Fundamental Techniques in Handling People

"If You Want to Gather Honey, Don't Kick Over the Beehive"

Criticism is futile because it puts a person on the defensive and usually makes him strive to justify himself. 

Criticism is dangerous, because it 

• wounds a person's precious pride, 
• hurts his sense of importance, and 
• arouses resentment.

By criticizing, we 

• do not make lasting changes and 
• often incur resentment.

The resentment that criticism engenders 

• can demoralize employees, family members and friends, and 
• still not correct the situation that has been condemned.

Don't complain about the snow on your neighbor's roof, when your own doorstep is unclean.

Confucius

When dealing with people, let us remember we are not dealing with creatures of logic. 

We are dealing with creatures of emotion, creatures bristling with prejudices and motivated by pride and vanity.

Any fool can criticize, condemn and complain – and most fools do. 

But it takes character and self-control to be understanding and forgiving.

A great man shows his greatness by the way he treats little men.

Thomas Carlyle

Instead of condemning people, let's try to understand them. 

Let's try to figure out why they do what they do. 

That's a lot more profitable and intriguing than criticism; and it breeds sympathy, tolerance and kindness.

Reference:  How to Win Friends and Influence People by Dale Carnegie

Dealing with people

Dealing with people is probably the biggest problem you face, especially if you are in business.

[...] even in such technical lines as engineering, about 15 percent of one's financial success is due to one's technical knowledge and about 85 percent is due to skill in human engineering – to personality and the ability to lead people.

One can for example, hire mere technical ability in engineering, accountancy, architecture or any other profession at nominal salaries. 

But the person who has technical knowledge plus the ability to express ideas, to assume leadership, and to arouse enthusiasm among people – that person is headed for higher earning power.

If you teach a man anything, he will never learn.

Bernard Shaw

Reference:
How to Win Friends and Influence People by Dale Carnegie

Investee Accounting

Investee Accounting

A company can account for an investee in one of three ways. 

The way that’s used depends on how much control the company has over the investee.

Control is assumed to depend on how much of the investee the company owns.

So the accounting method is usually determined by percentage ownership.

This is flawed.

Ownership doesn’t mean control. 

Just ask an entrepreneur with a start-up that’s 10 percent owned by the leading public company in its industry. 

What really drives control is 

• the prospect of more funding, 
• access to customers, or 
• a potential buyout. 

Nonetheless, percentage ownership is what’s commonly used.


1.  Owns less than 20 percent of the investee  (Cost Method)
If the company owns less than 20 percent of the investee, the cost method is used.

The investment is carried on the balance sheet as an asset at cost, and that’s it.



2.  Owns between 20 percent and 50 percent of the investee (Equity Method)
If the company owns between 20 percent and 50 percent of the investee, the equity method is used. 

The investment is initially carried on the balance sheet at cost. 

When the investee has net income, that net income is multiplied by the percent of the investee that the company owns.   This proportionate share of investee net income is then added to the company’s income statement.

It’s called something like earnings in affiliate. It flows through to the balance sheet as an addition to the carrying value of the investment.

If the equity method is used, the investee is an unconsolidated subsidiary of the company.


3.  Owns over half of the investee (Consolidation Method)
If the company owns over half of the investee, the consolidation method is used.

This makes the investee a consolidated subsidiary. 

The investee’s revenue and expenses are consolidated—mashed in—with the company’s revenue and expenses on the income statement.

Further down there’s a line called something like earnings attributable to noncontrolling interest. 

That’s the amount of the investee’s earnings that belong to its other owners. 

It’s the proportionate share of  earnings that aren’t the company’s. It’s subtracted.

The top part of the income statement dreams that the company owns all of the subsidiary. The lower part wakes it up.

The consolidation method also calls for all of the investee’s assets and liabilities to be included on the company’s balance sheet.

Noncontrolling interest —which appears in either the liabilities or equity section, as noted earlier—corrects for the portion of the investee that the company doesn’t own.

That is, earnings attributable to noncontrolling interest is to the income statement what noncontrolling interest is to the balance sheet.

Is it inexpensive? Four different price metrics:

#Nothing is worth infinity. 

We can overpay for even the best of companies.

So even if we understand a business (first step) and find it to be good (second step) we can still make a bad investment by paying too much.

The third step in the value investing model asks a final fundamental question: Is it inexpensive?



Inexpensiveness can be detected with four different price metrics:
1. Times free cash flow (MCAP/FCF)
2. Enterprise value to operating income (EV/OI)
3. Price to book (MCAP/BV)
4. Price to tangible book value (MCAP/TBV)



#Price metrics

1.  Times free cash flow. 

It equals a company’s market capitalization divided by its levered free cash flow. It’s abbreviated
MCAP/FCF.

The denominator, levered free cash flow. 

• It’s cash flow from operations minus capex. 
• Note that it captures the payment of both interest and taxes.

The numerator, market capitalization, is often shortened to market cap.

• It’s the number of shares outstanding times the current price per share.

Notice the consistency between numerator and denominator.

• Market cap is the price for the equity only. 
• Levered free cash flow is the cash thrown off by the business after debtholders have been paid their interest.  Hence levered free cash flow goes to the equity holders.

Theoretically, market cap is what it would cost to buy all of a company’s outstanding shares.

• But it’s actually an underestimate. 
• That’s because the current share price reflects only what some shareholders were—moments ago—willing to take for their stock. 
• Most are holding out for more.

2.  Enterprise value to operating income. 
It’s abbreviated EV/OI.

The denominator, operating income. 

• It’s revenue, minus cost of goods sold, minus operating expenses. 
• Note that it’s not net of interest or tax expenses.

The numerator, enterprise value, is the theoretical takeover price.

• It’s what one would fork over to buy the entire company, not just the outstanding shares.
• Paying it would leave no one else with any financial claim on the company. 
• There’d be no outside common stockholders, no preferred shareholders, no minority partners in subsidiaries, no bondholders, no bank creditors, no one.

Enterprise value is a tricky concept, for two reasons.

