Insider Buying vs. Insider Incentives

A blog reader sent me this email:

“Do you ever pay attention to insider transactions when analyzing a company?”

I do read through lists of insider buys from time-to-time. I follow a blog that covers these kind of transactions. But, I can’t think of any situation where I incorporated insider buying or selling into my analysis.

Learn How Executives are Compensated

I can, however, think of situations where a change in how insiders were compensated was included in my analysis. For example, years ago, I was looking at a stock called Copart (CPRT). It had a high enough return on capital and generated good enough cash flow that it was going to have more cash on hand than it could re-invest in the business pretty soon. Up to that point, it had been able to plow a lot of the operating cash flow back into expanding the business. However, it seemed like they had gotten too big to keep that up. So, they were going to have to buy back stock, pay a dividend, do an acquisition, or let cash pile up on the balance sheet.

I saw that the Chairman and the CEO (two different people, the CEO is the Chairman’s son-in-law) were now going to be compensated in a form that meant the share price a few years down the road is what mattered (if I remember right: compensation would now be a big block of five-year stock options combined with an elimination of essentially all other forms of compensation for those next 5 years). I had also read an interview with the Chairman (it was an old interview I think) where he didn’t strike me as the kind of person who was going to venture out beyond his circle of competence if and when he had too much cash.

So, I felt the likelihood of big stock buybacks happening soon was high.

To answer your question: no, I don’t really pay attention to insider buying and selling. But, yes, I do pay attention to whether insiders own a lot of stock, how they are compensated (what targets the company has for calculating bonuses), etc.

I can think of one situation where both the company and the CEO were buying a lot of stock at the same time. And, I should have bought that stock. If I had, I would’ve made a ton of money. However, to be honest, even if the CEO wasn’t buying shares and the company wasn’t buying back stock I should’ve seen this was a stock to bet big on.

It was trading for less than the parts would’ve fetched in sales to private owners. It was an obvious value investment. And that’s probably why insiders were buying.

Insiders Are Like You – Only Confident

Insiders tend to be value investors in their own companies. So, I think outside investors assume that insiders are acting more on inside information and less on just pure confidence than is really …

So: Am I Keeping Stocks Forever Now – Or Not?

There is a discrepancy between two posts I wrote. One is this post at Focused Compounding. Another is yesterday’s post here on this blog. A reader pointed this out:

In your post on NACCO from 15 December 2017, you state: “I don’t trade around a position. I buy all my shares at one point and sell all my shares at another.”

However in your post from 29 May 2017, your verdict is: “Geoff will never voluntarily exit a position entirely. Once he owns a stock, he’ll keep owning at least some of that stock forever unless that company is taken over or goes bankrupt. He will simplify things down to a true “buy and hold” approach. No thought will be given to selling a stock ever again.”

Don’t you think that these two statements are contradictory? Do you have a true “buy and hold” approach?

I don’t have a true buy and hold approach. I’m not a buy and hold investor. I’m always 100% open to selling a stock because I no longer like something about the business, the balance sheet, the management, the capital allocation, etc.

However, I’m not really open to selling a stock because it’s gotten too expensive.

Keep in mind: I find new stocks to buy over time. There are dry spells. Recently, I went almost two years without buying anything. But, my tendency to feed new ideas into the portfolio – in big initial position sizes – means that old ideas tend to become a smaller part of my portfolio over time.

So, even if a stock does become more expensive, I’d still be selling some shares of that stock over time just to fund new purchases. The stock could rise as a percent of my portfolio, but I’d still have sold shares in it. Two good examples are Frost and BWXT. Frost is a more than 25% position now (so, it’s slightly bigger in percentage terms than when I first bought it even though I’ve sold shares) and BWXT is close to a 15% position now while it was only originally part of a 20% position that got broke up (I bought Babcock & Wilcox stock pre-spinoff). I’ve sold about a third of BWXT and Frost, and yet they’re both just about the same percentage of my portfolio as when I first bought them.

Having said that, it should tend to be the case the the “stale” ideas in my portfolio will tend to get sold down and the “fresh” ideas in my portfolio will tend to be the biggest positions. The one exception to this would be if something in my portfolio was rising in price at a really unusual – probably very momentum driven – way.

It’ll be an interesting test of my resolve not to sell based on price if and when that ever happens.

So, I’m always open to selling a stock because I no longer like that stock (however, …

Why I Spend 95% of My Time Thinking About New Stocks

I’ve done a couple posts recently that have too many “rules” type statements in them. As investors: it’s less important what we tell ourselves we’re doing and more important what we’re actually – habitually – doing.

