“The stocks I pick don’t benefit much from well-timed sales. There’s usually little harm in holding on to them much, much longer than I do.
So, I’ve decided to hold the stocks I own indefinitely. When I find a really, really good stock idea – which might happen once a year – I will need to sell pieces of the stocks I already own to raise cash for that purpose. I’ll do that. So, if I’m fully invested and want to put 20% of my money into a new stock – I’ll have to sell 20% of each stock I now own. But, I’m not going to eliminate my entire position in a stock anymore. Those decisions to completely exit a specific stock haven’t added value for me. So, I’m not going to try to make them anymore.
From now on, I’m going to be a collector of stocks.”
Focused Compounding includes a “Library” with 27 stock reports. I co-wrote those stock reports with Quan Hoang between 2013 and 2016. Although Quan and I no longer work together, he agreed to put his thoughts on that experience in writing for our community members to read. I think reading Quan’s “Reflections” will help you put each of those 27 reports in better context.
Quan’s Reflections
Geoff asked me to write a reflection on my experience writing The Avid Hog (a newsletter we later renamed Singular Diligence). So in this post, I’ll share my experience and show why I believe stronger than ever that long-term investing is the best path to wealth.
Geoff and I started our venture in 2012. Initially we had been hired to start the research arm for a financial company. Right after my college graduation, I flew to Plano and was eager to work in person with him, who to me is like Ben Graham (or Phil Fisher) to Warren Buffett. However, due to some disagreement with our employer over the product we were developing, Geoff decided to quit. That night by a pond near both our apartments, Geoff told me that he was about to turn 28 and he did not like doing the job that he didn’t like just to find several years later too late to switch. He asked if I wanted to quit and partner with him. That was exactly my plan when I knew he quit because learning from him was the only reason I went to Plano.
So we start our venture without a clear direction. We just wanted to write a newsletter. I imagined that would be the best learning process for me. I would do in-depth research every day and my knowledge would compound. If I did a good job, the newsletter would bring in cash flow for me to invest and I could be financially independent. Even if the newsletter did not make money, I would still learn a lot. I was young and determined to become a great investor. I didn’t see any job that could truly train me as an investor (and I still don’t see today.) That’s also the reason why there are so few good investors. Most students are obsessed with getting a job. Investment banks would train you to be a next-quarter forecaster, not an investor. Most investment funds don’t have the right investment framework and spend most of their time watching the wrong kind of information. In general, once one gets a job (finance-related or not), he will enter a rat race, leaving them no time to seriously practice value investing. I didn’t like that path. I was young and I was willing to invest my time.
From that day on, I would go to Geoff’s apartment each day. We started by writing blog posts regularly to connect with our audience. That was the bad part of each day. I don’t like writing and I always struggle to find ideas …
Give each stock your absolute undivided attention – focus like you’ve never focused before (it’s fine if you can only do this for like 45 minutes at a time).
“I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches–representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did and you’d be forced to load up on what you’d really thought about. So you would do so much better.”- Warren Buffett
Many Buffett and Munger pupils preach following the “punch card mindset,” yet very few actually do. I really think applying this filter has made all the difference for me in my evolutionary process as an investor, and I’m quite confident it will dramatically improve your results as well; especially if you are striving to be a focused investor like Geoff and myself. What does following the punch card mindset mean to me? It means doing the due-diligence required to get to a level of certainty that you are willing to put 20%+ of your net worth in a single idea. It means not succumbing to the daily irrational swings of Mr. Market, and being able to stick to your original thesis if nothing fundamentally has materially changed within the business. It means not laying out capital unless you feel like the odds are so heavily in your favor that heads, you’ll make money, or tails, you can at least break even or not lose that much. It is easy to talk the talk, but actually putting it into practice can be much more challenging, as It should be. After all, why should It be easy to become rich? You need to be okay with the fact that not every stock you look at will be a punch card worthy investment. Logically speaking there would be no such thing as the punch card mindset if so. Success in investing to me is saying no a lot more than you say yes. The best part about investing though is even if you say “no” to an idea, the amount of work you did to get to that decision can be extremely useful to you. Everything in investing is all cumulative. All knowledge stores up like compound interest. So even if you feel like you are not getting anywhere because you are not finding any actionable ideas, trust me, you are. Just keep your head down and keep chugging along.
“The most important three words in investing may be: “I don’t know.” Having strong viewpoints on a lot of securities, and acting on them, is a sure-fire way to poor returns in my opinion. In my view, it’s easier to adopt this “I don’t know” ethos by focusing on the business first and valuation second, as opposed to the other way around. I’ve found that when valuation is the overriding driver of interest, I’m prone to get involved in challenging businesses or complicated ideas and liable to confuse a …
The other day, someone I talk stocks with on Skype asked how I normally go about starting my initial research into a stock. What documents do I gather?