1.  First, it’s derived in part from current market prices.

• So in name, it defies the value investing distinction between price and value. 
• The term enterprise price would make more sense.

2.  Second, it’s harder to calculate.

• In essence, it equals market cap plus the market price of all of the company’s preferred equity, noncontrolling interest, and debt and minus cash.

Like market cap, the enterprise value of a particular company is given on financial websites. Such off-the-shelf figures are convenient. But if a company looks promising, it’s wise to calculate enterprise value longhand. To see why, consider its components.



3.  Price to book. 
It equals market cap divided by book value. It’s abbreviated MCAP/BV.

Book value, recall, equals balance sheet equity.


4.  Price to tangible book value, or MCAP/TBV. 
It’s MCAP/BV with intangible assets removed from the denominator.   Patents, trademarks, goodwill, and other assets that aren’t physical get subtracted.

MCAP/TBV is a harsher measure than MCAP/BV.

• It effectively marks any asset that can’t be touched down to zero. 
• Some situations are better suited to this severity than others. 

To see which ones, we revisit goodwill.

Recall that goodwill equals acquisition price in excess of book value.

• We gave the example of company B having book value of $1,000,000; company A acquiring it for $1,500,000 in cash; and company A increasing the goodwill on its balance sheet by $500,000.

Note the assumption embedded in this practice.

• Goodwill is an asset. 
• So in buying company B and goodwill, company A is swapping assets for assets. That’s how accounting sees it. 
• No expense is recognized on the income statement, and no liability is booked on the balance sheet. 
• Nothing bad occurs.

#What’s inexpensive, and what isn’t?

1.  MCAP/FCF and EV/OI

When we calculate price metrics, we get actual numbers. MCAP/FCF may be 5, or 50. EV/OI may be 3, or 30. What’s inexpensive, and what isn’t?

I like MCAP/FCF to be no higher than 8, and EV/OI to be no higher than 7.  

Before moving on to benchmarks for the other two price metrics, let’s understand what these first two multiples mean.

• Imagine that a company’s future operating income will be $1,000,000 for each of the next 100 years. Discounting that stream back at—say—10 percent yields $9,999,274.
• That quantity, $9,999,274, is nearly $10 million. Notice that $10 million is 10 times the forecasted annual operating income.
• So if one calculates a company’s EV/OI as 10, that could mean that the market thinks operating earnings will be $1,000,000 for each of the next 100 years, and 10 percent is the right discount rate.
• Or, it could be mean that the market thinks operating income for the next 100 years will grow 4 percent annually from a $1,000,000 base, and that 14 percent is the right discount rate.

In other words, multiples are shorthand. 

• They’re shorthand for a formal present value analysis. 
• In them are embedded beliefs about growth rates and discount rates.

Holding everything else equal, it’s better to own a company with income that’s growing than one with income that isn’t. 

So when I say that I want EV/OI to be no higher than 7, what I’m saying is that I’ll only buy a stream of future operating income when it’s offered to me at a high discount rate.

Of course one never knows just what future operating earnings will be. Same with free cash flow. And where the exact discount rates come from isn’t important.

What is important is this: 
"low price multiples signal buying opportunities to the value investor when they reflect unjustifiably high discount rates."

2.  MCAP/BV and MCAP/TBV

The other two price metrics, MCAP/BV and MCAP/TBV, are a little different. 

• They don’t reflect a stream of future anything. 
• They’re multiples of what a company has now.

I prefer both MCAP/BV and MCAP/TBV to be no higher than 3.

But these are just qualifiers for me. They’re not what I look for.

What I look for is MCAP/FCF and EV/OI. 

It’s worth exploring why.


#Why MCAP/FCF and EV/OI are preferred to MCAP/BV and MCAP/TBV?

I aim to own companies that continue as going concerns.

• I want them alive. 
• Profitable ones are worth more that way. 

But MCAP/BV and MCAP/TBV express price relative to the value of companies dead. 

• If a firm stopped operating and sold everything—if it liquidated—the total amount available to distribute to shareholders would have something to do with its book value. 
• But when I buy a stock, I don’t hope for a stake in some dead company’s yard sale. I’m buying a claim on future streams of income and cash flow.

This isn’t to say that MCAP/BV and MCAP/TBV are useless. They can uncover opportunities. 

• Say that a company’s EV/OI is 9, and that both MCAP/BV and MCAP/TBV are 6. 
• The company doesn’t look inexpensive. 
• But MCAP/BV and MCAP/TBV are the same. 
• This leads the astute investor to see if the company owns some juicy tangible asset like land that’s carried on the balance sheet at a tiny, decades-old purchase price. 
• Will the company sell the land for cash? 
• Will that cash be excess? 
• If so, all of the price metrics could plunge. That’s the kind of useful thinking that the dead metrics tease out.

#The first step is to understand a business and the second step is to find it to be good; then valuation

Putting forth my benchmarks so bluntly—8, 7, 3, and 3—is a little dangerous and potentially misleading.

It’s dangerous because it could be interpreted to mean that it’s OK to cut right to valuation without first understanding a business and seeing if it’s good.  Many investors do that. And it can work. But with that approach mine are not the benchmarks to use.





Summary

Inexpensiveness can be detected with four different price metrics:
1. Times free cash flow (MCAP/FCF)
2. Enterprise value to operating income (EV/OI)
3. Price to book (MCAP/BV)
4. Price to tangible book value (MCAP/TBV)

Not illegal but morally wrong. Four ethical postures toward investing.

What if a company being considered for investment turns out to do something that one thinks is morally wrong?

Not illegal. Not against any regulations. But wrong. Something about its customers, its tactics, or its leadership strikes one as ethically off.

Maybe the company uses a dominant market position to beat family-owned businesses into insolvency. Perhaps its management team is insufficiently diverse from a gender or an ethnic perspective. Or possibly it’s the very nature of its products, because they’re unhealthful, addictive, or dangerous.

Whatever it is, something in one’s makeup—upbringing, religion, or just a conviction on how civilization should work—shoots a sharp message: the world would be better off without this firm.

