If I Want to Be a Professional Investor, Do I Need to Get an MBA?

A reader sent me this email:

I’ve been studying value investing for about 2-3 years now. The more I speak to my friends and family about investing the more they tell me I need to go back to school to get my MBA. Since my background is in computer programming I’ve looked into all the different ways to go about switching my career. I’ve looked into different MBA programs around the country but I have reservations about spending a large sum of money on a degree that probably won’t teach me how to become a better investor. I also have reservations about spending large sums of money period. The curriculums at many of these schools really don’t interest me except for a few classes. And if I’m not interested in a subject, I will fail it. What I really want to do in the end is become a better value investor and manage a small portfolio. So my questions to you are:

1. What is your (educational) background?
2. What are your thoughts on getting an MBA?

Thanks,
Tom

I’m a high school drop out. I never completed any school year beyond 8th grade. (That’s age 14 for our non-U.S. blog readers). I have a GED. And I briefly went to college.

I don’t think an MBA will make you a better investor. However, an MBA can be used to show you are serious. Basically, it’s like having a liberal arts degree from an Ivy League school. It’s useless. But it might convince employers you’re smart or at least hardworking.

The three things that make people take you more seriously for a career in investing are: a CFA, a MBA, and an undergraduate degree in economics from a top U.S. school. A CFA is best.

The most useful designation by far is the CPA. It’s not even close.

Training as an accountant and training as a lawyer are the two most useful educational backgrounds for an investor to have.

Accounting knowledge is directly useful. Legal training is indirectly useful. The way law schools train their students to become lawyers exercises the same mental muscles you use when you invest.

The eight most useful courses for investors to take are:

1. Financial Accounting
2. Managerial Accounting
3. Tax Accounting
4. Business Law
5. Marketing
6. Business Administration
7. Microeconomics
8. Macroeconomics

The cheapest way to learn these subjects is to buy the textbooks and read them yourself.

None of those courses are hard.

Like I said, I dropped out of school after 8th grade and I had no problem passing those 8 courses when I briefly went to college.

If someone who never really went to high school can pass those courses, I’m sure someone who finished college – even if it was as a computer programmer – can teach himself those 8 subjects at home using the standard textbooks.

To answer your question: I would strongly advise against getting an MBA.

But – then again – I’m a high school drop out. So I’m not sure you want to …

Why I Don’t Invest in Chinese Stocks

A reader sent me this email:

Hey Geoff,

Let me start this off by saying I am an almost brand new investor (rather than speculator), or at least I hope to become one. I read Warren Buffett’s biography the Snowball, which led me to the Intelligent Investor, and now I am trying to learn everything I can about value investing….I have only been in stocks for a few weeks.  I have bought some well known companies that looked cheap like MSFT, SKX, and RSH, but I am increasingly fascinated by the possibilities of small and micro caps. There are 2 Chinese companies that I have bought and I keep looking at the numbers and they almost seem too good to be true….They do not appear to be associated with the same fraud as a lot of the Chinese reverse mergers, and their P/E ratios and returns on equity look pretty awesome. Do you think I’m crazy to call these companies “investments”?

I don’t invest in Chinese stocks.

Since I look for net/nets, I often end up with a list of Chinese stocks. And my initial impression of Chinese net/nets has been extremely negative. I have seen things literally within seconds of opening their 20-F that turned me off. Things that made me feel there was a chance you could lose everything in the stock.

I could look at the specific stocks you mentioned if you really want. But, honestly, I work at this investing thing pretty hard. I spend a lot of time thinking about investments. I’ve read thousands and thousands of SEC reports. I started when I was 14. I’ve been writing about investments for the last 5 years. And I don’t trust myself to analyze Chinese stocks. I don’t trust my own judgment enough to let me go through the filings and try to separate the good ones from the bad ones. So I’m not sure why you should trust my judgment on any Chinese stocks.

I’m not just saying don’t consider Chinese stocks because you’re a new investor and I’m being overly protective and blah, blah, blah. I’m saying I personally have banned myself from ever considering Chinese stocks because I have seen things you wouldn’t believe in these filings. I don’t like to talk about it because I don’t short stocks. I don’t want to get into controversies over shorting stocks. And I don’t want to come off as racist or anti-China or something. But there are frauds in U.S. listed Chinese stocks. There are some very, very obvious frauds.

I have read press releases from Chinese net/nets where I honestly believe they are saying an event occurred that did not occur. I think they made the whole thing up. I don’t mean they shaded the truth one way or another. I mean they flat out lied about why their CFO left. I’ve seen this more than once.

