Posts By: Geoff Gannon

How to Become a Better Analyst – One Hour at a Time

Geoff here.

Over at Portfolio14, there is a good question about spending time researching new stocks as opposed to just adding to the same old positions:

Charlie Munger always says diversification is diworsification. My dilemma here is whether I should diversify in order to reduce my exposure to one single company. No matter how high my conviction is, there are always “unknown unknowns”. There is also this unhelpful thought urging me to divest: “Earning outstanding returns requires hardwork. If I keep on adding to just the same old position and not spending time to dig deep into other companies, I’m not working hard enough.”

(Portfolio14) 

This is a great question to ponder. On the one hand, I agree that diversification often leads to diworsification. On the other hand, it is important to practice, practice, practice:

A little over a year ago, Geoff Gannon wrote a post where he gave readers the salient financial information of company, but didn’t give the ticker/name of the company. He then had readers guess the stock price. It was an amazing little experiment derived from a quote of Warren Buffett where WEB goes on to say he likes to guess the stock price before looking at the actual price when he analyzes investments.

As always, WEB was well ahead of his time. Much work and study from behavioral finance/economics, like that of Daniel Kahneman, discusses the effects anchoring has on each of us. If we see a stock price before valuing the company, we will unconsciously fix our valuation near the actual price.

Ever since Geoff’s original post I have been fascinated by the experiment. I even went as far as making an Excel program that would randomly generate ticker from the Russell 3000, display the financial information with ticker and price hidden. I could then go about valuing the company and check my work to see how I was doing.

(Distressed Debt Investing)

What’s the solution here?

 

Be Focused in Your Buying – But Omnivorous in Your Research

Should you buy a lot of different stocks? Analyze a lot of different stocks but don’t buy them? Or take the Peter Lynch approach and buy tiny amounts of many stocks just to keep them on your radar – then only load up on the ones you really love?

It’s a tricky question. To gain experience you need to do something similar over and over again. But it can’t be exactly the same. Otherwise, you will become experienced just at that one task. If you become an expert at analyzing Microsoft (MSFT) – you will know how to analyze Microsoft, not how to analyze stocks generally.

 

Use Real World Examples to Master Abstract Concepts

There’s another complicated issue that has to do with patterns.

I think two of the surest signs of real mastery of a subject are:

• Ability to talk fluently about the subject in everyday language without use of jargon; ability to use short sentences; having

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Why I Concentrate on Clear Favorites and Soggy Cigar Butts

Geoff here.

The choice between concentration and diversification is a personal decision. But it is also a process decision.

There is nothing wrong with having 50 positions – if you can do that well – or 20, or 10.

I think people fool themselves into thinking they need to have 25 or 50 ideas. But there is nothing wrong with choosing to have that many.

 

Our Investing Heroes Thought Longer and Traded Slower – Check Their Turnover

Ben Graham and Walter Schloss both owned more than 50 stocks for most of their careers.

However, they turned their portfolios over much less frequently than people do today. So, even when operating at what was for them a frentic pace, they were still probably only adding one new position a month. Certainly not much faster than that. And sometimes much, much slower.

I think there is a limit to how many amazing decisions you can make in a month, a year, etc.

Running a portfolio in a way that requires a good idea every couple weeks is far beyond my abilities.

 

Limit the Number of Good Ideas Required – Not Necessarily the Number of Stocks Owned

But there are many ways to solve that problem. You can increase concentration. You can increase how long you hold a stock. Or you can buy entire groups of stocks at once. Buying a group of stocks sometimes qualifies as a single decision. I bought 5 Japanese net-nets at once, because I did not know enough about Japanese business to discriminate between Japanese companies that were both:

1. Profitable
2. Selling for less than their net cash

So I just bought up 5 such stocks at once. That was my way of making really just one big decision – going more than 40% into Japanese net-nets – without actually having to put 40% or 20% or something into a single Japanese stock.

There was no Japanese stock I felt comfortable putting 20% of my portfolio into. And I did not know how to get comfortable doing that – having never visited Japan and not being able to speak Japanese.

Language was actually the least of my problems investing in Japan. The divide in business culture between Japan and the United States was my biggest problem.

Sometimes, this can be a big issue in Europe as well. Especially when analyzing some companies in southern European countries.

 

There are Little Exceptions Hiding Everywhere – Europe, Asia, the Midwest

But it is best not to paint countries with too broad a brush.