Here’s what I said:
“Basically, I start by finding the longest series of financial data I can (GuruFocus, Morningstar, whatever) and then look at that along with reading the newest 10-K and the oldest 10-K in detail. So, 10-year+ financial data summary, 20 year old 10-K (or whatever), this year’s 10-K, and then the investor presentation if they have one, and the going public/spin-off documents if that’s online. Also, I read the latest proxy statement and the latest 10-Q as needed for info on management, share ownership, the balance sheet etc.”
I also check the very long-term performance of the stock. So, I will chart the stock – at someplace like Google Finance – against the market over a period of 20, 30, or 40 years.
So, here’s a full list of my usual sources:
1. Check long-term stock performance (what is the compound annual return in the stock over 20, 30, or 40 years?)
2. Find the longest series of historical financial data possible (search for a Value Line sheet, a GuruFocus page, or go to Morningstar or QuickFS.net to see the long-term financial results)
3. Read, highlight, and take notes on the latest 10-K (so 2016)
4. Read, highlight, and take notes on the oldest 10-K (On EDGAR, this is usually around the year 1995)
5. Read, highlight, and take notes on the company’s own investor presentation
6. Read, highlight, and take notes on the IPO or spin-off documents (On EDGAR, this will be something like an S-1 or 424B1)
7. Read, highlight, and take notes on the latest proxy statement (On EDGAR, this will be something like a DEF14A)
8. Read, highlight, and take notes on the latest 10-Q.
Why Check the Long-Term Stock Performance?
This is something a lot of value investors wouldn’t think of. But, I find it very useful. Any time you are looking at a stock’s performance your choice of start date and end date are important. The good news is that your start date will be fairly arbitrary if you just look as far back as possible. So, if the stock has 27 years of history as a public company – and you look back 27 years – you probably aren’t picking a price near an unusual low point in the stock’s history. In fact, you’re probably picking the IPO price, which will rarely have seemed a “value” price at the time. The other good news is that – as a value investor – you’re probably attracted to stocks that seem cheap now. They trade at low or at least reasonable multiples of earnings, EBITDA, sales, tangible book value, etc. This means that any stock you are looking at as a possible purchase is unlikely to be benefiting right now from a particularly good choice of an end point.
“Go Where There Are Network Effects” – Zero to One book, Peter Thiel
A business that has a strong and enduring Network Effect can be a great business to invest in. It is one of my favorite tools in my mental-model toolbox, and is one that I look for and think about often. The best part about a business that has a strong network effect is just like compound interest, it only gets better as the numbers get bigger. The simplest way to describe a network effect is when a product or service becomes more valuable as more people use it. For example, companies like Airbnb, Facebook, Microsoft, PayPal, eBay, Match Group and Twitter all have strong network effects. If a business can profit on this effect the rewards can be quite enormous. It can be a great starting point for investors seeking to find a business that has a wide and deep moat and a long runway for many years ahead.
People use Airbnb because they know there is a variety of different options to choose from when it comes to renting a place to stay, and “Hosts” list their houses on Airbnb because they know there’s an endless amount of people who are looking to rent instead of staying in a hotel.
People sign up and use Facebook because their friends and peers are signed up and use the website as well.
People continue to play video games on Xbox live because they know other people are gaming and competing on Xbox live.
PayPal is convenient because it is so popular, which encourages companies to accept payments from it.
Buyers use eBay because they know there will be a lot of sellers selling items, and sellers use eBay because they know there will be a lot of buyers buying items.
People swipe on Tinder because they know other people are swiping on Tinder.
People use Twitter because no one wants to miss Donald Trump’s tweets…. (I’m half-kidding here)
You get the point, right? Network effects can become significant after a certain number of users have been reached: this is the “Critical Mass” point. When the critical mass point has been achieved, the value obtained from this network effect can be greater than or equal to the price paid for the effect. What does that mean? It’s the point at which a growing company becomes more efficient, and no longer needs additional investment to remain economically sustainable. Charlie Munger always talks about learning the “big ideas” across many different disciplines, and critical mass comes from Nuclear Physics; where critical mass is defined as the smallest mass that can sustain a nuclear reaction at a constant level. When bringing this phenomenon into the investing world, it is about when a business becomes self-sustaining. Aiming to hit this critical mass point is the challenging part of business. This is why most tech companies are so focused on user growth and are often valued by user-progression, as opposed to traditional valuation …
Car-Mart (CRMT) now trades for $35 a share. I picked the stock for my old newsletter, The Avid Hog (you can read all 27 past issues of that newsletter here), when it was trading at $38 a share back in June of 2014. So, it’s now three years later. And the stock is now 8% cheaper. Do I like Car-Mart more today than I did in 2014?