I think there are Chinese companies out there that are consciously and actively lying to their investors …

So You Think You Can Read – Thursday

Find stocks reading articles written for nerds not investors. (The Frog’s Kiss)

Microsoft isn’t some old, stodgy industrial outfit. (Controlled Greed)

Travel Centers of America has a lot of leverage and conflicts of interest, but… (Whopper Investments)

Tobin Q, Shiller P/E, and AAII survey show stocks are overvalued and investors are overbullish. (ValueWalk)

Altria has 43 years of rising dividends, a 6% yield, and a fair stock price. (MagicDilligence)

Comamtech is a difficult merger arb play, but still a stock worth studying. (Whopper Investments)

Whitney Tilson hasn’t had success shorting good businesses at high prices. (Market Folly)

Old school value investors are getting outdone by newer, more aggressive players in St. Joe. (Stableboy Selections)

Green Mountain Coffee Roasters trades at $37 a share. It’s worth $5. (Special Situations Monitor)

Rock-Tenn is really buying Smurfit-Stone for just 5 times EBITDA. (Special Situations Monitor)

Charlie Munger speaks and Daily Journal shareholders transcribe. (Canadian Value Investing)

Richard Perry thinks bargains aren’t plentiful but event driven opportunities are. (Market Folly)

JANA Partners starts new positions in companies making value maximizing moves. (Market Folly)

T.Clarke is a good company with lots of heritage, but its future is tied to construction. (10 Value 10)

Dewhurst is a hidden champion. (Interactive Investor)

Maxco is liquidating. (Whopper Investments)

And Winmill & Co. is wondering why a prospective investor wants to see a balance sheet. (Whopper Investments)

Talk to Geoff…

Understanding Depreciation: 4 Depreciation Archetypes

A lot of investors don’t give depreciation enough thought. Whenever you compare P/E ratios, you are – to some extent – counting on depreciation between companies being totally comparable.

It’s not.

Forget loans for a second. And forget the idea of “appreciation” and “depreciation” in the sense of a rise or fall in value. Instead, we’re just going to talk about depreciation and amortization as they are used in financial statements.

We’re talking 10-Ks and 10-Qs. We’re talking balance sheets and income statements.

We’re talking accounting.

For our purposes, the words depreciation and amortization mean the same thing. It’s just that we’re going to say depreciation when we’re talking about something we can touch – like a cruise ship. And we’re going to say amortization when we’re talking about something we can’t touch – like a management agreement.

Otherwise, depreciation and amortization are synonyms.

You sometimes hear it said that depreciation is a reserve for the replacement of an asset. That’s wrong. Depreciation is a method used by accountants to spread the cost of an asset over the period in which the asset provides a benefit to its owner.

Basically, we’re talking about matching the costs and benefits – the revenues and expenses – of an asset so they appear on the income statement at the same time.

The basic idea you need to get from reading this article is that no one is attempting to account for the replacement cost of the asset when they determine the depreciation expense. Replacement cost has nothing to do with depreciation.

Instead, they are taking the cost – the expense – of what you are buying today, and then chopping it up and spreading it out over the time you use it.

If you want to think of the difference between buying a car and renting a car to understand depreciation, that’s fine. If you rent a car, you get charged every day. If you buy a car, you get charged once (but it’s a big charge). In a sense, depreciation is about providing the folks who read financial reports with a picture of a business’s performance that shows the car buyer in much the same way it would show the car renter. Each day we’re asking: what did it cost the driver to use his car today?

That analogy is far from perfect. And I’ve made things sound simpler than they really are. But, now, I’d like to move past talking abstractly about depreciation and amortization and move to talking about specific examples you will see in your investing adventures.

I’ve singled out these 4 stocks because they are examples – in fact, rather extreme examples – of 4 types of important depreciation situations you’ll come across when you research stocks.

In a sense, these 4 stocks are archetypes of situations in which depreciation and amortization can be important in picking stocks.

Although I said depreciation is used to match the timing of the expense of owning an asset with the benefits …

Accounting Connections

I just wrote an article over at GuruFocus that I think is worth reading. I get a lot of questions asking what’s a good accounting book to learn from. Right now, I’m reading John Tracy’s How to Read a Financial Report.

The point of the book is seeing the connections between the financial statements. That’s so important. And it’s really the only thing I have to say about accounting. It’s about fluency. It’s not about knowing in detail how this or that is calculated. It’s about knowing how things on the income statement and the balance sheet and the statement of cash flows work together to tell the story of a business.

Recently, I’ve written 3 articles that show how investors can use accounting:

DuPont Analysis for Value Investors

Warren Buffett: Berkshire Hathaway, Leverage, and You

Warren Buffett: Inflation, Depreciation, and the Earnings Mirage

If you want to see how I think about accounting, you should start with those articles.