I don’t raise this issue as some sort of moralist. I’m not a philosopher, missionary, or member of the clergy. I raise it for practical reasons.

To achieve long-term after-tax outperformance, one must hold on to stock in good companies for a long time. It’s easier to do this with a portfolio that’s consistent with one’s moral posture. Not exemplary or praiseworthy, just consistent. Otherwise, a sudden awakening of principles could compel one to sell stocks for an uneconomic reason. If that happens when prices are down,
financial health suffers.

It’s therefore useful to define one’s ethical disposition early. I’ve seen smart people do it in one of four ways.

The first is amorality. 
It’s not viewing investing through an ethical lens. It regards money management as an activity that sits outside of moral consideration. Put differently, it sees the ethical imperative of investing as growing wealth.

The second is what I call moral failure abstention. 
It’s not investing in companies with certain unsavory characteristics. It’s a list of don’ts. It often entails dismissing firms that make certain products. Cigarettes and handguns are two common current examples.

The third is what I call moral success affirmation. 
It involves investing only in companies with certain desirable characteristics. It’s a list of do’s. Again, this is commonly related to a firm’s products. A popular current example is renewable energy.

Fourth is what I call moral failure activism. 
It involves buying stock in companies with undesirable characteristics for the purpose of pushing for change as a shareholder. It’s premised on stockholders having more influence over company affairs than do mere citizens. For example, shareholders may be able to force a shareholder proposal onto the agenda of a company’s annual general meeting.

My purpose in sketching out these four ethical postures is not to advocate one over the other three. My purpose is to encourage the picking of one—or of some variant—to avoid a hiccup in performance later on.

Practicality may not be the only good reason to define one’s moral posture. But it’s the one that’s easiest to accept. And while one’s ethical views can change over time, I’ve observed that they tend to change less than other facets of an investor’s makeup. It’s an enduring feature with which the investor reckons, either early and painlessly or later and less so.



Summary

There are four different moral postures toward investing:
1. Amorality
2. Moral failure abstention
3. Moral success affirmation
4. Moral failure activism

Generating Ideas

The value investing model needs to be fed stock ideas. These ideas can come from different sources, some of which are more fruitful than others. I look at seven.


1.  The first source is bad news. 
Stories about companies often emphasize an extreme element of an event. These extremes get amplified in headlines. Headlines drive human reaction, sometimes too far. This can cause stock price
swings deeper than would a more sober take on the facts.

Overreactions don’t just come from individual investors. They come from professional money managers as well. For example, a hedge fund doesn’t want to scare off its limited partners when it reports holdings at the end of a quarter.  As such it may dump a perfectly good company going through some passing embarrassment.

Sometimes a news-driven stock price drop may be warranted, but overdone. Take Anheuser-Busch, the maker of Budweiser beer. In 2005, newspaper articles appeared suggesting that beer’s days were over. Alternatives like vodka with Red Bull were gaining ground with younger drinkers. I analyzed AnheuserBusch and found it to still have a thriving core business. But the stock price dropped anyway.

As I was turning this over, dad invited me to the baseball game in San Francisco. I can’t remember who the visiting team was, or who won. But I do remember what I saw: people drinking a lot of beer.

My observation hardly qualified as advanced market research. Plus it happened in an American ballpark, a natural context for beer drinking. But it was real. Beer’s days weren’t over. Shortly afterward I paid $45 per share for stock in Anheuser-Busch.

Three and a half years later, in November 2008, the company was acquired for $70 per share. Including dividends, that investment delivered an average annual return of around 15 percent. I neither sought nor liked the buyout.  But taxes on gains are the preferred kind of financial pain.

Other times a news-driven stock price drop is fully justified. For example, Volkswagen’s share price plunged following an emissions scandal that emerged in September 2015.  While the situation is still playing out as of this writing, it  appears that there was in fact an organized effort within the company to skirt regulations. That’s bad. Plus, Volkswagen didn’t register as good before the crisis. Its ROCE was underwhelming. To the astute investor hoping to hold for decades, the situation presented little opportunity.

On rare occasions a news-driven stock price change is totally unjustified. This can happen because a story affecting one company leads to trading in the stock of another. For example, online messaging company Twitter chose TWTR as its stock ticker symbol in preparation for its November 2013 IPO. This caused a wild surge-and-crash cycle in TWTRQ, the common stock of bankrupt electronics retailer Tweeter Home Entertainment Group.

Bad news can involve real tragedies. Security breaches compromise privacy, train crashes cause injury, and foodborne bacteria spark illness. No investor of conscience wishes for these mishaps.

But sensationalist reporting can trigger dislocations that don’t make sense. The gap between price and value yawns. The astute investor is meant to bridge it. Good investing has no friend like bad journalism.

2.  A second source of ideas is spin-offs. 
A spin-off is the public listing of a company that was  previously part of another listed company.

The spin-off process generally starts with a distribution of shares in the newly independent entity to the old parent’s shareholders in the form of a dividend. Then those new shares start trading.

Often, some of the old parent’s shareholders are institutional investors. When their spin-off shares start trading, they may sell them automatically. This is because the new stock doesn’t meet their formal investment criteria, such as a minimum market cap. This forced selling can depress the price of shares in companies that, if they’re both understood and good, are worth owning.

3.  A third source is regulatory filings. 
Many governments require large investors to periodically report their holdings. These filings are public. One can compare reports between periods to see which stocks talented professionals bought. 

In America, money managers with at least $100 million in assets under management are required to file a quarterly report that lists—with some exceptions—their U.S. stock holdings. Called a 13F, the report is due 45 days after the close of a quarter. They’re posted at www.sec.gov. Check midway through February, May, August, and November.

Mining 13Fs has many limitations. Understanding them helps to make the tactic work.

The first limitation is that one has to know which professionals are worth following. Outperforming mutual fund managers are easy to spot, since their track records are public and clear. But private fund managers may share their records only with clients. And professionals that run portfolios inside larger companies—even listed ones—may never detail their histories.