No.
Ideally, a stock should be:
Cheap
Good
Safe
I’m not sure Car-Mart meets all 3 of those criteria. And I am sure it has a harder time meeting those 3 criteria today than it did back in June of 2014. But, let’s start with the criterion that Car-Mart clearly passes.
Receivables Per Share: The Right Way to Value Car-Mart?
Buy and hold investors value a business on its future cash earning power.
So, the correct way to value a business is usually to begin by finding the key determinant – the ultimate source – of a company’s future cash earnings and multiply that number by a second figure. For a timber producer, you’d use the acres of timberland. You might look at a company owning 500,000 acres of timberland and see that buyers normally pay $600 an acre for such land. Based on that, you’d say the business is worth $300 million. If this corporation currently had $120 million in debt on its books, you’d then say all the common stock combined was only worth $180 million. If there were 9 million shares outstanding, you’d say each share of stock was worth $20 a share. In this way, you’ve done an entire calculation for a single share of stock based on something that is:
Constant
Calculable
and consequential
The amount of timberland a company owns varies much less from year-to-year than reported earnings. It’s a “constant” figure. It’s also a very easily “calculable” number. The company states the number of acres it owns in the 10-K each year. Finally, the quality and quantity of acres of timberland owned is clearly the most “consequential” number there is for such a business. Different owners, different managers, different ways of running the business could squeeze a little more profit or a little less profit from the business from year-to-year. But, how much land the company owns and where it owns that land can’t be changed. Clearly, the quality and quantity of acres of timberland owned is the key determinant – the ultimate source – of this company’s future cash earnings.
What is the ultimate source of Car-Mart’s future cash earnings?
What one number can we find that is: 1) constant, 2) calculable, and 3) consequential? We need to find the “essential earnings engine” for Car-Mart.
It’s receivables per share.
Here’s how I explained the right way to value Car-Mart, back in 2014:
“Car-Mart’s value over time should mirror its per share loan balance. This loan balance is what creates value for Car-Mart. So, it is receivables – net of the provision for …
I picked Grainger (GWW) for a newsletter I used to write. The pick was made in April of 2016. Grainger traded at $229 a share when I picked it. Today, the stock trades for $188 a share. That’s one reason to look at the stock now.
Reason #1 for considering GWW:
I picked the stock when the price was 22% higher than it is now.
There’s another. Over the last twelve months, here’s how Grainger’s stock performed versus the shares of is two closest peers.
Grainger: (16%)
Fastenal (FAST): (2%)
MSC Industrial (MSM): +19%
I picked MSC Industrial for the newsletter too. Last year, one of the questions I had to ask myself was which stock I liked better: Grainger or MSC Industrial? Back then, it was a tough question. Today, it should be a lot easier to answer.
Reason #2 for considering GWW:
Grainger is now 14% cheaper relative to Fastenal and 29% cheaper relative to MSC Industrial than it was a year ago.
So, is Mr. Market right? Does Grainger really deserve a downward re-valuation of 14% versus Fastenal and 29% versus MSC?
Before we can answer that question, we need to know why I picked Grainger in the first place.
