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 …

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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. …

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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 …

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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 …

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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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