Geoff Gannon November 25, 2016

Analyzing Stocks With a Partner

Someone who reads the blog emailed me this question:

“Buffett has Munger, and you have Quan. It seems like in this industry, a collaboration of minds can be a potent formula for long-term success if approached correctly. That said, how would you recommend investors/ aspiring portfolio managers to find a suitable partner who not only is able to shine light on your blind spots, but who can also be of one mind and culture?”


It’s a huge help to have someone to talk stocks with. But, I’m not sure it’s a help in quite the way people think it is. I think people believe that Buffett is less likely to make a big mistake if he has Munger to talk to, that I’m less likely to make a big mistake if I have Quan to talk to, and so on. I’m not sure that’s true. I know from my experience working with Quan that our thinking was more similar than subscribers thought. For example, one question I got a lot was who picked which stock. And that’s a hard question for me to answer. Some of that might be the exact process we used. I can describe that process a bit here.


When I was writing the newsletter with Quan, we had a stock discussion via instant messaging on Skype. We did this every week. The session lasted anywhere from maybe 2 hours at the very shortest to maybe 8 hours at the very longest. A normal session was 4-5 hours. So, we were talking for let’s say 4 hours a week about stocks. We weren’t talking about stocks we had already decided on. Instead we were just throwing out ideas for stocks we could put on a “watch list” of sorts. We called it our candidates pipeline. It was really a top ten list. So, instead of saying “yes” or “no” to a stock – what we did is rank that stock. We always had the stock Quan was currently writing notes on, the stock I was currently writing an issue on, and then 10 other stocks. In almost every case, once I started writing an issue – that issue did end up going to print. In most (but not all) cases, whenever Quan started writing notes on a stock – that stock eventually became an issue. But, there were probably 3 to 5 times that he started writing notes on a stock and yet we didn’t publish an issue on that stock. This was rare. Most stocks we thought about but eliminated were eliminated in the “top ten” stage.


So, we’d have a list of ten stocks that we weren’t yet doing but that we planned – if nothing better came along – to work on next. Let’s make up a list here. Let’s pretend #1 is Howden Joinery, #2 is UMB Financial, #3 is Cheesecake Factory (CAKE), #4 is Kroger (KR), #5 is Transcat (TRNS), and #6 is ATN International (ATNI). It would go on like this for 10 stocks. A lot of times there were stocks on there that we didn’t really love – but we had this rule that we had to always keep 10 stocks on the board. This kept us from ever saying an idea just wasn’t good enough. We were trying to do an issue a month – so the answer was that if it’s better than every other idea we have right now, it should be the next issue. This way of working – by making our next best idea the hurdle – was very helpful. Each week, as we’d talk, we’d move stocks up or down. So, maybe I would say that I had been reading about Cheesecake (since it’s number 3 on our hypothetical list) and I decided that its future growth prospects in terms of the number of sites it could open is just not high enough to justify its P/E. It might be fairly valued. But, it’s unlikely to be undervalued. So, I wanted to move it down the list. Well, instead of just moving it down the list – I had to say where I wanted to move it and what I wanted to move up in its place. In other words, I’d have to explain to Quan why I thought Cheesecake was a less attractive stock than Kroger, Transcat, and ATN International. Otherwise, the stock would stay where it was.


I’m sure that if each of us had done separate newsletters, we would have ended up with a different set of stocks than Singular Diligence covered. But, it’s not like Quan and I disagreed much on which stocks to do. I think we tended to be furthest apart in the earliest stages of considering stocks. Early on, we weren’t going to do any financial stocks. But, independently, Quan and I had kept looking at Progressive (PGR). This was an obvious choice for the newsletter. GEICO and Progressive are similar. Over the years, they’ve become even more similar. Progressive has a very long history of excellent stock returns (something we always looked at). Some value investors own it. I think it had been consistently buying back stock and it may even have been within spitting distance of a 5-year low when Quan and I first talked about the stock. Things like a continuously declining share count (“cannibals” as Munger calls them) and a 5-year low (we don’t look at 52-week lows – but we are interested in when a company seems to have gotten better while its share price has gone nowhere) would have attracted us to the stock. So, either I brought Progressive up to Quan or Quan brought Progressive up to me. And the other one said he’d already looked at the stock. And neither of us was sure at first whether we’d do it. It’s not that we didn’t like Progressive. We just weren’t sure we ever wanted to do an insurer. We had done HomeServe (a U.K. stock). But, the actual insurance aspect of HomeServe – the risks it takes – is extremely minor when compared to something like Progressive. Progressive is a true financial stock. It is taking tremendous underwriting risk. In fact, you won’t find many insurers that write more in premiums (and expect to cover more in losses) relative to their shareholder’s equity than Progressive. If Progressive suddenly had a combined ratio of 110 for 2-3 years in a row – the company would be insolvent. On the other hand, if Progressive had low equity levels and then had 2-3 years of its usual – very good – underwriting profit, it could quickly re-build an insufficient capital level to an overcapitalized position. Progressive takes very little investment risk. But, it takes huge underwriting risk. Premiums are very high relative to equity. It can – if it misprices its policies – wipe out a good chunk of its shareholder’s equity in a single year.


So, Quan and I thought about Progressive a lot. Did we really want to break the seal on financial stocks? Once we did Progressive, other financial ideas might start appearing on our top 10 list. I mean, if we can do Progressive – why not Wells Fargo?


