Attaining financial resilience, flexibility, and ultimately financial independence will be instrumental in your leading a more harmonious life.

This Substack expands on the letter by explaining how I invest.

However, before we start on investing, take five minutes to read this excellent post The 5 Levels of Wealth. The post is not about wealth. It’s a framework on how to think about money to reduce the financial cacophony in your life.

Over the years, my kids, nieces and nephews, step-children have asked me questions about investing and how I evaluate an opportunity. I finally decided to compile my thoughts on my approach. Your approach may be different.

Organization

I have compiled my thoughts in a series of posts in the following order:

Introduction (this post)

The Essentials of Investing

An Introduction to Value Investing

Investing

What Really Matters

Investment Analysis

Asset Classes

Equity Investing

Digesting the 10K

Investment Evaluation

When to Sell

Monitoring My Investments

Key Resources

About this document

Truth be told, I wrote this as one large document and then split it up after the fact. The section breaks are somewhat arbitrary. However, I suggest you read the posts from top to bottom.

Advice to Kids

Getting back to my kids, if there was anything that I wanted them to learn, it was to think and live independently. Thankfully, they have grown up to be competent and independent people.

It was important to me that they achieve investing literacy: a rudimentary understanding of investing, how to navigate it, and how to use it to improve their lives.

When they graduated from college, I wrote them a long email with the gratuitous “Dad Advice.” The emails are long gone. Here are the themes:

About Life

· You have your whole adult life ahead of you.

· Think, be, and live Independently

· Go find your life.

· Own your future

· Have perspective and foresight about emerging situations

You have a huge head start in life:

· You have the best gift: your health.

· You are educated.

· You don’t have any debt—college or otherwise.

About Money

· Financial independence is empowerment.

It doesn’t take millions to be independent. It’s more about financial discipline: constantly saving and having sufficient cash on hand.

· Think of money as the lubricant, not the propellant, of your life.

Pay attention to it. Having some money makes your life much easier, but never let it rule your life.

· Embrace sustainable living, both financially and environmentally.

· Don’t Enslave Yourself

Although the working poor have real problems because of their lack of earning power, most first-world educated middle-class people spend their way into economic slavery. Once enslaved, it’s tough to get out.

· Live within your means.

Don’t subscribe to lifestyle creep or keeping up with the Joneses. Psychologists call this the hedonic treadmill: you never get ahead. The Joneses are trying to keep up the Smiths, and the Smiths are trying to keep up with the Browns.

· Have enough cash on hand (liquidity)

This is to get you through the inevitable financial set-backs. Cash acts as a ballast against the bumps and scrapes of life. All the fur coats in the world aren’t worth a damn if you don’t have enough cash for next month’s rent.

· Liquidity also enables you to act opportunistically

· Building your wealth is like voting

Do it early and often. Take advantage of the many decades of compounding ahead of you. (more on compounding below). Saving now will make your life infinitely easier later on.

· Take advantage of tax efficient programs

Start with work 401Ks-especially if there is an employer match. Max it out even if doing so is painful in the early years.

Financial independence is like a flywheel. It takes forever to get going, but once it does, it becomes a force multiplier for your life.

My daughter’s first job was an AmeriCorps internship. She made so little she qualified for food stamps. Of course she got help from the Bank of Dad, but it was still a threadbare existence for a couple of years. She now saves over 30% of her salary in Roth’s, 401Ks and other programs.

My goal for this guide is the teach investing literacy to enable people to pursue a path towards financial independence.

You have to start with accounting. Accounting is the alphabet of investing. I don’t cover accounting extensively here, so you might want to bone up on it elsewhere. I suggest starting with online courses such as at the Khan Academy or Coursera. I don’t have a recommendation. Go online and poke around.

If you want to achieve financial independence, you need to build up an asset base that self-perpetuates so you don’t have to work so hard. To quote Warren Buffett:

If you don't find a way to make money while you sleep, you will work until you die.

About Wall Street

Wall Street is structured to make money from investors, not with investors. Never forget that.

You may have heard the expression, “Las Vegas wasn’t built on winners.” Neither was Wall Street. Your friendly financial advisor—a fancy name for a salesman—and most of the Street is built with toll booths, inefficiencies, and economic rents. It’s a zero-sum game: the more that goes to the Street, the less stays with you. Don’t forget that either.