I think a foreign investor’s image of American business includes stock analysts, earnings calls, and press releases. But there are thousands of public American companies – often far from either New York of Los Angeles – that are as tight lipped as any company you’ll find in less bombastic parts of the world.

I have found Japanese companies with the kind of business culture an American can understand and I have found Portuguese companies with the …

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One Good Idea a Year is All You Need to Beat the Market

Geoff here.

Someone who reads the blog asked me a question about why I don’t just use Joel Greenblatt’s Magic Formula to invest instead of picking my own stocks.

This lead to a discussion of what kind of results you can achieve picking your own stocks.

It’s a question closely related to portfolio concentration. I’ve never figured out how to perform well while holding a lot of stocks. When I’ve outperformed the market, that outperformance has really boiled down to just a few decisions.

Over the last 3 years, I’ve averaged less than one such performance powering investment.

 

The Power of One Good Idea a Year

I started managing a new account in January of 2009. That’s close to the perfect timing imaginable for having good returns. So these numbers are wildly inflated over what anyone can expect in the future.

Because it’s a single account, I have exact results for each year. Here are my returns:

2009: 41%

2010: 33%

2011: 21%

YTD: 0%

You can see I’m underperforming the S&P 500 this year.

The average number of stocks I’ve held has been about 5. The highest I ever owned at once was 11 – and that included some positions that never reached the size I wanted. My lowest number of positions at one time was 1, but that was when the majority of the account was in cash.

My outperformance was driven entirely by a few major successes:

1. IMS Health
2. Bancinsurance
3. Sanjo Machine Works (and Japanese net-nets generally)

 

IMS Health

IMS Health was a fairly large – over $1 billion market cap – stock with a wide moat. It was selling for less than 10 times free cash flow when I first bought it. Eventually, it was bought out by a private equity firm.

 

Bancinsurance

Bancinsurance was a niche property and casualty insurance company. It usually had a combined ratio under 100. Meaning it made a profit on underwriting. Not just on its investments. It was selling at about 60% of book value when I first bought it. Eventually, the CEO bought it out.

 

Sanjo Machine Works

Sanjo Machine Works was a Japanese company. I first bought it around 50% of its cash.  Eventually, the CEO bought it out.

 

Japanese Net-Nets (Generally)

My Japanese net-net investments were a departure for me in that I diversified across 5 stocks at once. They did better in Japanese Yen than I ended up doing because the Yen fell against the dollar. They still did fine. Sanjo was the star performer. The rest had modest positive results in dollar terms.

 

3 Years of Outperformance Really Just Due to 3 Decisions

I made other investments over the last 3 and a half years. But very few of them mattered. There were no big losses. Many of the other investments slightly outperformed or slightly underperformed the market while I owned them. But, together, they were pretty much a wash relative to the stock market.

So, my entire outperformance …

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Some Links You’ll Like

Geoff here.

I started this blog on Christmas Eve 2005. Back then, I used to link to things. I’d tell readers what interesting blogs were out there, etc.

I haven’t done that much lately. Mostly because of Twitter. If you aren’t following me on Twitter – you aren’t seeing links to the stuff I’m reading.

But sometimes a few interesting links pile up at once and I decide it’s worth mentioning them on the blog – not just on Twitter.

Today is one of those times.

 

Practice Truth, Fear Nothing – A Wall of Great Value Investing Posters

The creator of this site – Practice Truth, Fear Nothing – sent me a link to his “wall” of value investing and creative thinking/advertising. He’s in the advertising business. You may or may not like the stuff that applies to advertising. You’ll love that stuff that applies to value investing. Check it out.

 

Market Folly: Top Finance People to Follow on Twitter

Market Folly is a blog I always read. And I don’t talk about it enough on this site. If you follow me on Twitter, you know I read it. But if you just read this blog – you’d probably never know I read Market Folly.

Hopefully, this will change that. Twitter is a great resource for seeing what other value investors, bloggers, etc. are reading. Whenever I Tweet, there’s a link. I use it mostly to share reading material.

You can get a lot out of using Twitter for your investing. And you can start by following the folks on Market Folly’s list.

 

Interactive Investor Blog: A Must Read Blog Getting Even Better

I read Market Folly all the time. But I rarely talk about it on this blog. No idea why. I read Richard Beddard’s blog all the time. And I do talk about it on this blog. Again, no idea why one gets mentioned here all the time and the other doesn’t.