One can’t really know if a professional is worth following before seeing a track record. Fame is not a proxy for performance. I am routinely struck by the high profile of some perennial laggards, and the anonymity of some total stars.

A second limitation is that 13Fs disclose only long positions. 
They don’t disclose short positions. This makes them useless for studying managers that pair long and short positions in what are effectively single bets. It’s potentially dangerous to mistake the visible long half of such a bet as the full bet.

Third, 13Fs don’t disclose the prices paid for shares. 
One can research the low for a quarter and safely conclude that the price paid was not below that. But greater specificity isn’t available.

A fourth limitation is the time lag. 
In the 45 days since the end of the quarter, stocks just bought could already have been sold. Correspondingly, positions sold could have been reestablished.

Fifth, the filing itself can drive the price of a stock up. 
When a well-known professional buys something, many blindly follow. This can end any inexpensiveness that once helped to make the stock attractive.

Sixth, a stock appearing for the first time on a 13F may not have actually been bought. 
It may have been received in a spin-off. A money manager may even have started selling it between the date of receipt and the date of the filing.  It could be the opposite of an idea worth considering.

Seventh, the authority bias can push one to play copycat. 
A psychologically undisciplined investor can unthinkingly mimic a master. But masters make mistakes. It’s better to view the debut of a stock on a 13F as an invitation to analyze from scratch.

A different cognitive bias can push one away from reading 13Fs. It’s the peculiarity bias. It can make 13F mining seem parroty. Dirty, even. But that’s misguided. Consider an analogy.

Imagine a restaurateur with a downtown restaurant. Every quarter, the restaurateur receives in the mail a letter from a trusted authority. The letter discloses the major actions taken by the most successful restaurant in the country. One quarter it might say that the exemplary establishment raised soft drink prices by 5 percent. The next quarter, it bought a new fryer. And so forth.

Would the restaurateur throw out the letter without reading it? Of course not. It’s informative and accurate, and might contain a useful idea. It’s like the best trade magazine imaginable, free and errorless. Plus the restaurateur accepts no obligation to do whatever the better establishment did just by reading.

An investor ignoring 13Fs is like the restaurateur throwing out the letter. It’s an odd, limiting act. A better approach is to read select 13Fs fully aware of their shortcomings, secure in the knowledge that autonomy is not sacrificed. One isn’t required to replicate a hero’s trade any more than the restaurateur is required to buy a new fryer. A disclosure is not a directive.

4.  The fourth idea source is reorganizations. 
Often shortened to reorg, a reorganization is a transformative event in a company. It could be 

• a merger, 
• a big change in capital structure, or 
• the sale of a major division. 

It often involves complications that only an investor comfortable with complexity would care to sort out.

Such complications repel many. This limits the universe of potential buyers. A lower share price can result.

5.  A fifth source is small capitalization stocks. 
Also called small-caps, these issues generally have market caps under $2 billion.

Companies this size can be hard for institutional investors to buy, for two reasons. 

• For one, they may be prohibited by charter from buying stocks with a market cap below some threshold. 
• Second, even if they’re allowed to buy small-caps, it might not be useful for them to do so.

Picture a $50 billion mutual fund that sees promise in a $500 million market cap firm.  Even if it buys 10 percent of the company, and that stake doubles in price, the needle on the fund’s overall performance would barely budge. So the investment wouldn’t be worth making.

These two factors leave many small-cap stocks untouched by a big part of the asset management universe. The result can be lower share prices worth pursuing for those running smaller amounts of capital.

Small-cap investing can take on some of the characteristics of activism. Activism is agitating for change in owned companies. It can come with small-cap investing for two reasons. 

• First, sometimes it’s necessary. Small-cap company management teams may take advantage of the absence of big institutional investors to do things that they wouldn’t with greater oversight. 
• Second, it’s possible. Small-cap executives may be more accessible than large company executives. Presidents quickly returning e-mails is not unusual. 

In short, small-cap investing can occasion a deeper involvement with holdings, something that the astute investor readies for.

6.  A sixth source is stock screeners. 
Stock screeners are Internet tools that filter stocks according to quantitative parameters. They’re often based on valuation metrics. One might fetch a list of stocks ranked by their price to book ratio, for example.

Stock screeners aren’t my favorite source. To the long-term holder interested in first understanding a business and seeing if it’s good, starting with valuation is putting the cart before the horse. Additionally, stock screeners can call attention to companies in outlying financial situations that wouldn’t interest someone looking to hold for life. Nonetheless, many strong investors get good at tapping this source for ideas.

7.  Seventh is serendipity. 
Serendipity is the mental preparedness to receive tips from everyday life. It requires being engaged with the world. While driven by chance, it doesn’t strike randomly. It favors the open mind.

I first became interested in the Swedish company Clas Ohlson when I noticed that every time I went into one of their Stockholm hardware stores, there seemed to be a lot of customers buying a lot of things. I analyzed the company and found it to be good. Had I not been receptive to ideas that crop up unexpectedly, I might not have noticed it.

Incidentally, this particular find didn’t play out perfectly. The stock never got inexpensive enough for me to buy. Plus, I got a little overzealous in my search for disconfirming evidence.

During travels around Sweden, I would pop into stores just to make sure that the chain’s appeal wasn’t limited to Stockholm. It wasn’t. They all had customers. Then late one afternoon at the end of a weekend in the city of Helsingborg, I walked into the Clas Ohlson store on the main pedestrian mall.  Empty. Gotcha, Clas Ohlson. As I was peeking down the aisles to make sure that  I hadn’t missed anyone, a woman called over from behind a counter, “Pardon, but we’re closed.”

Serendipity is also useful in reaching conclusions about companies already under consideration. In 2012 I was analyzing Tesco, the British grocer. Investors I admired owned it. Also, I’d recently been floored by its express store on Monck Street in London. It had everything that I’d come for, all located right where I expected.