Don’t be intimidated about investing.

When it comes to raw intellect, 98% of Wall Street makes the top half of the graduating class possible.

Conversely, the bottom half of Wall Street makes the top 98% of the graduating class possible.

They may be the greediest, but they are not the best and the brightest. There is nothing special about these guys.

Brace Yourself. My portrayal of Wall Streeters is nasty. Some are predatory towards and exploitative of investors. Most are not, but simply don’t earn their keep. The value they provide does not offset their cost to investors. My description here is a caricature

On balance, Wall Streeters are a bunch of schlubs trying to make a quick buck from gullible and disengaged investors—both individuals and institutions. The schlubs are the customer-facing Wall Streeters.

In addition, to these folks, the Street has legions of financial people you will never see. Broadly speaking, they are either “buy-side”—meaning they manage money and buy securities—or “sell-side,” their counter-parties, flogging securities to the buy-side.

The buy-side types tend to be superficial and simplistic—glib and fully buzzword compliant—with knowledge that is ten miles wide and a nanometer deep. As personality types, they are quick with a joke and are good drinking buddies.

Often they have grown up on the right side of the railroad tracks and want to participate in the capital markets without getting their hands dirty. When you plumb them for any depth, they will give you a look similar to figure in an Edward Hopper painting staring vacuously into oblivion. Think of Dan Quayle in a debate when asked a probing question.

The sell-side ones tend to be hard-boiled, dirt-under-the-fingernail types from the wrong side of the railroad tracks—with something to prove. They are ambitious at any cost. Metaphorically, if you offer them a single slice of the two remaining slices of a pizza, they will always grab the larger slice, devour it. Then they ask—or just take—the other slice, and then whine that it is not meat-lovers pizza.

Wall Streeters make money in four ways: (1) from spreads—the difference between what the buyer pays and the seller receives, (2) from commissions on transactions, (3) from management fees charged explicitly or implicitly to investors and (4) trying to outsmart their Wall Street counter-parties.

This last point bears elaboration. Inside the Wall Street engine room are legions of institutional players invisible to retail investors. Hundreds of billions of dollars per year are spent trying to gain a micro-advantage over counter-parties—generally other institutional players. Most players spend their lives trying outwit each other with tactics like price arbitrage or risk arbitrage. It is financial engineering, nothing more.

An example of price arbitrage is buying a security on one exchange and selling it simultaneously on a second exchange, pocketing the small price difference.

Risk arbitrage is moving risk among counter-parties. It’s all an act of financial engineering to get a micro-advantage over the other guy. In aggregate, it is the Wall Street equivalent of a bunch of teenagers having a loud drinking party—out “Bro-ing” each other in a hapless bid to get laid—and then running away when the cops show up. The kid hosting the party is stuck holding the bag.

Wall Street uses instruments like credit default swaps (financial insurance protecting investors from issuer default), foreign exchange swaps and interest rate swaps and other derivatives in order to move risk to other parties. The players are conduits engaging in layers of activities among constellations of counter-parties, shedding risk and pocketing fees along the way.

Golly, what a surprise.

Not everyone on Wall Street can outsmart the other guy. One Wall Street trick is to use leverage and magnify micro-gains. This requires a quick side-bar discussion on leverage.

A Sidebar on Leverage

In the spirit of attempting to outwit counter-parties, a lot of institutional investors resort to leverage—debt. The key assumption is that the cost of debt is less than the return on investment, and that the debtor gets to pocket the difference. Leverage magnifies outcomes—both positive and negative.

Some retail investors may use debt in the form of margin to buy securities. In my view, this is dangerous, and I advocate avoiding margin like the plague, not just on principle, but because when things go wrong they fail precipitously. (It’s hard to go broke when you are not in debt.)

To understand leverage in a real-world context, suppose you bought a $1M house with $50K down. 95% of the capital ($950K) is debt. In this instance, the leverage is $950/$50 or 19 to one. If the house rises in value to $1.1M, your equity rises from $50K to $150K for a 200% gain ($100K gain on $50K initial investment).