I hadn’t given it much thought until writing this post – when I thought about all the people who read this blog but don’t follow me on Twitter.

Anyway, Richard’s blog has been great for years. And I’ve been reading it for years. So I feel kind of silly recommending it over and over again.

That’s changed in the last year or so. Richard’s blog has been getting even better. One of my favorite features is Richard’s two minute drills. These are based on advice Peter Lynch gave.

Peter Lynch is underappreciated by value investors. Maybe his name is too well known or something. Maybe his advice is too simple. I don’t know. The guy always made sense to me.

Like Warren Buffett, Peter Lynch was especially good at thinking about how to think about stocks. He was good at knowing that it wasn’t enough to have the most info – you had to act right on the info you had.

Lynch was always really quick …

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Who is this Quan Hoang Guy? – And Why Is He on My Blog?

Someone who reads the blog sent me this email:

Geoff,

Who is this Quan Hoang guy? And why is he in your blog!!!!

Regards,

Gurpreet

Quan Hoang is someone I’ve emailed with since March 2011. So, well over a year now. He was a college student then. When I moved to Texas, Quan wanted to move out here and work with me.

Now, we get together each day and write. I will be blogging every day. And Quan will be writing too. So, you’ll see 2 posts a day at the blog.

The blog will be much more active than usual.

I think you’ll like it.

If you want to get to know Quan better, you can:

• Follow Quan on Twitter
• Talk to Quan

He’ll be a permanent fixture at Gannon On Investing. Which – you may have noticed – has been renamed Gannon (and Hoang) On Investing.…

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How Western Digital (WDC) Can Be a Good Investment – Even When It’s Not a Net-Net

Geoff once expressed a controversial opinion that he would only buy Western Digital (WDC) as a net-net. I totally agree with him. I consider buying WDC as one of the mistakes I made during the period that I formed my investment style. But defending his opinion is not the purpose of this post. On the contrary, I think WDC can be a good investment. So, I’m going to ponder over my mistake and talk about what changed my mind.

I bought Western Digital in September 2010 at $26. Without a full understanding of its margin of safety, I bought WDC for these reasons:

 

• Return on invested capital was always high, even in 2009.
• WDC is the best managed company in the industry.It has a more stable margin than its competitors.
• WDC had steadily grown market share while maintaining high profitability in an extremely competitive market. And became market leader soon after my purchase.
• P/E ratio was low and I thought Mr. Market’s view  would turn once  supply and demand balanced.
• I thought the iPad and other mobile devices are complementary goods, not substitute goods to the PC.
• I thought it would take a long time for solid-state hard drives to replace hard disk drives (HDDs), and WDC would have time to catch up with the first comers.

 

Another reason I bought WDC was its better financial position than Seagate (STX), which I bought later after a LBO rumor (another mistake!). I actually made 40% and 25% from WDC and STX, respectively, but those are my biggest mistakes. Why?

 

Buying The Right Stock is Not Enough – You Have to Hold It Too

Holding WDC and STX was stressful.

I waited for the balance between supply and demand. But then the earthquake in Japan disrupted the supply chain that affected PC sales.

Then data proved that I was wrong about mobile devices. Mobile devices did hurt PC sales. Lesson: don’t ever bet on something uncertain. You can be either right or wrong. I was wrong in this case. Perhaps a diversified portfolio of stocks with higher upside (when we are right) than downside (when we are wrong) will perform well but I think holding such a portfolio is too hard for most humans.

And a bigger problem. A lot of WDC’s assets are tangible assets, which has little use other than producing HDDs. With the condition at the time I bought, WDC  could have been undervalued but what if HDDs became obsolete by the time the stock price returned to intrinsic value? Its plants would become useless. Its past earnings would be meaningless. That’s why buying WDC at lower than net current asset value can provides a margin of safety. I’m not sure buying at a low P/E will.

A more simple risk, what if something bad happens to the plants? Then came the Thai flood which severely interrupted WDC’s operation. I was right about buying WDC as a cyclical. Earnings did increase by double digits. But …

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One Ratio to Rule Them All: EV/EBITDA

For understanding a business rather than a corporate structure – EV/EBITDA is probably my favorite price ratio.

 

Why EV/EBITDA Is the Worst Price Ratio Except For All the Others

Obviously, you need to consider all other factors like how much of EBITDA actually becomes free cash flow, etc.