Serendipity intervened the next month, back in California. I noticed an ad for a new chain of supermarkets called Fresh & Easy. It turned out to be owned by Tesco. I visited the store closest to my house, in the city of Mountain View. Product quality was high, prices were fair, and the staff was attentive. Of course the staff was attentive—I was the only customer. I stopped my analysis. Since then Tesco’s stock price has plunged, due in part to a drop in same-store sales to which my neighborhood Fresh & Easy clearly contributed.  It’s closed now.

Serendipity is great with consumer-facing industries like retail. They’re exposed. But one may be familiar with other, less universally visible industries because of a job or background. It works there, too.

Serendipity has the pleasant effect of boosting the relevance of ordinary environments. Everything is evidence. The logos on people’s shoes, the number of passengers on the plane, the brand on the broken escalator—all can inform judgments about what people buy, what companies make, and what products work. This doesn’t condemn one to a life at a heightened state of alert. Rather, it offers a spigot of ideas whose handle the astute investor controls.




#The seven sources are mere inspirations for the model. 
None of them credential an idea to pass through with preferential treatment. In fact, once one feeds an idea into the model, it’s best to forget where it came from.

The advantages of this practice are clear. When we forget that we’re looking at a company because it’s a spin-off, it’s owned by a hero, or its stock price plunged, we keep a whole raft of cognitive biases at bay. We get raw material worth processing, plus the clear mind needed to process it well.



Summary

Promising sources of investment ideas include:

1. Bad news
2. Spin-offs
3. Regulatory filings
4. Reorganizations
5. Small-caps
6. Stock screeners
7. Serendipity

Differences between Value Investors

The distinction between price and value is the sole requisite principle of value investing. It’s the only must. Beyond that, there are valid differences in  approach. I see eight.


1.  First is asset class. 
Listed equities return best over time, as addressed. But there are practitioners able to squeeze performance out of other sorts of holdings. Bonds work for some, real estate works for others. They’re tougher rows to hoe, but some hoe them well.

2.  A second valid difference is holding period. 
Some value investors plan to hold what they buy for just months. Others hope to hold indefinitely. Different timelines occasion different priorities. For example, short-term holders consider catalysts. A catalyst is a reason that a price could soar from the depressed level that helped to make a security attractive. Unexpectedly good quarterly results could be a catalyst, as could the dismissal of an unpopular executive.

Catalysts are less interesting to long-term investors. They’re too near-term a concern. Never intending to sell, I don’t give them a thought. 

3.  A third valid difference is activism. 
Activist investors agitate for change in the companies that they own. They might be viewed as their own catalysts. The alternative is staying uninvolved. It’s the choice of most investors, both good and bad. I call it inactivism, since passive implies index fund investing.

Activism requires an extraordinary level of gravitas and tenacity. People who are feared and skilled in this specialty are the ones that achieve the best results. Activism is not something in which one fruitfully dabbles.


4.  Fourth is diversification. 
Some value investors have diversified portfolios, with perhaps 50 or more names. Others prefer concentration, with fewer than 10.

These thresholds depend somewhat on the amount of money managed. A $50,000 portfolio spread out among a dozen different stocks might be considered diversified, while a $10 billion fund invested in a dozen names might seem concentrated.

Diversification tends to decrease volatility, should that be a goal. But, the more diversified a portfolio is, the harder it is to beat a relevant index.

One way to appreciate this is through the law of large numbers. It’s a principle from probability. It says that the more times an experiment is run, the closer the average result will be to the expected result. In investing, the expected result is the index’s return. So the more names in the portfolio—each name being an experiment, in the parlance of the law—the closer the portfolio’s return will
be to that of the index.

Some stripes of value investing force one into a diversified portfolio. Small cap investing can, since there aren’t that many shares traded of each company.  They’re small. So a small-cap investor that adds $100,000 to assets under management might have to find a new name because the ones already owned don’t have enough shares available to buy.


5.  A fifth valid difference is quality. 
Our approach has been to focus on how good a business is in an absolute sense, before considering price. We labor over historic performance metrics, strategic positioning, and shareholder-friendliness. We look for quality.

But an equally convinced group focuses on buying companies that are inexpensive relative to how good they are. To them garbage is fine, as long as it’s cheap garbage. Some in this group get exceptional results.

My focus on company quality reflects three of my other preferences: inactivism, concentration, and a long holding period. What I buy has to be good because I’m not going to fix it, I’ve only got a few others like it, and it’s mine forever.

These preferences aren’t about great foresight or morality. They’re about taxes. Unrealized appreciation isn’t taxed in the United States, so everything else being equal, holding is advantageous. I draw a straight line from tax policy to investment policy.


6.  Sixth is leverage. 
Leverage is debt. What is true for operating companies is true for investors: debt amplifies results. When an investor buys on margin, results that would otherwise be good become exceptional, and results that would otherwise be bad become catastrophic. The potential of the latter keeps many value investors away from debt. But not all.



7.  Seventh is complexity. 
Some value investors prefer simple setups. They like common stock in straightforward companies. I do, as the model makes clear. But others like it complicated. They may seek convertible bonds that become equity only under hard-to-forecast circumstances. They may prefer stock in development-stage pharmaceutical companies undergoing clinical trials, or in technology companies whose fortunes are dependent on the outcome of pioneering research.

They adore these complications not because they’re falling prey to the cleverness bias. They adore them because it gives them less buy-side competition. Other investors will simply abstain from trying to sort out convoluted situations. This can keep prices lower than they would be otherwise.


8.  Eighth is shorting. 
Shorting is a way to bet on a stock price’s decline. It involves selling stock without actually owning it, by renting it from someone who does, with the goal of profiting when the price falls.

Shorting is theoretically attractive. It promises a way to benefit from a finding that a security is overpriced. But it’s thorny to implement. Shares to rent can be hard to find, fees can be high, and a short squeeze can cause a price meant to plunge to actually soar.

Despite these complications, some value investors do short. But many do so as agents, not as principals. That’s because it increases their compensation. Shorting is a hallmark of a complicated fund. It’s the kind of stunt that managers attempt in order to justify compensation schemes of 2 percent plus 20 percent. It’s a ticket out of the land of 1 percent.