That is the positive effect of debt. If the house drops to $900K, you are underwater. If the house drops and you lose your income (i.e. means of making the mortgage payments), you are completely screwed. History shows that seemingly uncorrelated events have a habit of being coincident at exactly the wrong time. History also shows that when the you-know-what hits the fan, there are all sorts of unanticipated consequences.

Leverage is what brought down Lehman Brothers in 2008 and Long-Term Capital Management in 1998. The excerpt below is a gem from Pioneering Portfolio Management by David Swenson, the long time manager of Yale’s endowment. (Swenson re-wrote the book on how to grow endowments.) Given his track record, he deserves a place on the Mt. Rushmore of investors.

LTCM (Long-Term Capital Management) concocted a toxic blend of arrogance and leverage that nearly brought down the world’s financial system.

LTCM’s business model involved investing in a broadly diversified pool of arbitrage strategies, which attempted to exploit anomalies in the markets for equities, bonds, swaps, futures, and a broad range of other derivatives. Using sophisticated models, to diversify overall portfolio risk, the first believed it has reduced risk to such a low level so as to justify an extraordinary high level of leverage.

…LTCM took on massive off-balance sheet positions. On a market exposure basis, combining holdings both on balance sheet and off, LTCM had a total of more than $1.4 trillion of positions supported by less than $5 billion in equity, representing leverage of more than 290 to one.

When trouble arrived in the form of Russia’s financial meltdown, LTCM’s staggering leverage quickly took the firm down.

If you didn’t understand all of the terminology above, don’t worry about it. Here are the key concepts:

• Wall Street can be extraordinarily arrogant. Not all children are above average.

• There can be all sorts of unanticipated consequences. For LTCM, it was Russia’s meltdown.

• An essential problem with leverage is that counter-parties call the loan at exactly the wrong moment. As a debtor you have no control over this post-facto.

• Without sufficient liquidity, everything goes down the drain.

One final note.

There is explicit leverage, as in “I’m going to buy Google stock on margin,” and implicit leverage. For example many ETFs borrow extensively to leverage their investments. As a retail investor in an ETF, you may not be liable for covering the ETF’s debt, but your investment can get wiped out much more easily. The ETF investment documents may reference the leverage, but it will be downplayed and buried where few investors bother to look.

Trading versus Investing

There is an important conceptual distinction worth noting. Traders as described above are running the Red Queen’s Race in Through the Looking Glass in a zero-sum game of one-upmanship.

Investors, by contrast, are looking for assets that will grow in value disproportionately over time. My advice: don’t play the trading game. You will be outgunned and outmaneuvered by Wall Street. Play the investing game and focus on opportunities peripheral to Wall Street’s theater of influence.

Okay, back from the sidebar on leverage.

Another Way to Slice the Onion

Another taxonomy for the Wall Street players is Front office, mid-office, and back-office. (Notice that Front is capitalized, but mid and back are not.) Each group attracts its personality type. Again, my descriptions are caricatures.

Front office are the traders and the trading desks. These types have big mouths with little brains, huge egos, overbearing personalities and operate with frat-boy impunity. Think of the film The Wolf of Wall Street. Their badge of honor is to demand and get their own Bloomberg terminal—the ultimate sign of status and power. These guys are the loudest and inevitably think they are the smartest ones in the room. Alas, that only happens when one is in solitary confinement. Now, there’s an inspiring thought.

Mid-Office attracts the same personalities at HR in the corporate world. Risk and Compliance fall into this group. Generally, their role is to toe the company line, but make sure the trains don’t fly off the rails. They eschew the limelight, like proximity to power, and embrace mutable ethics—enforcing the rules only when it is opportune to do so.

The back-office types are like the guys in the circus who follow the animal parade and clean up after the elephants. As a personality type, generally they suffer from self esteem issues and throughout their lives have assumed the role of cleaning up messes.

What’s my role? I’m the circus clown who gets shot out of the canon. I use humor—like right now—to disarm people. But nobody takes me seriously.

Every circus has its P.T. Barnum, which is why you need to guard your wallet and look out for number one. If you want to achieve financial independence, your objective is long term after-tax wealth creation for yourself. Despite Wall Street.

Earlier I alluded to the low intellect of most Wall Street people. Here is an example of a typical money guy.

