An Investing Approach
Indiana University March 2018
I am not the smartest person in the room and I understand, and accept that. I have a deep love of history so when I became interested in investing the first thing I did was try and identify what processes other successful investors had used.
This search led me first to Warren Buffett and from him to Benjamin Graham, Charlie Munger, and Phil Fisher (“The Big 3”). The simple ideas behind their investing process i.e. Mr. Market, Margin of Safety, and portfolio concentration I found to be intriguing and also was a good fit with my psychological profile.
As a concentrated value investor my primary objective is to find companies that I think have above average business models and have a long-run ahead of them. Now this sounds simple, and it is to some extent, but it is certainly not easy.
The first thing you have to do is study lots of business both existing companies and those that may no longer be around. There are several ways to do this with the first being to look around a books that successful investors have recommended in the past. You can develop a knowledge of what make companies work (and not work!) while reading about the development of companies such as Wal-Mart, Les Schwab, National Cash Register, Standard Oil, IBM, McDonalds, and Microsoft just to name a few.
So you probably thinking that is great so I can read about mostly old companies but how do I find current great companies? My first recommendation is search for fund managers that have an approach similar to yours. Take a close look at every company they hold and try to figure out what the fund manager saw that made him/her interested in buying stock in the company.
My next suggestion will likely make you cringe. You should find the time to look at every company starting alphabetically. This requires a ton of time and I understand why you might hesitate but it will help you understand companies better and help you figure out sectors you may want to avoid in the future. Also, critically, it will help you develop a company watch list.
So let’s transition into portfolio concentration which dovetails nicely with having a company watch list. I’m sure this won’t be shocking news to you but above average companies rarely sell cheaply. This is where the ideas of the Big 3 come in, you must have the ability to first identify them and even more importantly be able to wait until the market prices them at a level that is attractive. All that time you spent reading about companies and searching for potential purchases will come in handy when you develop a watch list of companies that you think have superior business models but find their market price to be too high.
My primary focus is always to find the great company that is currently mispriced but since it’s so hard to find those opportunities I also will invest in companies that find themselves in some sort of short to medium term problem that has driven their stock price down. I have found that if the market thinks the company will have problems that may take an extended period of time to fix they sell out and are not price sensitive. One example of this happening is when a business has a facility that has failed an FDA inspection. The stock price immediately takes a large hit and many “investors” will immediately sell to avoid the stagnant stock period they know will be coming.
I also will occasionally invest in other “special situations” that include merger arbitrage, spinoffs, etc.. This area has become much harder to harvest easy returns from though as the day of the stock broker selling on the news of a merger announcement has passed and the popularity on the strategy has increased dramatically over the past decade.
One last word on portfolio concentration, you must develop the ability to find accounting red flags. This topic is far too large to discuss here but I would recommend reading the book Financial Shenanigans, (2nd and 4th Editions are the ones I recommend) to expose yourself to this area.
One must have characteristic of a concentrated value investor is the ability to sit on your ass and do nothing unless the right pitch comes right down the middle. Here is what Lou SImpson had to say in an old GEICO annual report:
“..in equity investing, when you don’t have any really good ideas (i.e. excellent companies at very attractive prices) doing nothing – or selling – is the best course of action.”
Now this may sound obvious but it’s much harder than it seems. For one thing you can have extended periods of inactivity and if your managing other people’s money they may not understand this behavior as it contradicts one of the institutional investing circles manas i.e. you should be near fully invested at all times.
What should you take for the Mr. Market idea presented to you by Benjamin Graham in his superb book, The Intelligent Investor? Investors do not behave in a rational manner all the time. When bubbles happen, when manias take place, they often forget their investment process because this time it’s different than what has come before and the rules can be temporarily suspended. I’ve seen this lead to financial disasters time after time for those that can’t maintain their focus and independent mindset.
“Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period – or even to look foolish – is also essential.” Warren Buffett 2017 Berkshire Hathaway Annual Letter.
I try to find companies that have a historical record of profitability, those that have recently had issues such as a failed FDA plant inspection that has caused a significant decline in their stock price, or have short-term problems that will affect profitability.
I also must be able to develop and understanding of the business which means I need to be able these questions: how do they generate cash, does the business have a quality that enables it outperform similar companies, what is its competitive history and what will the competitive environment look like in the future?
I’m most interested in companies that have a stable history of profitability or that will have a clear route to continued profitability.
As an example I often watch for companies that have approved drugs but their production plants run afoul of an inspection by the FDA. This means they will face profitability pressures and will take quite some time and money to correct the issues. These companies are often punished hard by the stock market and are worth placing on your watch list and can become possible buys after a evaluation of the degree of serious of the FDA actions and how long it may take to resolve the issues to the satisfaction of the FDA.
Keep your eyes always open for companies to invest in. That is easy to say but how can I find them?
- Always be searching
When I was diagnosed with sleep apnea I wanted to understand the problem better with eventually led me to look at two at, and invest in, two publicly traded companies that provided devices that addressed that market. Resmed example
- Watch List
Always be searching for companies that you find interesting but not currently compelling, usually because of a high stock price in relation to a company’s intrinsic value. You should spend lots of time developing this so that you can be ready to seize opportunities when they present themselves.
There are two main types of screen I would recommend. The first type would be screens that look for certain financial characteristics such as high ROE, high EBITDA margins, etc… I also use screens when I want to find competitors to companies I develop an interest in.
I look at the daily decliners.gainers and new 52 week low list in the WSJ everyday and will often take a look at any company that catches me eye.
I have also done screens on Morningstar that show all small-cap funds, for instance, and have searched the holdings of every fund listed.
- Start looking at companies from A-Z
Buffett and the Moody Manuals. My suggestion would be to start looking at every company in a industry sectors that you find interesting then expand to every company within market capitalization bands.
Mr. Buffett speaking to Columbia students in 2006:
“Reading has made him rich over time. He told the story of going through Moody’s annuals in 1951. “It was absolutely a question of turning pages”.
He also mentioned looking at a copy of the 2005 Korean Stock Market guide. It was more of an almanac than a brokerage report. It was sent to him for free by a broker. “If it had been $10, I wouldn’t have paid for it.” Based on the recommendation of a friend who thought South Korean stocks were cheap, Buffett spent 5-6 hours leafing through the pages and put together a $100m portfolio of 20 or so companies. Daehan Flour sold 25% of the flour in South Korea, which had a large and stable economy. It’s earnings over the last few years: 12,870 won, 18,000 won, 22,830 won. It had over 100,000 won in securities. The stock price was 38,000 won. “You have to make money buying stocks like this at 2x earnings. Brokers aren’t going to tell you about Daehan Flour.”
Start with the usual suspects such as the WSJ, Financial Times, magazines, and trade journals. Also pay attention when reading any article or book that happens to mention a company. If you find the company interesting spend a few minutes and see if the company is public.
I also read tons of 10K statement as well as the annual reports of companies I own and their competitors. I also find it interesting to examine 13F filings of fund managers I respect.