So, how do I spend my day?

If I told you I spend 95% of my time thinking about new stock ideas and 5% of my time thinking about the stocks I already own – I’d be exaggerating how much time I spend thinking about the stocks I already own.

I’m on a constant quest to find new stocks. That might not be obvious judging by how rarely I buy something new. But, that’s how I spend my days. I’m always looking to buy something new.

I don’t really think about what I own. And I don’t really think about “selling right”.

I just think about “buying right”.

Which really consists of:

1)      Picking the right business to be in

2)      Paying the right price

Using NACCO as an example, I decided early on in my research on that spin-off that the coal business was the business I wanted to be in and the small appliance business was the business I didn’t want to be in. It then became a question of the price I was willing to pay.

In very rough terms, I’d decided that I wanted to pay less than $40 a share for the coal business. When I first looked at the price after the spin-off, the coal business was selling for about $32.50. So, I bought it.

The truth is: I’m not really going to re-visit NACCO at all – except sometimes to write a little about it – till the end of 2018.

Someone asked me recently if writing about stocks made me a better investor or a worse investor. I’ll answer that question on the first Q&A episode of my new podcast (reminder: read this post, and send us a question if you get a chance).

It certainly makes me a different investor. The investor part of me spent all my time thinking about NACCO before buying it. The writer has spent all his time thinking about NACCO after buying it.

If I wasn’t writing about the stock, I would’ve bought it in October 2017 and then only checked in again with it around December 2018.

I’ve always thought my attention is best spent focused 100% on finding new ideas. And I know from past experience that thinking a lot about what you own is as likely to hurt your returns as to help those returns.

I know that a lot of attention and effort spent on a stock in the research phase generates better returns. I’m not sure that extra attention and effort spent on a stock you already own generates better returns.

For some people, I think it leads to worse returns.…

A U.S. Corporate Tax Cut is Not Priced into Stocks

Why I Don’t Use WACC

A blog reader emailed me this question about why I appraise stocks using a pure enterprise value approach – as if debt and equity had the same “cost of capital” – instead of using a Weighted Average Cost of Capital (WACC) approach:

“…debt and equity have different costs. In businesses with a (large) amount of the capital provided by debt at low rates, this would distort the business value. In essence I am asking why do you not determine the value of the business using a WACC, similar to how Professor Greenwald proposes in Value Investing: From Graham to Buffett and Beyond. The Earnings Power Value model seems theoretically correct, but of course determining WACC is complicated and subject to changes in the future. Nevertheless, your approach of capitalizing MSC at 5% is basically capitalizing the entire business value, including the amount financed by debt, at what is presumably your cost of equity for a business with MSC’s ROIC and growth characteristics. Perhaps I am coming at this from a different angle than you, but it seems a little inconsistent from the way I am thinking about it, and for businesses with more debt this would lead to bigger distortions. AutoNation would be a good example of a business with meaningful…debt that this approach would distort the valuation on.”

When I’m doing my appraisal of the stock – this is my judgment on what the stock is worth not whether or not I’d buy the stock knowing it’s worth this amount – I’m judging the business as a business rather than the business as a corporation with a certain capital allocator at the helm. Capital allocation makes a huge difference in the long-term returns of stocks. You can find proof of that by reading “The Outsiders”. Financial engineering makes a difference in the long-term returns of a stock. You can read any book about John Malone or Warren Buffett to see that point illustrated.

But, for me…

My appraisal of Berkshire Hathaway is my appraisal of the business independent of Warren Buffett. Now, knowing Warren Buffett controls Berkshire Hathaway would make me more likely to buy the stock and to hold the stock. So, it’s an investment consideration. But, it’s not an appraisal consideration for me. When I appraise Berkshire Hathaway, I appraise the businesses without considering who is allocating capital. Otherwise, I’d value Berkshire at one price today and a different price if Warren died tomorrow. I don’t think that’s a logical way to appraise an asset. Although I do think that buying an asset that’s managed by the right person is a good way to invest.

A good example of this is DreamWorks Animation (now part of Comcast). Quan and I valued DreamWorks Animation at a level that was sometimes more than double the stock’s price.

There was a point where we could have bought the stock at probably 45% of what we thought the business was worth.

However, we asked each …

Stocks You Can’t Buy

The always interesting Japanese stock blog (it’s written in English), Kenkyo Investing, has a post on a negative enterprise value stock called Hokuyaku Takeyama. The reason this stock is cheap is because it trades on the Sapporo Stock Exchange – not one of the more popular exchanges like Tokyo or Osaka. Very few stocks only trade on the Sapporo Stock Exchange. So, very few investors make the special effort to do business with a broker who will give them access to this exchange.