Around 2001 I met with a venture capitalist (VC) who invested in health sciences and medical technology. A VC is a buy-side investor who invests on behalf of institutional clients, such as college endowments. As a retail investor, you will likely never work with a VC.

I assume the VC had the right pedigree and was blessed with an MBA from the right school. He seemed to be successful as a VC. My background was in information technology, and I was familiar with VCs in IT, but not health sciences.

In our meeting, one the first things my host revealed was that early in his career he had made the mistake of confusing an internist with a medical intern—and emphasized to me at length they are not the same, and not to be confused. This was his fatherly advice of the day.

I can’t spell doctor, yet I had understood that distinction since I was a teenager. My immediate reaction is, “This guy is an idiot.” I was also incredulous that he would admit this faux-pas to someone he hardly knew.

He may think of himself as a financial Jedi. I have an alternative assessment: another imposter exposed.

Not all “money guys” are this clueless, but most of them have the intellect and talent of a goldfish. That’s not to suggest they are all useless. However, in my experience, 99% of them don’t pay for themselves. I don’t need to pay my goldfish 1% of my assets per year to tell me things I already know or to steer me towards investments that earn him supersized commissions.

My advice is to rise above the fray and focus on what matters most: your own long term after-tax wealth creation.

The Wall Street Mystique

Wall Street’s mystique is all BS. Anyone capable of mastering 6^th grade arithmetic and 6^th grade reading is capable of understanding the basics of investing and navigating the investment world to figure out what makes financial sense.

One of Wall Street’s trick is obfuscation through complexity. Here is a quote attributed to Albert Einstein:

If you can’t explain it simply, you don’t understand it well enough.

I’m no Einstein, and I guessing your broker isn’t either. If the person flogging the investment can’t explain it simply, it is generally because (a) he doesn’t understand it himself or (b) he is hiding something. Dump him and move on.

Another Wall Street deception is to provide exclusivity to convey faux prestige—allowing you past the velvet rope.

Guess what: you are being played.

Status and status hierarchy plays to investor vanities and comes in the form of,

“Our usual client minimum is $2 million, but because of this exclusive opportunity, we will hesitantly manage your $40,000. Act now before this opportunity expires.”

This type of ego-stroking has led to the rise of the access economy, where status, exclusivity, access, and proximity are the coin of the realm.

I first heard the term “The Access Economy” in this post: Click here. The post is worth reading.

I call using proximity to get you to open your wallet the “Mar-a-Lago syndrome.” Don’t fall for this nonsense.

A typical way Wall Street manipulates investors is by “access” to exclusive openings, events, and opportunities, e.g. the champagne and caviar receptions and galas—to learn about the next “can’t-miss” opportunity. This pitch is the white-shoe version of boiler-room pitch to buy the next can’t-miss opportunity in timeshares in a Caribbean country where the last coup d’etat happened 45 days ago.

Museums have also mastered this trick. The good ones play the donor class like a fiddle. They monetize their brand through social stratification. For example, the Metropolitan Museum in New York has a dizzying array of boards to create a status hierarchy in order to differentiate the social tiers and create a hedonic treadmill for philanthropy. The primary intent is to motivate the status seekers and social climbers to milk them for donations.

Here’s a spectacular example. In 2021, the Met licensed naming rights for one of their wings on a term license (I believe $125 million for 50 years). Back in the day, $5 million would get you immortality by having your name emblazoned on the building permanently. This is the vanity equivalent of an Egyptian pyramid.

Now $125 million only allows you to rent your name. The Met’s audacity is stupefying—or awesome—depending upon your perspective—but they pulled it off. God bless them, I guess.

Let’s pivot back to investments and avoiding plays on your vanity.

Here is a gut check: if you are feeling an impetus to ‘be a player,’ you are probably being played. Step back, take a deep breath, and reassess. Your best action may be to move on.

As another example of investor manipulation, Wall Street continually concocts new products and pitches, be it cryptocurrencies, ETFs, NFTs, SPACs, portfolio insurance…you name it. The best article I have read on the schemes and scams is Benn Eifert’s On Bullshit in Investing. This is an unbelievable post, and I urge you to read it here:

Noahpinion

On bullshit in investing

The epic crash in stocks and crypto has been the big financial story of 2022. When the Fed raised rates, it exposed a lot of bad investments — as Warren Buffett once said, “Only when the tide goes out do you discover who's been swimming naked.” But it would be nice if investors could recognize the too-good-to-be-true stuff before the big crash, so as no…

Read more

4 years ago · 175 likes · 39 comments · Noah Smith

Here is Eifert’s opening paragraph:

The investing industry is ridden with bullshit. The most common and insidious form is over-optimism: offers of tantalizing risk/reward that defy any notion of reality, often based on misinformation or deception. Less common but even more dangerous are outright frauds.

