Geoff Gannon August 2, 2017

The Two Things Every Stock Picker Needs to Learn: Independence and Arrogance

I get a lot of emails from people asking how to become a better investor. They usually have very specific ideas about what would help them improve. For example, they think they need to get better at reading 10-Ks and that would fix their problem. Or they think they need to get better at deciding which stock to research in the first place. The truth is that most of the people I’ve talked with and tried to help improve as investors suffer from the same mental block.

They think there is a right way and a wrong way to analyze a stock. They have – whether they realize it or not, and I think usually they do not – a kind of moralistic view of how investing ought to be done. They believe that if you do what you’re supposed to do, work hard, etc. you will get a good outcome. Investing doesn’t work like that. Stock analysis doesn’t work like that. It really doesn’t matter whether you are a very hard working, diligent researcher of stocks or a lazy but brilliant one. There are no points for effort. Nor is there any degree of difficulty modifiers. Often, the best ideas are easy to come up with. They don’t take much time to research. They are 99% inspiration and 1% perspiration type ideas.

So, what do you need to be a good stock analyst? What is the key to hunting for and finding the right ideas to bet big on?

You need a different, better way of seeing the stock than most investors do. I’ve talked about the importance of “framing” an investment problem before. In my discussions with readers, I’ve realized they really underestimate the importance of this. Yes, I read the footnotes to financial statements, and I take notes on the 10-K, and I put together Excel spreadsheets. But there’s really nothing in any investment thesis that’s going to flip the correct answer of whether to buy a certain stock from a “no” to a “yes” or vice versa depending on whether the P/E is 14 or 18, the projected future growth rate is 4% or 6%, the Net Debt / EBITDA ratio is 1.5 or 2.5. If something as small as that can change your decision to invest – this stock probably isn’t worth your time.

The investment ideas really worth having are all “framing” problems. You have to find a stock where the way you frame the entire problem of analysis and appraisal is different from the way other people frame that same problem.

Let’s start with two examples from my own portfolio. Right now, I have 40% of my portfolio in Frost (CFR) and 25% of my portfolio BWX Technologies (BWXT). No other stock accounts for more than 6% of my portfolio. So, these are really the only two stocks that matter in my portfolio. In both cases, I framed the problem of appraising those stocks differently than most investors probably did.

Let’s start with the smaller position: BWX Technologies. I bought BWX Technologies when it was Babcock & Wilcox. That company had been separated from a larger public company – McDermott International – about 5 years before and Babcock itself was expected to break-up a second time into two units: BWX Technologies and B&W Enterprises. B&W Enterprises was a highly cyclical engineering company tied especially to maintenance on coal power plants in the U.S. and new build revenue on other types of power plants around the world that also used big steam boilers. That is what united the two parts of Babcock. Both BWX Technologies and B&W Enterprises had long experience engineering steam boilers for use in industrial power plants, power plants owned by electric utilities, and the onboard nuclear power plants that power U.S. Navy submarines and aircraft carriers. I was not interested in owning B&W Enterprises. I was interested in BWX Technologies. That company’s profits came from its work providing nuclear reactors and other critical components to 3 U.S. Navy projects: 1) aircraft carriers, 2) nuclear ballistic missile subs, and 3) attack subs. It also made some profits from other nuclear work for other parts of the U.S. government. For example, it down blended weapons grade uranium from the level of enrichment that the U.S. military used in its nuclear weapons program to a level that would allow civilian uses. And it also provided material to the U.S. nuclear weapons program. There were some other businesses like maintaining nuclear power plants in Canada (where nuclear reactors were built to a different design than the rest of the world). I thought nuclear was a mature technology with a limited number of companies that had experience in it, with certain national rivalries and security concerns that often kept foreign competition low, and – most importantly – I thought it was an area most companies weren’t interested in entering. In Warren Buffett’s terms: I thought BWX Technologies had a wide moat. In GuruFocus terms, I thought it was inherently a “5-star” type predictable company. None of this showed up in the headline financial data though. BWX Technologies had been part of a much larger company and then part of a combined company with a unit that did work on coal power plants. Also, there was a unit called mPower that was basically a skunkworks type project for an experimental modular nuclear reactor (a nuclear reactor so small you could deliver it by train anywhere there was a rail line and run it for years without needing to refuel).