Watlington Waterworks (Bermuda Stock Exchange)

I wrote about a similar situation in March of 2011. That stock was called Watlington Waterworks. It’s a water company on the island of Bermuda. Because it’s on the island of Bermuda – a rich, densely populated remote island with no fresh water – the economics of Watlington Waterworks are generally superior to all other water companies around the world. And yet – in March of 2011 – the stock traded for lower multiples of earnings, book value, etc. than other water companies. In the 7 years since I wrote about Watlington Waterworks, the stock has risen in price by about 9% a year. It also paid a dividend. So, holders of the stock got 10%+ owning something that was a true diversifier in their portfolio (Watlington’s price doesn’t move based on how the Dow Jones, Nasdaq, or S&P 500 are doing). In fact, on many days, it doesn’t move. What’s more impressive is that Watlington returned more than 10% a year over 7 years while finishing that period with a P/E ratio less than 12, a price-to-book ratio less than 1, and a rock solid balance sheet.

Many stocks have returned more than 10% a year over the last 7 years. However, very few stocks that returned more than 10% a year now have a P/E under 12, a P/B under 1, and a solid balance sheet. Meanwhile, many companies that now have a P/E under 12 and a P/B under 1 have returned far worse than 10% a year over the last 7 years. In other words: Watlington is rare in the sense it combines a 7-year total return performance that has been adequate with a stock price that has always remained at an investment level rather than straying into speculative levels like most stocks. Basically, it’s been a decent “set it and forget it” investment. The business has never really performed badly. And the stock’s price has never really been anything but cheap.

Also worth mentioning is the way I presented Watlington Waterworks. I showed the company’s recent financial results on this blog – but didn’t give out the company’s name or business description. Readers then guessed where the stock traded. Back in 2011, almost everyone came up with a guess in the $20 to $30 price range. At the time, the stock traded at $14.

What Ben Graham Would Really Be Buying Today

These are the kinds of stocks you want to find …

Why You Might Want to Stop Measuring Your Portfolio’s Performance Against the S&P; 500

Someone emailed me this question about tracking portfolio performance:

“All investors are comparing their portfolio performance with the S&P 500 or DAX (depends were they live). I have asked a value investor why he compared the S&P 500 performance with his portfolio performance…for me as a value investor it makes no sense. A value investor holds individual assets with each of them having a different risk…it’s like comparing apples and oranges.

The value investor told me that…Warren Buffett compares his performance with the S&P 500. But I believe he did it, because other investors…expect it or ask for such a comparison.

How do you measure your portfolio success? Do you calculate your average entry P/E and compare it with S&P500 or Dow P/E to show how much you (over)paid for your assets? Or do you avoid such a comparison and calculate only the NAV of your portfolio?”

I don’t discuss my portfolio performance on this blog.

And I think it’s generally a good idea not to track your portfolio performance versus a benchmark.

It’s certainly a bad idea to monitor your performance versus the S&P 500 on something as short as a year-by-year basis.

Why?

Well, simply monitoring something affects behavior. So, while you might think “what’s the harm in weighing myself twice a day – that’s not the same thing as going on a diet” – in reality, weighing yourself twice a day is a lot like going on a diet. If you really wanted to make decisions about how much to eat, how much to exercise, etc. completely independent of your weight – there’s only one way to do that: never weigh yourself. Once you weigh yourself, your decisions about eating and exercising and such will no longer be independent of your weight.

Knowing how much the S&P 500 has returned this quarter, this year, this decade, etc. is a curse. You aren’t investing in the S&P 500. So, tethering your expectations to the S&P 500 – both on the upside and on the downside – isn’t helpful. The incorrect assumption here is that the S&P 500 is a useful gauge of opportunity cost. It’s not.

Let me give you an example using my own performance. Because of when the 2008 financial crisis hit, we can conveniently break my investing career into two parts: 1999-2007 and 2009-2017.

Does knowing what the S&P 500 did from 1999-2007 and 2009-2017 help me or hurt me?

It hurts me. A lot.

Because – as a value investor – the opportunities for me to make money were actually very similar in 1999-2007 and 2009-2017. In both periods, I outperformed the S&P. However, my outperformance in 2009-2017 was small while my outperformance in 1999-2007 was big. In absolute terms, my annual returns were fairly similar for the period from 1999-2007 and 2009-2017. It is the performance of the S&P 500 that changed.

Many value investors have a goal to outperform the S&P 500. But, is this a useful goal?