Welcome to the Casino

The stock market itself is a casino, instantaneously reflecting investor sentiment, as exhibited by gyrating stock prices. Everyone in the market thinks they can outwit the other guy.

Prices can (and do) go irrationally high or irrationally low. Look up Tulip Mania on Wikipedia as an example. Undisciplined investors (about 99% of all investors) get caught in the fervor and price assets to the sky, and then run for the hills when the market crashes and burns.

Eventually, tulip prices collapse because they are not supported by the fundamentals: the underlying economics of the investment. The notion that someone else will pay even more for your overpriced tulip is called momentum investing, a form a musical chairs. When the music stops, someone ends up without a seat. When the market crashes, 80% of the participants lose their seats.

John Bogle, founder of the Vanguard Group, once quipped:

The stock market is a giant distraction to the business of investing.

As an investor your job is to distinguish between the current price of an investment and its underlying value.

Definitions: Pricing is what the latest schmuck paid when he bought the investment. Value gets to the underlying economic worth of a security. Price and value are not the same.

Here is a better articulation. Howard Marks, a founder of Oaktree Capital and a long time investment manager, writes periodic investment memos. In one of his gems, here, he states:

In my parlance, the value of an asset is derived from its “fundamentals.” The fundamentals of a company, for example, encompass a great many things. These include its current earnings, its earning power in the future, the steadiness or variability of its future earnings, the market value of its component assets, the skill of management, its potential to develop new products, the competitive landscape, the strength of its balance sheet, and the myriad additional factors that will influence the company’s future. Ultimately, the totality of an asset’s fundamentals constitute its earning power, which in turn is the source of its value.

I urge you to read this memo, as well as his other memos, on the Oaktree website. He is a very insightful investment writer.

Generally speaking the underlying value of an investment grows in concert with the change in earning power of the assets represented by the investment. The focus of this entire Substack is parsing that previous statement. My desired outcome is for you to develop your framework to differentiate true investment opportunities from Wall Street gimmicks.

At a macro-economic level, over time the aggregate earning power of all companies will track the growth in the economy, which itself generally grows as a result of the rise in living standards primarily from productivity gains. If long-term productivity grows at 3%, then at a macro level capital value will grow at roughly this same rate.

Meanwhile, stock and other asset prices bounce all over the place. Most of this gyration comes from changes in investor sentiment. Some of it comes from a redistribution of economic activity—e.g. fewer steel mills, more healthcare spending. You can use the disparity between value and pricing to your advantage—provided you think for yourself.

Later on, we’ll discuss how to assess value relative to price.

Investing is not about comforting yourself with the social proof of your peers. Successful investing requires thinking and acting independently, often against the grain. It is a solitary activity that requires you to be brutally analytical. Ignoring the crowd and being independent (contrarian when necessary) can be scary as hell.

This casino nature of the market leads to several conclusions:

1. Macro-economic changes aside, it’s a zero-sum game: the more money that goes to Wall Street, the less stays with you.

2. For every transaction, there is a counter-party. What makes you think you are smarter than your counter-party? Shrewd investors identify mispriced assets. Warren Buffett, for instance, has focused on mispriced companies with sustainable competitive advantages. This is within a school of thought is called Value Investing, and primarily uses an asset’s earning power to assess it’s value. Buffett and others cite a concept called intrinsic value. Buffett calls it “owner earnings.” We’ll come back to that later.

3. Since Wall Street firms are so good at extracting excess profits from unsuspecting investors, in theory one should be able to make a killing by investing in the stocks of Wall Street companies. I have done this successfully, but picking the right company is difficult. Most often the insiders siphon off the excess profits and don’t pass them onto shareholders. To put it another way: Wall Street cares about Wall Street, not Main Street.