Dicey Strategies:  Can work and Doesn't work sometimes

Of the eight dimensions on which value investors can differ, two invite suspicion. 

1.  Shorting is one. 
It just doesn’t work that well. I know of no principals that both rely on shorting and outperform over the long term.

2.  Leverage is the other. 
While debt can be milked for bonus returns much of the time, one big margin call can be enough to foul years of solid results.



I nonetheless include shorting and leverage on the list to allow for the possibility that they could be made to work under some circumstances. 

• But they’re dicey. 
• They’re back doors out of the kingdom of value investing and into a land of some other, less practical strategy. 
• Some would say that this invalidates them as intelligent tactics. 

To those with long-term perspectives, something that doesn’t work sometimes can ultimately be indistinguishable from something that doesn’t work at all.



Summary

Dimensions on which bona fide value investors can differ include:

1. Asset class

2. Holding period

3. Activism

4. Diversification

5. Quality

6. Leverage

7. Complexity

8. Shorting

Preservation of Capital. Not losing money.

#Losing money is worse than not losing money. 

Some math makes clear why value investors act conservatively.

Picture a portfolio that realizes a 50 percent loss in a year. Not one that started the year with stock that just happens to have halved in price 12 months later. One that actually realized a 50 percent loss. One that began on January 1 with cash, bought stock during the year, sold that stock later in the year, and on December 31 had half as much cash as it started with. What would it take for the portfolio to get a fresh start?

It would need a 100 percent return the next year just to get back to zero. That’s hard. 

Consider soccer. If a player takes a shot on goal and misses, nothing happens to the score. The player gets a fresh start with the next ball. But if soccer was investing, the player would get negative points for missing. Goals would be required just to get back to zero.

That’s why value investors behave with such restraint. We put capital preservation first. We do so because the mathematics of our missed shots is punitive.




#When capital preservation is underemphasized

When capital preservation is underemphasized, returns suffer. 

Returns suffer because losses add up like weights. 

This truth isn’t evident to those who believe in the risk-return trade-off. They see the subordination of capital preservation as a step toward outperformance. And those believers constitute the majority. 

Perhaps that’s why the asset management industry has such staggering failure rates. Most actively managed equity funds—those that pick individual stocks—don’t beat basic market indexes.

Most. That’s the output of a blind majority.




#Repel Losses

Two practices help to preserve the value investing model’s ability to repel losses.

A.  The first is to keep it current. 

Think of the model as having three layers (Figure 21.1).

1.  The top layer is the general guidance:

• know what to do, 
• do it, and 
• don’t do anything else. 

2..  The middle layer gets more specific, insisting that investments be

• understood, 
• good, and
• inexpensive.

3.   The bottom layer is more specific still. It’s all of the lower text:

• the six parameters of understanding,
• the historic operating metrics,
• the cognitive biases, and so forth.

FIGURE 21.1: The value investing model


The top layer is permanent.
Knowing what to do, doing it, and not doing anything else is so durably commonsensical that one might even apply it to other endeavors.

But the bottom layer could change.
Both accounting standards and disclosure requirements will evolve.

• For example, the Federal Accounting Standards Board might mandate some new calculation of operating income such that ROCE has to adapt. 
• Or perhaps the SEC will eliminate related-party transaction reporting such that the number of shareholder-friendliness indicators has to be trimmed down to three. 
• The more time that has passed, the more important it is to be aware of such developments.

B.  The second practice is to think in percents. 

One should focus on the total return expressed as a percentage, not on currency amounts.

• A 20 percent realized loss is not okay just because the actual damage was only $1,000. 
• And a $1,000,000 gain is not impressive if it represents just a 2 percent annualized return.

Thinking in percents nurtures habits that perform faithfully over a lifetime.

• Discipline learned in the early years of little capital works just as well in the later years of more capital. New tricks aren’t required just because of more zeroes.

When one thinks in percents, the absolute gains follow. 

• They follow because value investing is remunerative. 
• That provides most practitioners with enough motivation to stay with the strategy. 

#Value Investing has other benefits too

But since I committed to it at the end of the last century, I’ve come to see that value investing has other benefits as well.

• For one, it keeps me engaged with the world. 

Turn on the serendipity spigot, and suddenly everything applies. Shopping, news, traffic—all become inputs just as worth processing as financial statements. The instants and fragments of everyday life become relevant in a vivid way.

• Second, value investing is, at root, truth seeking. 

It takes inherently hazy situations and chases the facts. What’s this thing worth? I see a realness in that.

• Third, it rewards a long-term perspective. 

It compels me to consider how enterprises will develop over time. Part of that drill is picturing civilization years forward. That carries an aspect of foresight that I like.



#Value Investing benefits at personal level 

That long-term perspective applies on a personal level as well.

• I hope to keep value investing long after other lines of work would have become difficult.

Making presentations, attending meetings, and flying overseas all get harder with age. But value investing requires none of that.

• I’ll do it for as long as I have all my marbles. 

My younger loved ones are standing by to let me know when the first one plinks out.

• Above subsistence and below gluttony, there’s little correlation between net worth and happiness. 

Money just doesn’t produce life’s great joys. Those come from those loved ones, from health, and from other sources that don’t care much about geometric means, depreciation schedules, or enterprise values.

• But an absence of money can keep one from the great joys. And therein lies value investing’s promise. 

It gives one the freedom to fully embrace what really matters. To be able to drop everything and lavish attention on such gifts, fearlessly, and at times of one’s choosing—That, I think, is what rich is.




Summary

1. Capital preservation is a value investing priority because of the mathematics of realized losses.
2. The risk-return trade-off blinds most asset managers to the primacy of capital preservation.
3. Most actively managed equity funds fail to beat basic market indexes over time.
4. The bottom layer of the value investing model is the part most likely to change.
5. Thinking in percents encourages habits that work over a lifetime.
6. Value investing has benefits beyond remunerativeness.


Reference:;
Good Stocks Cheap - Value Investing with Confidence for a Lifetime of Stock Market Outperformance.