Basically, the way I framed the problem was that I was looking at a crown jewel type business that should trade at 20 to 30 times earnings in normal times. And yet, when you tried to take the entire combined company – B&W Enterprises, mPower, and BWX Technologies – together and value it, you saw the market was putting a P/E of 10 to 20 times normal earnings on the stock.

There really were not big differences in any sort of math here between what I saw and what anyone else saw. I had perhaps slightly more aggressive targets for the unit that became BWX Technologies over the next 5 years than others might have (but I was basing that on BWXT’s announced backlog, the U.S. Navy’s announced long-term plan for its capital ship needs, etc.). There was nothing very math-y about any of my calculations. There were a couple key differences to how I saw the stock. One, was deciding that mPower had a value of zero – not a negative value as some investors might have put on it if they lumped in its EBIT loss each year with the EBIT profit of the established businesses and then slapped a multiple on the corporate EBIT as a whole. Two, was deciding that BWX Technologies was really as blue as a blue chip stock could get and should trade at a P/E of 25 or whatever companies like Coca-Cola, Colgate, etc. deserve – because its future seemed as certain and as profitable to me as those kinds of companies. And then the last part was that I decided to buy the stock right then – when it still consisted of mPower, B&W Enterprises, and BWX Technologies all together and hadn’t technically announced for sure that it was definitely going to split up on such and such a date. So, my way of framing the problem was to say that BWX Technologies was a wide moat, predictable company worth 25 times earnings and you could buy it now if you’d just put up with some waiting time and uncertainty about when mPower would be shut down and when the spin-off would take place. In retrospect, you could have done fine in BWX Technologies by making a different decision than me on that last one. You could have waited till BWX Technologies was trading cleanly on its own. You couldn’t – however – have made as much money if you waited a full year or so for BWX Technologies to report a full year on its own, give long-term EPS growth guidance, etc. So, to me, BWX Technologies is an investment that is all about how you “frame” the problem. I didn’t see anything other investors didn’t. I just saw the stock differently. I saw it as this blue chip unit hidden in a hodgepodge of 3 different business units that were muddying the reported results.

My bigger position is in Frost. This is an extreme example of kind of crunching the numbers exactly the same as other investors do – but just choosing to focus on different numbers. I think Frost is – in normal times – one of the most value creating banks in the country. Let me explain. Frost has some of the lowest “all-in” funding costs per dollar of deposits. Banks pay two types of costs for their deposits. They pay interest. And then they pay everything else – branch costs, the cost of providing you with a nice website, moving your money around at no extra cost, etc. However, banks also charge fees. Frost doesn’t charge much in fees. It charges very little relative to what it provides. But, for some – especially big – banks fees are a huge offset to services. So, the way I look at banks is simply to add up what I think normal interest expense is and normal NET non-interest expense (cost of services less revenue from fees) and then divide that number by the bank’s deposits. If you do this, you get an “all-in” cost of funding which might be 2%, 4%, 6%, etc. Right now, if it’s 6% – that bank’s not worth anything. Banks make loans which aren’t better investments than government bonds, mortgage backed bonds, corporate bonds, etc. So, the way I “frame” the problem of valuing a bank – money is a commodity. Loanable funds are the same as investable funds. I don’t care if you are a life insurer that is buying long-term corporate bonds, a bank that is making loans to small businesses, or a sovereign wealth fund that is buying U.S. Treasuries. The asset side of your balance sheet is basically the same. I’m not going to be interested in an investment because of what the financial firm owns. I’m only interested in what it “owes”. I am interested in an insurer for its float. I am interested in a bank for its deposits.

Many banks use some liabilities other than customer deposits. These tend to be expensive. Frost’s balance sheet is pretty close to fully funded by shareholder’s equity (a little bit) and customer checking and savings accounts (a big bit). I don’t want them to use a lot of shareholder’s equity – that’s “my” money that they’ve had to retain. What I want them to use is a lot of low-cost, stable deposits. That is their “float”. If Frost can invest in 4.5% bonds the same as everyone else but it can fund deposits at an “all-in” cost of 2.5%, then it can make a 2% pre-tax profit on this “float”. And then I think Frost is a bank with a higher than average retention rate. Although I can’t definitively prove it, there’s evidence that Frost’s retention rate is the equal of any other bank in the U.S. A bank with a higher retention rate will grow deposits faster than a bank with an industry average retention rate. And then Frost is in Texas. Texas will grow its economy – and its banking deposits – faster than the rest of the country. So, the way I “frame” Frost is that I see a bank with low cost float that is going to grow that float faster than other banks (including banks with much higher cost float). I may or may not be right about that. However, I’m definitely different in doing that. I value Frost purely on deposits per share and the growth rate in deposits per share. So, if Frost had $200 a share in deposits and was growing deposits at 6% a year, I’d use a multiplier (it’s always actually a fraction less than 1) to multiply the deposits per share by to get a valuation figure. So, I might say that Frost is – if growing deposits by 6% a year – worth somewhere between 0.25 and 0.35 times deposits.