Ben Graham, the father of value investing, summed up the stock market this way:

In the short run, the market is a voting machine but in the long run, it is a weighing machine.

‘Voting machine’ refers to investor sentiment: companies are either Wall Street darlings or dogs. ‘Weighing machine’ refers to how, in the long run, a security price will gravitate towards the underlying value of the assets or the asset’s earning power.

You need to take ownership of your financial future. Owning your future requires you to lean forward, engage, and understand various investing options. Don’t abdicate to the Wall Street “wizards.” Hint: the wizards are charlatans.

A close corollary: at the end of the day, the smart money isn’t that smart. More importantly, when the “smart money” is out there flogging its latest gimmick, it is looking for patsies. Stay away.

John Bogle of Vanguard was greatly beneficial to the average investor. He believed in investing in sensible things and minimizing costs. People who subscribe to his philosophy are called Bogleheads. Vanguard pioneered the index fund, a type of passive investing. For many investors index funds very good options, although I have never owned one.

The Power of Compounding

At its core investing is about deferred consumption: how much will I have in the future if I do not consume today? That’s why personal financial discipline is key to building wealth. If you constantly consume today, you will have nothing for tomorrow.

One of the great techniques for building wealth involves the power of long-term compounding.

For example, I know a family who immigrated to the US in 1961, scraped together a down payment to buy a house in Santa Monica in 1969 for $32,500. Over the next fifty years, the value of the house compounded at an average annual rate of 9.25%. Care to guess how much they sold the house for in 2019?

$500K? $200K? $1M?

$3.25 million is the answer.

An investment with a 9.25% compound annual rate of return grows 100-fold over fifty years. To adjust for inflation, in 2019 it took $6.91 to purchase the equivalent of $1 of goods in 1969. Thus, in real terms the value of the house grew 100/6.91 = 14.47 fold, ignoring taxes. Even considering taxes, commissions and fees, the real purchasing power grew over ten times.

That is the power of long-term compounding. My suggestion is to use the power of long-term compounding to grow your wealth. And that is why starting early in your life is key.

Financially astute readers will spot several flaws in the conclusion of 100 to one return on investment. During their ownership, the family had ongoing expenses such as mortgage payments, insurance, real estate taxes, maintenance, and improvements. Additionally, when they bought the house, the family made a down payment, which was thus unavailable to earn investment returns from alternative investments such as the stock market.

All of these aspects are true and need to be factored into an investment analysis. As we will see in subsequent sections, there are methodologies for doing this.

Additionally, any 100 to one gain in real estate is far from a slam-dunk. Luck played a part. The house was located in Gillette Regent Square, a section of Santa Monica that gentrified during their ownership period. Had the family bought a house in working class neighborhood of Cleveland, their financial outcome would likely have been inauspicious.

Anne Scheiber

Let’s discuss Anne Scheiber, the greatest individual investor you have never heard of. Here is the opening paragraph in her Wikipedia entry:

Anne Scheiber (October 1, 1893 – January 9, 1995) was an American IRS auditor and a post-mortem [sic] philanthropist who was known for her unconventional way of obtaining wealth. Though she never earned a salary of more than $4,000 per year, she amassed a fortune of $22 million through frugal living and investing.

The Wikipedia entry (and related articles) provide the following numbers:

Anne retired in 1944.

Her highest salary was $4000 ($4000 in 1944 is equivalent to $75,500 in 2023).

She retired on an annual pension of $3100 ($53,000 in 2023).

When she retired, she had total savings of $5000 ($86,000 in 2023).

How did she amass $22 million ($44 million in 2023)? Here’s how:

· She lived within her means.

· She was an astute investor.

· She was a “buy and hold” investor. She stuck with her investments and allowed them to grow.

· She compounded her wealth over fifty-one years (from 1944 until her death in 1995.)

Note that Anne’s investments grew over 255 times in 51 years, versus 100 times in 50 years for the Santa Monica family.

One lesson from Anne is the power of compounding. From a modest starting point, she created a compounding machine that outran her living expenses. Turning $5000 into $22 million over fifty-one years has an imputed annual rate of return of 17.8%. Some articles report that she actually compounded her monies at 22%. (Presumably the difference is what she needed for her living expenses.)