Talk to Geoff About Accounting Connections…

Screening for Decent Businesses at Decent Prices – 7 U.K. Stocks

I’ve mentioned before how Richard Beddard’s Interactive Investor blog is probably my favorite blog.

Well, reading Richard’s posts finally inspired me to start using Sharelockholmes. It’s a site that screens stocks in the United Kingdom. And it’s very, very good.

It’s also reasonably priced. About $8 a month at the current exchange rate.

Anyway, I was thinking about how I’d just written an article where I said Warren Buffett looks for a good business priced to return 10% a year initially and grow from there. It used to be 15%. But he’s lowered his standards. Berkshire simply has too much cash to invest. It doesn’t help that stock prices aren’t real low right now. But you play the cards you’re dealt.

It shouldn’t be too hard to find the kind of decent businesses at decent prices that Warren Buffett might invest in, right?

This is the quote I had in mind when designing my screen:

If we were working with $25 million – so we could sort of look at the whole universe of stocks – I would guess that you could find 15 or 20 out of three or four thousand that you would find that were A) selling for substantially less than they’re worth, and B) that the intrinsic value of the business was going to grow at a compound rate which was very satisfactory. You don’t want to buy a dollar bill that’s sitting for 50 cents, and it demands positive capital, and it’s going to be a dollar bill ten years from now. You want a dollar bill that’s going to compound at 12%…And, you want to be around some competent people. Just the same thing as if you went in and bought a Ford dealership in South Bend. The same exact thought process goes through your…mind about all the other businesses that are in Standard and Poor’s.

I figured I could do a quick screen and come up with a preliminary list of stocks that looked like they could both start you off with a 10% initial return – basically, a P/E ratio under 10 – and then reinvest future earnings at an acceptable rate.

Well, the preliminary list actually turned out to be quite short.

My requirements may have been a smidge too strict.

I asked Sharelockholmes to find companies with a 10-year ROE of at least 10% and a price to 10-year EPS of no more than 10. I also demanded the Z-Score be at least 3 since that’s the clearly “safe” cut-off.

I then threw out any homebuilders myself, because I couldn’t trust their Z-Scores. I didn’t feel right including them in a list intended for Americans and other investors who might be looking at the U.K. stock market for the first time. Development works a little differently over there. It’s tough to judge homebuilders by their 10-year records since there was a housing boom. So I just felt better leaving homebuilders out of this for now.

Once that …

Return on Invested Assets

There are a lot of ways to calculate return on capital. Whenever, you see me use the term, it means:

Operating Income / (Total Assets – (Intangibles + Cash))

That’s it.

To be completely honest, I don’t look at net income. I look at operating income and I look at free cash flow. As far as I’m concerned – operating income, free cash flow, and comprehensive income make more sense than net income. But net income is the number they print in the papers. So it gets talked about.

Shouldn’t you include intangibles?

No.

I want to know what the business naturally earns on its own assets. The book value of all assets is somewhat arbitrary. The book value of intangibles is completely arbitrary. It’s based on corporate events like acquisitions. It’s not the general manager’s responsibility. Often, the most valuable intangibles don’t appear on the balance sheet. And the least valuable intangibles appear on the balance sheet only to be written off later.

Shouldn’t you count some cash as non-surplus?

No.

I hear people say that all the time. But it doesn’t make much sense to me. Sure, businesses usually have some cash on the balance sheet. But it’s much easier to assume that cash is always an asset apart from day-to-day operations than to try separating required cash balances from surplus cash. That’s being too clever.

If you really want to talk about surplus and non-surplus cash, that depends on cash relative to liabilities. In other words, a totally unleveraged company can always borrow money and get the “required” cash into the coffers that way. While a leveraged company can have plenty of cash on hand and yet not really be holding enough cash to pay its bills as they come due, because it’s got debt repayment to deal with too.

For me, cash should always be separated from the return on capital calculation. Cash is part of the solvency analysis. It’s not part of the business quality analysis.

And it’s easier to use just one formula. Otherwise, you get too clever and start letting your personal biases determine the right formula for every industry.

Basically, I want to start by looking at the business alone. The stuff the company actually does and the assets it actually uses. I don’t want to start by worrying about whether it uses common stock, preferred stock, short-term debt, long-term debt, insurance float, whatever. I want to start with the business. Then I move on to the finances.

There is one very legitimate argument against using the return on capital formula above…

Isn’t the return on equity what really matters?

Absolutely.