I don’t care what the P/E is today. I don’t care what the price to tangible book value is. I also don’t care what the “efficiency ratio” is (this is costs as a percent of revenue) because I always think in terms of costs relative to deposits never costs relative to revenue. And I don’t think about net interest margin. Float will appear to be less valuable in low interest rate environments and will appear to be more valuable in high interest rate environments. However, bank customers rarely switch banks or pull their deposits – so a dollar you add to your “float” in a low interest rate environment will eventually be an extra dollar you have in the next high interest rate environment.

I bought Frost a couple years ago. Before buying it, I analyzed and appraised it. When I valued Frost this way, I got an appraisal that was something like 2-3 times the then current stock price. Frost was then trading at 0.16 times its deposits while I valued the stock at 0.37 times deposits.

This is what I mean by an investment not being about seeing something others don’t and instead being about seeing the entire stock analysis problem differently. If I had framed Frost as something to be valued on the basis of the current P/E, P/B, etc. I would have seen the P/B was high and the P/E was a fairly normal 14 or so. Frost was – at the time I bought it – about the most normal looking stock you could find in terms of P/E, dividend yield, and EPS growth rate. It looked like a boring and correctly valued stock.

I looked at it differently. I valued the stock for the low cost “float” provided by its deposits. I didn’t look at the reported EPS growth rate from 2008-2014. Instead, I looked at the deposit growth rate from 2008-2014. And I didn’t look at what that float would provide in interest income when the Fed Funds Rate was 0% (as it was when I started looking at Frost). Instead, I looked at the interest income Frost would take in when the Fed Funds Rate was 3%.

What I am outlining here may seem like a boring rehash of the investment cases for two stocks I already own and which you can no longer buy at anywhere near the prices I paid for my shares. But, the process I am laying out here is one of the most important parts of successful investing. There is an intellectual pillar to good investing and there is an emotional pillar to good investing. The intellectual pillar is seeing things differently than others see the stock. The emotional pillar is holding on to your shares while others continue to see the stock the way you think is wrong.

There isn’t much I can do to help anyone with the emotional pillar of good investing. But, the answer to mastering the intellectual pillar is easy. You need to be more arrogant and independent. You need to be independent minded enough to be willing to frame the problem of appraising a stock in a way that is completely different from the approach everyone else is taking. And then you need to be arrogant enough to recognize that sometimes – far less than half the time, but yes, sometimes – your view is so clearly correct and yet so clearly at odds with the standard valuation approach, that you need to act on it.

I know it’s scary to think that way. Suggesting that most value investors I’ve come across lack both the independence and the arrogance to carry out a good, contrarian analysis and pounce seems like dangerous advice. But that’s what stock picking is. If you want to use “standard” approaches with the Ben Graham stamp of approval or something like that – you can. I think that’s a great approach. But, it’s a basket approach. You don’t need to spend a lot of time “picking” specific stocks along the traditional value metrics of price-to-book, EV/EBITDA, etc. If all banks are cheap enough – buy a basket of 5 of them, don’t try to select one over another. But, if you want to invest a lot of time in picking one stock over another – the only sensible approach is to up your level of intellectual independence and arrogance to the levels you see in someone like Warren Buffett.

If you’re going to pick specific stocks, you have to trust your analytical abilities enough to allow you to create a model of a stock that differs from the standard model. Every stock pick is an act of arrogance. If you don’t think you’re capable of seeing a stock more clearly than the market – get out of the game.

In 99 cases out of 100, I’m not capable of seeing a stock more clearly than the market. But, when I do act – it’s usually because I have the intellectual independence and, yes, arrogance to believe I’m framing the investment problem more clearly than the market is.