But I do not think reported net income is that useful. And free cash flow is complicated. At a mature business it will tell you everything you need to know. At a fast growing company, it will not tell you much of anything.

As for the idea of maintenance cap-ex – I have never felt I have any special insights into what that number is apart from what is shown in actual capital spending and depreciation expense.

When looking at something like:

• Dun & Bradstreet (DNB)
• Omnicom (OMC)
• Carbo Ceramics (CRR)

I definitely do take note of the fact they trade around 8x EBITDA – and I think that is not where a really good business should trade. It’s where a run of the mill business should trade.

I guess you could get that from the P/E ratio. But when you look at very low P/E stocks – like very low P/B stocks – you’re often looking at stocks with unusually high leverage. And this distorts the P/E situation.

 

Which Ratio You Use Matters Most When It Disagrees With the P/E Ratio

The P/E ratio also punishes companies that don’t use leverage.

Bloomberg says J&J Snack Foods (JJSF) has a P/E ratio of 21. And an EV/EBITDA ratio of 8. Meanwhile, Campbell Soup (CPB) has a P/E of 13 and EV/EBITDA of 8. One of them has some net cash. The other has some net debt. J&J is run with about as much cash on hand as total liabilities.

They can do that because the founder is still in charge. But if Campbell Soup thinks it can run its business with debt equal to 2 times operating income – then if someone like Campbell Soup buys J&J, aren’t they going to figure they can add another $160 million in debt. And use that $110 million in cash someplace else.

And doesn’t that mean J&J is cheaper to a strategic buyer than its P/E ratio suggests.

That only deals with the “EV” part. What about the EBITDA part? Why not EBIT?

 

Don’t Assume Accountants See Amortization the Way You Do

The “DA” part of a company’s financial statements is usually the most suspect. It’s the most likely to disguise interesting, odd situations.

Look at Birner Dental Management Services (BDMS). The P/E is 21. Which is interesting because the dividend yield is 5.2%. That means the stock is trading at 19 times its dividend (1/0.052 = 19.23) and 21 times its earnings. In other words, the dividend per share is higher than earnings per share. Is this a one-time thing?

No. The company is always amortizing past acquisitions. So, the EV/EBITDA of 8 is probably a more honest gauge of …

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Best Place to Run Screens: StockScreen123 – Bloomberg.com Underrated

Someone who reads the blog sent me this email:

Geoff – 

Nice article on EV/EBITDA – no qualms here. I’m curious, however, where you run your screens? Being the cheap bastard that I am, I don’t subscribe to any specific data sites, so I’ve typically begun with google finance, which isn’t very helpful when it comes to non-GAAP criteria.

Thanks,

Jay

 

StockScreen123 is the Best Place to Run Screens – But It Takes Time to Learn

The best place to run screens – for the price – is StockScreen123. It is not user friendly. You need to read about how the functions work, etc. and experiment a bit. But it’s the best site by far.

I highly recommend it.

For U.K. stocks I use Sharelockholmes.

For worldwide, I don’t have a good (cheap) solution. A lot of people use the FT screener.

 

Bloomberg.com is Actually a Super Handy Site – If You Know What It’s Best At 

Blommberg’s (free) website has great coverage of just about every stock on planet Earth. They don’t have much data. But if you type in a public company name – that trades anywhere in the world – you’ll get basic info like EV/EBITDA.

Here are some obscure examples to prove my point:

• Precia (PREC:FP) 
• Otec (1736)
• Paradise (PARF)
• Watlington Waterworks (WWW:BH)

If they’ve got those companies – they’ve got everything.

So Bloomberg is a great resource when you know a company’s name but you aren’t sure whether it’s public or private, where it trades, etc.

I often start my stock research at Bloomberg.…

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How My Investing Philosophy Has Changed Over Time

Someone over at GuruFocus asked me about my background:

Hey Geoff, I recently started listening to some of the audio recordings you posted. You are really knowledgeable, what is your background? 

My educational background is that I am a high school dropout. My investing background is that I got interested investing when I bought my first stock at 14. That’s when I read Ben Graham’s Security Analysis and The Intelligent Investor.

 

My Investing Approach Has Drifted From Graham Toward Buffett

Over time, based on my own investing results, I probably became less of a Graham type investor and more of a Buffett type investor.

