what cash earnings would be in a normal year for NACCO (now that’s it just the coal business). The range of earnings estimates these different methods give you actually cluster around $4.75 to $5.50 a share (not the $3.25 figure I cite). However, I didn’t think those numbers were important when the stock was at $32.50.

Why? Because…

Earnings of $4.75 to $5.50 on a $32.50 stock are overkill. You don’t need to know if a stock has a P/E of 6 to 7. What you need to know is how certain it is that a stock doesn’t have a P/E any higher than 10 to 11.

So, I spent more time focusing on the fact that the method of estimating earnings that was most conservative – using this year’s tons of production and multiplying it by the lowest ever profit per ton the company achieved in …

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Why Smart Speculations Still Aren’t Investments

I got an email in response to my earlier post about the line between investment and speculation. It’s a good email, so I want to quote it in full:

 

“Really interesting post today, but I was wondering how you would evaluate the Weight Watchers (WTW) situation. 

 

It seems like an investment that turned into a speculative situation.

 

I think there are a couple of cases like this where a seemingly safe investment turns into a very speculative situation. Fossil (FOSL) is another one that comes to mind. Even though it had some debt, nobody would think that it would have an existential crisis at some point due to changes in business and the weight of its debt. I don’t think anybody would have called it a speculation 3 years ago at over $100 a share. But on the other hand, it’s speculative now at under $7 a share.

 

On the other hand you have situations like Facebook (FB) which IPO’d at an extremely speculative price but the business turned out to be so strong that even at that price, it morphed into an excellent investment had the margins not expanded so much.

 

I’m not saying that’s the case for Amazon or Netflix today, but maybe it’s not so easy to distinguish between investment and speculation in some cases because there are factors that we cannot foresee or do not yet understand. If you have the knowledge that it’s almost certain the company will grow into and beyond the current valuation, then perhaps it would be a good investment at what others may consider to be a speculative price. 

 

If you know that a business could potentially come under hard times and the modest amount of debt it has could compound the problem, then a company with a very modest valuation may morph into a speculative stock at even 1/10th the original price a few years down the road.

 

In the end, a lot of it depends on what you really know I think.”

 

George Orwell wrote an essay called “Politics and the English Language”. One passage from that essay is helpful to quote here:

 

“The word Fascism has now no meaning except in so far as it signifies ‘something not desirable’. The words democracy, socialism, freedom, patriotic, realistic, justice have each of them several different meanings which cannot be reconciled with one another. In the case of a word like democracy, not only is there no agreed definition, but the attempt to make one is resisted from all sides. It is almost universally felt that when we call a country democratic we are praising it: consequently the defenders of every kind of regime claim that it is a democracy, and fear that they might have to stop using that word if it were tied down to any one meaning.”

 

The word “democracy” has an actual definition, etymology, and history we can trace. The etymology is Greek. It means literally …

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In 2017: What is the Line Between Investment and Speculation?

In a recent post, Richard Beddard mentions Ben Graham’s speech “The New Speculation in Common Stocks” and particularly how it ends with a quote from the Roman poet Ovid:

“You will go safest in the middle course.”

At the end of that talk, Graham adds: “I think this principle holds good for investors and their security-analyst advisors.”

What Graham is saying is that investors should avoid both stocks that are speculative because the underlying enterprise is speculative and stocks that are speculative because the price is speculative.

I agree with Graham on this one. And I think it helps clear up some confusion that readers have with my own approach to investing. I get a lot of questions from investors – each coming from one of the two opposing philosophical camps – that go something like this: “When I look at the stocks you own, I wonder are you really 100% a value investor?” That’s the question from the Ben Graham value camp. And then the other question goes something like: “When I look at the stocks you own, I wonder are you really 100% a wide moat investor?”

My answer to these questions tends to go something like this:

If you look back at all the stocks I’ve bought, how many times in my life have I ever really paid more than about a P/E of 15?

And, if you look back at all the stocks I’ve bought, how many times in my life have I ever really bought into a company with a weak competitive position?

Those – to me – are the two speculations the average investor slides right into without much thought.

1.       He speculates that this business he likes is not just better than other businesses but better enough to more than offset paying a higher than average price for the stock (that is, a P/E over 15).

2.       And he speculates that this business he likes will withstand the ravages of competition that are an ever-present part of capitalism.

Now, there are other kinds of speculations you can make. Readers are quick to point out that I own NACCO (NC) which is basically a speculation that no more than one of the coal power plants the company supplies will be shut down in the truly near-term future. I also own BWX Technologies (BWXT) which is a speculation that the U.S. Navy will continue to use aircraft carriers, ballistic missile submarines, and attack submarines – and that those 3 classes will be nuclear powered. I own Frost (CFR) which is a speculation on higher interest rates in the sense that if the Fed Funds Rate was never to rise from the level it is at today, my returns in Frost would be middling.

But when you stretch the word “speculation” that far, you demolish any distinction between investment and speculation in the way Graham used those words. The future is always uncertain. But, we have to be able to define the words “investment” and …

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