Portfolios and Selling

#Good company gets inexpensive, how much to buy?

When an understood, good company gets inexpensive, we buy its stock. But how much?

(1)  Enough uninvested cash (CASH)
My rule is simple. Provided that I have enough uninvested cash, I put 10 percent of the portfolio in it. I’ve seen other good investors use infinitely more complicated guidelines, but none that I’ve found to be more practical.

If I’m not comfortable putting at least a tenth of the portfolio into an equity, I don’t want the equity. If my conviction is lower I don’t buy less, I buy none.

(2)  Strong conviction (COURAGE)
A strong conviction is important in part because right after a buy the price of a stock is almost certain to drop. That’s the corollary to another near-certainty: that the price paid for a stock is unlikely to be a low. Rock-bottoms don’t send out invitations. So knowing when one will happen is impossible. The astute investor counts on missing them.

Correspondingly, I prefer not to put more than a tenth of the portfolio into a single equity. This reduces the chance that I’ll lack the cash necessary to take advantage of other opportunities that emerge.



#Buying is one aspect of portfolio construction. Another is selling.

There are two problems with selling. 

1.  The first is taxes. 

The profitable sale of stock is taxable in most circumstances. Just how much this eats into long-term returns is best illustrated by example.

Picture two portfolios. Each starts with only cash, buys only non-dividend paying stocks, and liquidates after 30 years. Assume that any stock sales are subject to a total long-term capital gains tax rate of 30 percent.

Portfolio one uses all its cash to buy stock on the first day. It appreciates 15 percent before taxes every year. It doesn’t sell anything until the liquidation date, at which point it immediately pays any taxes due.


Portfolio two also uses all its cash to buy stock on the first day. It too appreciates 15 percent per year before taxes. But it churns its holdings annually. At the end of every year, it sells everything, and uses all the after-tax proceeds to instantly buy different stocks. When it liquidates after 30 years, it too promptly pays any taxes due.

Portfolio one would end the 30-year period with more money. But what’s striking is just how much more. It would wind up with over twice as much cash. That’s because every year when portfolio two paid its capital gains taxes, it whittled down the amount set to grow at 15 percent over the following year. In other words, ongoing tax payments stunted the power of compounding.

By contrast, portfolio one’s capital was never whittled down. It regularly got to multiply its 15 percent by a bigger number:

http://www.goodstockscheap.com/17.1.xlsx

Of course one could never count on an equity portfolio to appreciate at exactly 15 percent annually, and the chance of immediately finding stocks to replace just-sold ones is low. Plus the 30-year period is arbitrary, and a 30 percent tax rate doesn’t apply to everyone. But however simplified, this example
highlights the toll that frequent selling takes.


2.  The second problem with selling is alternatives. 

Companies that are understood and good don’t go on sale every day. They’re hard to find. So absent an acute cash requirement, each stock sale mandates a hunt for the next opportunity.



#When selling makes sense

Even with these problems, selling does makes sense in some instances. I see four.

(a)  The first is when price flies past value. 
If EV/OI is over 25, and there are no mitigating facts, I find it hard to justify holding.

(b) The second instance is when a company that originally registered as good turns out not to be. 
This could be because the original analysis was wrong. Perhaps the threat of new entrants was stronger than it first appeared, or a market thought to be growing really wasn’t. Or it could be because circumstances have changed. Maybe a once-mighty retail chain has come under pressure from online-only sellers, or a company that thrived under regulation has faltered in deregulation.

The cognitive bias of consistency can make it hard to see such instances. We may want to hold just to validate our buys. But analyses really can be wrong, and contexts really can change. Selling in such situations keeps a snag from ripping into both a realized loss and a missed chance to redeploy cash into a better opportunity.

(c)  The third instance is when one is bought out. 
Public companies sometimes get acquired. Such transactions often happen at a premium to the recent trading price. A vote may be put to shareholders on the matter, but for everyone other than major stakeholders, it’s perfunctory. One effectively has no say.

I’ve been bought out several times. I dislike it. It turns a pleasantly appreciating investment into a taxable event. But if profitable, given the absence of practical options, it makes sense to accept such sales.

(d)  The fourth instance is when cash is needed to make an investment that’s clearly better than one already held. 
The problem with this is that fresh ideas often glow with a special promise. They’re new. The hope bias gets a prime shot at causing mischief. As such, I get extremely suspicious of my reasoning when I think that I’m spotting such a circumstance. I’ve never actually sold one company for the specific purpose of buying another.



#When selling makes no sense

Two commonly cited reasons for selling puzzle me.

1.  One is rebalancing. 
It’s selling part of a stock holding because appreciation has caused it to represent a disproportionately large percentage of the portfolio.

Rebalancing makes sense to those who equate risk with total portfolio volatility. I don’t. So on the sell side, I’ve never seen the merits of this practice.

It makes more sense to me on the buy side, since unless part of a holding was sold, a decrease in its portfolio prominence means that its price dropped. One could now buy more of it cheaper. But on the sell side rebalancing looks to me like the anchoring bias in action.

2.  A second common reason for selling is to prove that an investment was a success (taking profits). 
The sale is seen as a sort of finish line. Underlying this perception is a view that cash is somehow more real than stocks.

It’s not. Cash and stocks are different forms that wealth can take. Unrealized gains are not endemically less concrete than realized gains. Selling doesn’t demonstrate investing competence any better than does intelligent holding.


Yet another reason for selling is Industry compensation
There’s an additional reason that selling happens. It relates only to institutional portfolios, like hedge funds. It’s about compensation.

Investment funds often pay managers 2 percent of assets under management per year, plus 20 percent of any gain above some hurdle. That 20 percent is applied to pretax returns. It’s blind to taxes. For this reason professionals may emerge as more enthusiastic about selling than would their limited partners. After all, unless they’re tax-exempt, the limited partners are the ones that come to bear the bulk of the tax liabilities born of the fund’s realized gains.

One faces great impetus to sell. It feels good. It’s conclusive. It turns the brokerage statement into a congratulations card. But it also triggers a tax expense and—short of a pressing need for cash—forces a search for the next underpriced equity.