I made the most money by far buying and holding companies with strong competitive positions when they were temporarily priced at 6 or 10 or 12 times earnings. I also buy net-nets, net cash bargains, etc. But generally I like a reliable business with almost no history of losses and a market leading position in its niche. That’s probably more Buffett than Graham.

 

Hidden Champions of the 21^st Century is My Favorite Book  

My favorite book is: “Hidden Champions of the 21^st Century.”

Technically, it’s a business book – not an investing book. But business books are almost always more informative for investors than finance type books.

If I had to hand 3 books to someone who didn’t know anything about what it takes to be an investor – I’d hand him:

1. You Can Be a Stock Market Genius
2. The Intelligent Investor (1949)
3. Hidden Champions of the 21^st Century

If you aren’t in love with the idea of the treasure hunt after reading those 3 books – I don’t think you’ll ever become a value investor.

 

All I Really Know – Compounding, Mr. Market, Margin of Safety, Moats

If you know:

• The Berkshire/Teledyne stories
• Ben Graham’s Mr. Market Metaphor
• His margin of safety principle
• And you’ve read “Hidden Champions of the 21^st Century”

You have everything you need to make money snowball in the stock market.

 

All It Really Takes – Patience, Common Sense, and a Few Sound Principles

My feeling is – and it’s controversial, but it’s right – that if you’ve got those 4 ideas in your head and once a year you buy the very best stock you can and then you forget you own it for at least the next 3 years, you’re gonna do okay in the stock market.

You don’t need to know if you should be 100% in stocks or 100% in bonds – I was 100% in stocks when the dot-com bubble burst – and I’ve made more than 15% a year returns since then.

 

Most of the Advanced Concepts Are a Distraction – Forget Them

Now, true, I didn’t own any tech in 2000. I owned companies in groceries, snack foods, and video games. But that’s not because I was clairvoyant. It’s because I was a kid. I didn’t know any better. Over …

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Can You Screen For Shareholder Composition? – 30 Strange Stocks

Nate Tobik has a terrific blog post about shareholder composition over at Oddball Stocks called “Could Value Investors Be the Reason a Stock’s Cheap?”

I’ve often found companies with unusual shareholder composition to be interesting opportunities. That’s not exactly the point of Nate’s post. He wonders – correctly, I think – whether the sort of catalyst a value stock like George Risk (RSKIA) requires is something that gets folks other than value investors interested in the stock.

A change in the perception of what kind of stock a company is can have a huge influence on where it trades. If you look at Village Supermarket (VLGEA), it went from being a regional grocer valued at a discount to the big guys to being seen as a predictable stalwart of sorts. The increase in the ratio of price-to-earnings, price-to-book, and price-to-sales has been magical. The business has improved. But then Mr. Market has also valued improvement in the business at about 3 times more than he did just 10 to 15 years ago.

 

Who Owns a Stock Matters

I think shareholder composition often helps explain why a stock is cheap. However, it’s not always just a matter of whether the folks who own the stock are value investors, growth investors, etc.

 

Shares Are Sometimes Spread Around in Weird Ways

Sometimes – like at Solitron Devices (SODI) – shareholders are former creditors.

I read a recent blog post where someone had commented wondering why Solitron is a public company. That’s easy. Solitron was once a big public company. It went bankrupt. It just never went private.

The company you see today bears little resemblance to the company that went public. Instead, it’s the company that emerged from bankruptcy in the 1990s.

Other times, shareholders have become “lost” over the years. They’ve forgotten they own the stock. And they don’t trade it. This was the situation at George Risk.

And George Risk has made a point in its SEC filings of saying that paying a dividend on the stock helped remind “lost” shareholders about the stock – and helped them get these shareholders to offer shares on the open market. Where the company is a buyer of its own shares.

I once read an interview with the CEO of a family controlled, thinly traded bank. When asked why the company went public he said they wanted local businessmen to have a stake in the bank. They went public as something of a local PR ploy.

 

Warren Buffett Made Money on Stocks With Oddly Distributed Shares

Two of Warren Buffett’s big successes – National American Fire Insurance and Blue Chip Stamps – were stocks with very oddly distributed shares.

 

Warren Buffett and National American Fire Insurance

I told the story of National American Fire Insurance in “How Warren Buffett Made His First $100,000”:

This company was controlled by Howard Ahmanson. It’s a strange story. The original stock was pretty much worthless. It ended up being …

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