I don’t think so. …

The Risk of Regret: NACCO (NC)

Someone emailed me this question about NACCO (NC):

“If you don’t mind me asking, why do you so strongly recommend other people not buy the stock given your obvious high conviction? It seems like a classic value situation where a company in a hated industry (coal) with a long-term bleak outlook has an individual player (NC) where the cash flow characteristics are more than enough to justify the current stock price. If you prefer not to answer because your answer is embedded in your member-only site, I totally understand, but I am quite intrigued. For what it’s worth, I am not at a point where I am seriously considering NC for potential investment – I am more interested in Frost (CFR), although I would prefer it to come down more. I am just trying to understand the business and what a fair price for it is. It seems to me that if we had 100% certainty that all the contracts would remain viable for a couple of decades, then NC is easily worth say double where it trades now, but the name of the game is in handicapping the risks of the mines closing, and I would be interested in your thoughts about doing that. It’s obvious that you view this risk as worth the price paid, but I am curious why you do not think others should take the same risk.”

I’ll quote from the write-up I did on the Focused Compounding member site. I had sub-titled sections in this write-up. So, let’s just bullet point the headlines that appeared in the article.

They were:

* All value comes from the unconsolidated mines

* There are risks

* NACCO’s business model

* Each share of NACCO is backed by 5 tons of annual coal production

* NACCO makes anywhere from 57 cents to $1.75 per ton of coal it supplies

* Side not: amortization of coal supply contracts

* NACCO vs. NACoal

* Quality of earnings

* Risk of catastrophic loss

* How I “frame” NACCO

* Why I don’t recommend NACCO shares

You asked about “why I don’t recommend NACCO shares” and that’s one of the section headers. So, let’s look at that part:

“I put 50% of my portfolio into NACCO. But, I think people reading this should put 0% of their portfolio into NACCO. As long as electricity demand in the U.S. is declining and natural gas production is rising, coal power plants will shut down. As a shareholder of NACCO, you could wake up any morning to the news that the company has lost 35% of its earnings overnight. I don’t think this is a risk most investors can handle.

Therefore, I don’t recommend anyone invests in NACCO even though it’s now my biggest position.

Let me be clear: I’m not just saying this is a ‘perceived’ risk you may want to avoid.

It’s a real risk.

NACCO is a risky stock.

I absolutely can’t prove that all …

Do I Think About Macro? Sometimes. Do I Write About Macro? Never.

When writing about a stock, it’s always easier to use a more conventional estimate so you don’t have to argue with people about your “model”. This is one way in which writing about investing – showing your work publicly – is bad for your own investment process.

Regarding macroeconomic variables – the expected rate of nominal GDP growth, the Fed Funds Rate, the price of oil, etc. – the conventional assumption is usually the most recent reading modified by the recent trend. So, if the price of oil was “x” over the last 3-5 years, some people think 0.75x is reasonable and some think 1.25x is reasonable. But, estimates of 0.5x and 1.5x and beyond are considered unreasonable.

This “recency” issue makes it hard to have macroeconomic discussions. The level and trend of the recent past becomes the conventionally accepted answer for future estimates. The problem for you as an investor is that any application of conventional wisdom is useless. If the conventional wisdom is that the Fed Funds Rate will be 1.5% fairly soon – and you also believe the Fed Funds Rate will be 1.5% fairly soon – you may be correct, but your correctness will do you no good. Stocks are already “handicapped” according to the conventional wisdom.

The only macro assumption that can do you any good as an investor is a belief that is both:

1)      Correct and

2)      Out of step with conventional wisdom

Sometimes, I do have such beliefs. But, they’re never any fun to write about. So, I try not to write about them. However, in terms of my actual investing behavior – I can’t help myself from buying something I believe to be incorrectly “handicapped”. So, you will sometimes see indications of macro assumptions in my actual investments even though they don’t appear in my writing.

Fed Funds Rate

When doing my own (private) work on Frost, I can assume a normal Fed Funds Rate of 3% to 4% without any problem. But, when writing about Frost for others – I have to spend a ton of time justifying something I think seems obvious. A lot of my Frost report was wasted on discussing the Fed Funds Rate instead of discussing Frost. In my own head: I spent very little time worrying about where the Fed Funds Rate would be and when.

Oil Prices

In some cases, the mental toll writing and defending such justifications takes on you just isn’t worth it. So, you don’t write about that topic. For example, people who discussed stocks with me privately – like Quan – long knew that I was using assumptions of $30 to $70 a barrel for oil even when Brent was trading at $110 a barrel. In fact, since I started this blog 11 years ago, my assumptions for the price of oil have never changed. My process has always been “plug in $30 a barrel” and see what you …