But, when I don’t know anything about a company, I always start by looking at the return on invested tangible assets. Then, if it’s a railroad, or a power company, or a water company, or a bank, or whatever – we can talk about what the appropriate leverage ratio should be.

But I like to start by looking at the actual …

Why I Never Talk to Management

I never talk to a company’s management before I invest in their stock.

Since I usually invest in micro cap stocks, it’s very easy to talk to management. I just don’t think it helps. In fact, I think it hurts.

It’s psychologically dangerous, because investors who talk to management get confident for all the wrong reasons. You can’t take anything management says at face value. Not because CEOs and CFOs are liars. But because we are all liars. Especially to ourselves. So, if your question is:  “are you going to pay a dividend?” or “are you going to do a stupid acquisition?”, they’ll tell you what you want to hear until one minute before they announce they’ve done the exact opposite thing.

They’re probably telling themselves they are committed to a dividend until the second they have the chance to buy a competitor instead. That’s when they think: “This is a once in a lifetime opportunity. We can’t pass up on this. It’s okay. Just this once.”

It’s natural. We all do it. Projections and future plans aren’t something I want to hear about. I look at management’s past interviews, past record, and past behavior. I read old annual reports in order. So, if the company has annual reports on its website for the years 1999 – 2010, I start with the 1999 annual report and read up to the present.

I assume people never change.

That sounds harsh. But it’s an effective way to invest. Serial borrowers will keep borrowing, serial acquirers will keep acquiring, serial share issuers will keep issuing shares.

I don’t believe them when they say they’ll stop. I treat it just like if an alcoholic said: “tomorrow I’m going to stop drinking.” Okay. I appreciate the sentiment. But we both know what’s going to happen tomorrow.

Until you’ve got demonstrated proof of a difficult and unusual change in behavior – not just language – I’m going to smile and nod and not believe a word you say.

That’s why I never talk to management before I buy a stock.

Now, talking to management and studying management are two completely different things. I’m all for studying management. I’m all for analyzing management.

I’m all for observing management. I just don’t believe an observer should speak with his specimens.

And once you own the stock, well that’s a different story entirely. If you want management to do something, you can talk to them. But if you just want information…

I’m skeptical that talking is the best way to get it.

Talk to Geoff About Talking to Management…

The Accounting Equation

This is something that’s come up in emails readers and I have exchanged. If I was teaching an Investing 101 course, when students walked in on the first day this would be on the board:

Assets = Liabilities + Equity

Which means…

Assets – Liabilities = Equity

and…

Assets – Equity = Liabilities

This is taught in accounting classes to show how every transaction affects at least two of a company’s accounts and the equation always stays balanced.

I mention it just because it’s useful in situations like the blind stock valuation where I didn’t show the mystery company’s liabilities. Some folks mentioned that I didn’t show the liabilities. Of course, I did show the mystery company’s liabilities because:

Assets – Equity = Liabilities

For balance sheets found in 10-Qs and 10-Ks filed with the SEC, it’s pretty common to just show the total assets and shareholder’s equity at the bottom of the balance sheet without totaling the liabilities.

The reason for this is that for the sheet to “balance” you can’t literally show assets on one side and liabilities on the other. You actually show assets on one side and liabilities plus equity on the other.

If you watched my eyes run down a balance sheet, the first thing I actually do – by force of habit – is race to the assets and equity at the bottom of the page to instantly see how leveraged the company is. Sometimes that’s all it takes to eliminate a stock from further consideration.

In theory, that bottom most number is liabilities plus shareholder’s equity (which is on the line above it). But, since you know the accounting equation, you know that liabilities plus shareholder’s equity is always equal to assets (Assets = Liabilities + Equity) so the two bottom most numbers are effectively a company’s equity and assets. The difference between them is total liabilities.

So, the two bottom most lines of a balance sheet actually tell you a company’s assets, liabilities, and equity in just one glance.

That one glance also tells you how leveraged the company is. If you see a lot of assets sitting below a little equity, that’s a highly leveraged company. If the two numbers are close together, that’s an unleveraged  company.

It can also be helpful to think in terms of leverage ratios.

Like I do in my latest GuruFocus article about how Berkshire Hathaway uses leverage.…

Warren Buffett Article Series

I’m in the midst of writing a series of Warren Buffett articles over at GuruFocus. Let me know what you think.

1. Warren Buffett: Mid-Content Tab Card Company
2. Warren Buffett: Make the Past Your Crystal Ball
3. Warren Buffett: Inflation, Depreciation and the Earnings Mirage
4. How Warren Buffett Thinks About Micro Cap Stocks
5. Warren Buffett: How to Make 50% a Year in Micro Cap Stocks

Talk to Geoff About His Warren Buffett Article Series…