And that’s exactly what happened. We saw how much Progressive was hurting because of low interest rates. I described it as “flying on one engine” because Progressive usually made profits on both investments and underwriting. But, the stock’s current P/E only reflected the underwriting profit. It had way more float than it had ten years ago – yet it wasn’t earning more investment profit than it had 10 years ago. If that was true of Progressive – it was probably true of some banks too. There had to be banks that had twice as much in deposits today as they did before the financial crisis – and yet they weren’t earning a penny more in income than they had before the crisis. The stock I’m describing here is Frost (CFR). I had mentioned it to Quan several times. But, we weren’t doing financial stocks. It’s just not something we ever planned to do. And so, whenever I mentioned Frost – Quan wouldn’t say there was anything wrong with Frost. He just said we weren’t doing financials. But then we had done Progressive. So, now we were doing financials. So, it was time to look at banks.


Warren Buffett has said something like – I’m paraphrasing here: the best investments are the ones where the numbers almost tell you not to invest, because then you are so sure of the underlying business.


I don’t think he is talking about numbers specifically when he says that. I don’t think that statement is an argument against value investing. It’s an argument against prejudice. So, Warren Buffett is – at heart – a value investor. He is going to make the mistake of passing on a great business because it trades at too high a P/E ratio more often than he’s going to make the mistake of buying a great business at too high a price. Well, we each have our own biases. I certainly have that same value bias that Buffett has. I have missed out on some stocks I should have bought because they were trading at an above average P/E ratio, EV/EBITDA ratio, etc. They looked expensive by all the usual metrics. I also have a bias against financials stocks. So does Quan. So, it took a lot for us to move in that direction. We didn’t do it for just any insurance company – we did it for Progressive. And then when we moved into banks, we didn’t just pick any bank – we picked Frost (CFR). Progressive is a much better business than almost any other insurer. Frost is a much better business than almost any other bank.


It’s interesting to talk about how we moved into doing banks at all. It took a lot of time. What happened was Quan had to do some research into the industry. He needed to gather information on a lot of banks and create some Excel sheets we couldn’t find ready made elsewhere. There were two reasons for this. One, we needed long-term data on the industry to prove that something like the 2008 financial crisis wasn’t more common than we thought. And, two, we needed many banks to draw from for potential picks. It was especially hard to come up with good banks. We thought we’d find a ton of them. If we’d been looking for banks that were cheap enough – value stocks – we might have found plenty. There are thousands of banks in the U.S. But, they aren’t equally attractive. Small banks don’t have the economies of scale of big banks. They tend to have higher expenses as a percent of their total earning assets. They also don’t have equally attractive deposit bases. I know the three banks I was most interested in from the start were: Frost (CFR), Bank of Hawaii (BOH), and Wells Fargo (WFC) because I was most comfortable with their deposit bases. We never did an issue on Wells. Quan looked at it for a very long time. I can’t think of another time where we talked so much about a stock we didn’t do. But, we did do issues on Frost and Bank of Hawaii.


We also did issues on Prosperity, BOK Financial, and Commerce (CBSH). We found those stocks as peers. Frost’s most natural peer in Texas is Prosperity. It’s the second largest bank in Texas. And then Frost’s closest peer in energy lending is BOK Financial. Commerce would have shown up as a peer of BOK Financial. And we were going to do an issue on UMB Financial. UMB is controlled by different descendants (I guess they’re cousins) of the founder of Commerce. So, members of the “Kemper” family control both Commerce and UMB. However, the lines of succession split off almost a century ago, so these people are not closely related even though the banks share the same founder and are both controlled by Kempers.


So, what can this tell you about working with an investing partner? Quan and I both had a bias against financial stocks. It may have taken us even longer than it would have if we were investing on our own to branch out into these stocks. Would I have written about Frost sooner if Quan hadn’t been so reluctant to do banks? Maybe. But, I certainly wouldn’t have done issues on Prosperity, BOK Financial, and Commerce without Quan. Those were much more his picks than mine. Without Quan, I might have eventually done issues on both Frost and Bank of Hawaii. I don’t know about Wells Fargo. Wells is a tricky idea to discuss. Quan and I both like the stock a lot. We thought – even at the time we were looking at the stock – that it was one of the cheapest banks we’d looked at on a normalized basis. And yet we didn’t do it. Quan was more insistent than me that we not do it. But, I’m not sure I’d do Wells if I’d been writing the newsletter on my own. I know I would have written about Frost first, Bank of Hawaii second, and Wells – if I ever decided to write about Wells – third. I was more comfortable with both Frost and BOH than Wells. Quan was more comfortable with all the banks we did than with Wells.


There are sometimes slight differences between Quan’s preferences and mine. For example, I told some subscribers who asked about it that Quan probably likes Prosperity (PB) a bit more than I do and I probably like Bank of Hawaii (BOH) a bit more than Quan does. But I like Prosperity fine. And Quan likes BOH fine. Maybe this reflects a difference that Quan is a little more comfortable with a long-term strategy of serial acquisitions and I’m a little more comfortable with a long-term strategy of continual stock buybacks. Prosperity is unusual in how many acquisitions it does. BOH is unusual in how much stock it buys back.


There’s a chance I would’ve done Wells if Quan wasn’t co-writing the newsletter. There’s a chance I would’ve done ATN International (ATNI) if Quan wasn’t co-writing the newsletter. I think ATNI is more likely than Wells. But, in most cases where we eliminated a stock – it was unanimous.


I’ll give just two examples. Two stocks we liked a lot – and thought were “good” bets in some sense – but eliminated from consideration were Western Union (WU) and Wells Fargo (WFC). However, we were pretty much in agreement that Wells was too difficult to understand and that we didn’t like the management at Western Union. If one person had each of these “hunches” alone – would they have ignored it? Maybe. So, maybe analyzing stocks in pairs helps build your confidence more than it helps you avoid your blind spots.