Reason for Picking Grainger in the First Place
I thought Grainger was a Growth At a Reasonable Price (GARP) stock. Here’s what I wrote a year ago:
“…Grainger can grow sales by at least 5% a year. Profit growth should be more than 5% and less than 8% a year. At that pace of growth in sales, Grainger would return two-thirds of its earnings each year. So, if you bought Grainger at around a P/E of 16 or 17, the company would pay out 4% of your purchase price each year in buybacks and dividends while companywide profit would grow 5% to 8% a year. Your return in the stock would be in the 9% to 12% a year range. This is far better than you’ll get long-term in the S&P 500. So, Grainger is a ‘growth at a reasonable price’ stock even when priced as high as 17 times earnings and when growing sales as slowly as 5% a year. The combination of margin expansion and share buybacks mean the company could grow sales as slow as 5% a year and yet grow earnings per share at close to 10% a year. The ‘growth’ in ‘growth at a reasonable price’ that an investor should care about is only earnings growth and only in per share terms. It doesn’t matter whether companywide sales grow 10% a year or 5% a year if EPS growth is 10% a year in both scenarios, the stock is no more or less valuable due to the difference in sales growth. Companywide sales growth doesn’t benefit shareholders. Only growth in earnings per share makes any difference to an investor. So, by that measure, a stock with a P/E of 15 or 20 …
“Jeff Bezos is the most remarkable business person of our age, I’ve never seen a guy succeed in two businesses almost simultaneously that are really quite divergent in terms of customers and all the operations.” – Warren Buffett
I really do agree with Warren in the statement above. Anyone who knows me, knows I am a complete Amazon advocate. Not only does my firm own Amazon stock, but I am a frequent user of the website and really have developed into some sort of fanboy. It is a company that, in my opinion, is virtually certain to be bigger 5-10 years from now than it is today. Every year it leaves me flabbergasted that Amazon continuously knocks it out of the park. Companies that are doing 100B+ in revenue annually should not be continuously growing sales by 25+% per year. To me it is extraordinary. And it is certainly a case study in action that we can all learn from and add to our investing-wisdom toolbox, whether you are a shareholder or not. But before we talk about the present, I think it can help all of us as investors to go back to the beginning and study the company. After all, investing is all about pattern recognition. The beauty of hindsight is that it’s always 20/20. Let’s use this hindsight to our advantage and learn from it.
In this series, we are going to go back and review every Annual Letter to Shareholders written by Jeff Bezos. I really encourage everyone to do this yourself here. I have printed off every Shareholder Letter and have read them multiple times and, like any good literature, I take away something new from it each time. When reading, I encourage everyone to continuously ask yourself this: “Is there any information in this writing that I can take with me to make myself a better investor?” One of the greatest things about investing is that we are constantly learning and all information in life is relative –meaning you can read books completely unrelated to business, read newspapers, watch movies, you name it, and still take away some sort of insight or wisdom that can relate to investing. That’s essentially what we are trying to do here at Focused Compounding; compounding both capital and wisdom. If you have not already, I deeply encourage everyone to read the book “The Everything Store” by Brad Stone. It is a great book that will help you get familiar with the beginnings of Amazon, and more specifically with Jeff Bezos as a CEO.
Let’s go back to 1997 when Jeff Bezos wrote his first letter to shareholders. Anyone who is familiar with the company will know this letter serves as the groundwork of principles that Amazon still embodies today. In fact, Jeff has posted the 1997 letter at the end of every Letter to Shareholders every year since writing it to keep the standards top of mind.
A manager who doesn’t just talk the talk but actually walks …
“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”
– Warren Buffett
A business with market power is a good business. A business without market power is a bad business. In that quote, Buffett gives a clear definition of market power when he says: “if you’ve got the power to raise priceswithout losing business to a competitor” you’ve got a very good business. Basically, if you’ve got the power to raise prices without losing business to a competitor, you’ve got market power.
Market power is not an internal advantage. It is not a technological advantage, a better corporate culture, or a process improvement your competitors have yet to figure out. Market power is external. It is a strong bargaining position versus those folks a company must sit across the negotiating table from.
Market power is the ability to make demands on customers and suppliers free from the fear that those customers and suppliers can credibly threaten to end their relationship with you.
Market power is often misunderstood as being an advantage one competitor has over another. That’s the wrong way of thinking about it. Businesses don’t squeeze profits from competitors. Businesses squeeze profits from customers and suppliers.
Often, competitors engage in rivalry that undermines each other’s bargaining position with customers and suppliers. In such industries, customers can play one competitor off against another. By doing this, they can negotiate for higher product quality, lower prices, longer payment terms, etc.
However, there are industries free from that kind of rivalry.
As investors, those are the industries we want to focus on. The best businesses in the world are in the best industries in the world. And the best industries in the world are those where the rivalry between competitors does not undermine the market power these businesses have over their customers and suppliers.
Dependency: Mini-Monopoly
All publishers have a mini-monopoly over each title they publish.
In children’s books, if you’re a bookstore that wants to carry Harry Potter – you have to pay Scholastic (SCHL) whatever Scholastic wants to charge for that title. Scholastic is your sole source of Harry Potter books. The only power you have in the market for Harry Potter books is to either accept or decline a take-it-or-leave-it offer from one seller. There are no competing offers you can consider.
In videogames, if you’re a gamer who wants to play World of Warcraft – you have to pay Activision-Blizzard (ATVI) whatever monthly fee Activision wants to charge for that MMORPG. Blizzard is the sole source for your WoW fix. The only power you have in the market for World of Warcraft access is to either accept or decline a take-it-or-leave-it-offer from one seller. Those who decline the …