When a sale is wise, its justification is distinct. It’s an overpricing, an analytical error, a contextual change, a buyout, or a better opportunity. Absent that clarity, I hold.



#Equity portfolio can generate cash through buyouts and dividends
Even without active selling, an equity portfolio can generate cash. It can do so in two ways.

1.  The first is through acquisitions, as mentioned earlier.

2.  The second is through dividends. 
Dividends can become sizable. This fact gets lost in the commonly quoted metric of dividend yield.

Recall that dividend yield equals annual dividends divided by current stock price. But to an owner, current only counts in the numerator.

When I first bought Nike stock, the dividend yield was around 2 percent. Over a decade later when I sold it, it was still around 2 percent. But by then my dividend yield—the current annual dividend divided by the price I’d paid for the stock—was closer to 10 percent. Dividends had gone up over time, but my cost hadn’t. That’s how dividends can become a booming cash source underappreciated by all but those who get them.



#Over time, good focused (concentrated) stock portfolios outperform diversified portfolios.
Remember that my portfolio is concentrated. It contains no more than a dozen names, and usually far fewer. On purpose, it’s not diversified. Many good equity portfolios are, but mine isn’t.


1.  Good focused portfolio versus diversified portfolio
I choose to concentrate because I’ve observed over time that good, focused stock portfolios outperform diversified stock portfolios. This is because diversified portfolios are more like an index. They have more names in them. The more a portfolio looks like an index, the more it behaves like an index. It’s hard to both resemble and outperform something.


2.  Bad focused portfolio versus diversified portfolio
Of course a bad focused equity portfolio can certainly lag a diversified stock portfolio.

Concentration isn’t enough to assure outperformance. But if it’s purposefully constructed, a focused group of inexpensively bought good companies is particularly promising.



#Sequestered Cash outside of the equity portfolio for  ordinary expenses 
While I don’t diversify within my equity portfolio, I do diversify outside of it. I always keep enough cash on hand to cover expenses for a few years. As I get older, I expect to increase this number of years.

1.  In Federally insured banks
This isn’t cash inside the equity portfolio waiting to be invested in stocks. It’s cash outside of the equity portfolio, held in federally insured banks. It will never be anything other than cash or spent.

Sequestering cash enables me to confidently ride the wild price swings guaranteed to come with a concentrated equity portfolio. It’s what lets me take the long view. When the price of my stock portfolio halved during the 2008 financial crisis, I didn’t panic. I knew that I could meet all of my expenses. There was no basis for panic.

Many governments insure bank deposits. Coverage varies by country. In America, the Federal Deposit Insurance Corporation generally guarantees up to $250,000. In the United Kingdom, the Financial Services Compensation Scheme stands behind £75,000. In Canada, the Canada Deposit Insurance Corporation backs C$100,000.

Because the whole point of sequestered cash is to avoid the scare that forces ill-timed stock sales, it’s wise to stay well under the insured limit. Opening up accounts at several different banks is not hard.


2.  In same currency as one's expenses Sequestered cash is best held in the same currency as one’s expenses. If it isn’t, foreign exchange rate fluctuations can hurt one’s ability to meet obligations.

As I write this, the British pound has slumped to a 30-year low against the U.S. dollar. This follows Britain’s decision to leave the European Union.1 Some American investors think the slump is overdone and have invested in the British pound.

To people whose expenses are in U.S. dollars, those pounds don’t count as sequestered cash. Instead, they count as a currency investment.



#These repositories for sequestered cash aren't really good
Two things that may look like good repositories for sequestered cash really aren’t.

1.   The first is certificates of deposit, or CDs. 

Outside of the United States they’re commonly called time deposits. They offer higher interest rates than do regular bank accounts. Money must stay in them for a predetermined period. If it’s withdrawn early, a penalty is applied that more than wipes out the extra interest.

If the CD interest rate is much higher than the regular interest rate, one could theoretically keep a portion of sequestered cash in CDs. The portion would have to be limited to that which shouldn’t be needed for the duration of the lockup period.

That said, I don’t use CDs. Since the timing of cash needs can surprise, I prefer to keep the focus of sequestered cash on costless accessibility.

2.   The other repository is cash-like funds (commercial paper). 
They too offer higher interest rates. An example is a fund that invests in commercial paper. Commercial paper is short-term notes issued by corporations.

Such cash-like vehicles usually behave like cash. One can pay bills with them. But I’ve seen instances when they don’t. During the financial crisis, an acquaintance of mine was surprised to learn that her financial institution had temporarily halted withdrawals from such a fund. She couldn’t make payments with it.

This potential—the inability to immediately liquidate—is the problem with these alternatives. The purpose of sequestered cash is to free one from worry during equity market gyrations. If what’s used for expenses ever can’t be used for expenses, that benefit is lost. One can wind up having to sell part of an equity portfolio when it’s underpriced, erasing the benefits of stock investing.


#Problems with cash
Cash has its own problems, of course. Inflation erodes its purchasing power over time. Expansionary monetary policies—governments printing money— exacerbate this. But if held in government-insured accounts under applicable limits, at least it’s always there. That availability is what makes the interim ups and downs of an equity portfolio’s price not only bearable, but almost trivial.





Summary
1. Conviction prepares one for the likely price drop that follows a stock buy.
2. Selling stocks can make sense 

• price flies past value, 
• when a company thought to be good turns out not to be, 
• in buyouts, or 
• when a clearly better opportunity emerges.

3. The problems with selling are taxes and alternatives.
4. Questionable reasons for selling include 

• rebalancing, 
• memorializing success, and 
• industry compensation.

5. Equity portfolios can generate cash without active selling through 

• buyouts and 
• dividends.

6. Good focused equity portfolios outperform diversified equity portfolios over the long term.
7. Cash sequestered for ordinary expenses in government-insured accounts makes equity portfolio price gyrations less troubling.


Reference:

Good Stocks Cheap by Kenneth Jeffrey Marshall 2017