Although she was a shrewd investor, I surmise that she lived a very sad life. Her ancestral family lost a lot of assets in Poland during World War I. She was financially betrayed by an incompetent stock-broker during the 1930s. Despite a law degree from Georgetown—a difficult feat for a Jewish woman in the early 20^th century—she had only an ordinary job as an IRS auditor and never received a promotion. She lived her entire adult life in a studio apartment. She never married. Her only acquaintances were her (new) stock-broker and an attorney.

My take on Anne Scheiber is that she was rich in things that you could count, but bereft in things that actually counted. This is a case of money being the propellant of life and not being a lubricant for living a better life.

My advice: invest like Anne, but don’t live like her.

To her credit, she relied on her wits and financial acumen, starting with a modest asset base, and supported herself for fifty years.

Bless her soul. In the end, she left her assets to Yeshiva University with the explicit goal of empowering women with the choices she had been denied. She had no affiliation with the Yeshiva and never visited the campus.

The Bottom Line

My point is to create an investing and compounding machine that powers your financial independence. The best way to do this is to start early and continually add to your investable assets. We discuss the nuts and bolts in subsequent posts.

Continue to next post

1.    How much you put in.

2.    How much you take out.

3.    When you take it out.

4.    With what certainty.

Here are some basic definitions.

The term capital markets refers the collection of venues where people exchange their cash for a financial instrument, also known as a security, in an asset class. The major classes of financial assets are:

·       Equities (stocks)

·       Fixed Income (debt instruments)

·       Commodities and Energy

·       Investment real estate—as opposed to your home, which is a form of consumption

I omit collectibles (e.g. art and coins), foreign exchange and crypto-currencies.  All of these lack intrinsic value, a concept we discuss later. I have a particular contempt for crypto-currencies. I heard Buffett once referred to Bitcoin as rat poison. Warren is an optimist. If you rally want to be repulsed, read Numbers Go Up by Zeke Faux.

Equities are shares of stock, which represent a fractional ownership in a company.

Fixed income are investments where the investor is paid based on a contractual agreement with the borrower.  Fixed income can include debt issued by individuals, companies, or governments. Examples are bonds and treasury bills.

Commodities are products grown on the land, such as corn and soybeans, or extracted from the land, such as silver and gold.  Energy includes all forms of fossil fuels

Investment Real Estate includes real properties which are occupied by a tenant who pays the owner for the right to use the property. Many people, especially your friendly real estate agent, classify your home as in investment. This is a misnomer, or perhaps a justification, based on the agenda of the advocate. The house where you live is a form of consumption.

Derivatives. There is an entire class of investments—but not assets—called derivatives.  A derivative is a financial instrument which derives its value from an underlying asset, for example, a stock option set to the price of an underlying stock.

Suppose I have an option to buy 10 shares of XYZ stock at $50 per share.  If XYZ’s stock price goes from $50 to $70 per share, the option is worth the difference; ($70-$50) * 10 shares = $200.

In general, derivatives are sudden-death instruments: like Cinderella, their value vaporizes on a specific date or with a specific event. My option on XYZ will expire at some point in time at which point it becomes worthless, e.g. two years, or upon a defined event, such as the sale of XYZ to another company.

I have never bought or sold an option, because I find options are like juggling swords doused in lighter fluid and set on fire. I have found that investments do not necessarily work out based on a predefined time frame. Options are outside my comfort zone and my circle of competence.

I have a long time friend who sells covered call options (covered calls). A call option is like the example above with XYZ. A seller can sell an option to another, giving the buyer the right to buy the underlying shares at at strike price. For XYZ, when the price got above $50 per share, the option holder gets to buy an agreed number of shares for $50 per share. A covered call is where the option seller owns the underlying stock but agrees to sell it to option buyer. Thus if XYZ linger at $45 per share during the life of the option, the option buyer is out of luck. My friend has made a lot of money watching the options he sold expire.

Circle of competence is a fancy way of saying, “Know what you don’t know, and stay away from it.”  If you are playing a game and don’t have a comparative advantage relative to the other participants, find a different game. By definition if you don’t have an advantage, you are operating at a disadvantage.

Warren Buffett, the greatest investor of all time, stays away from biotech because he doesn’t know the difference between DNA and the CIA. He has no comparative advantage, and is thus at a disadvantage relative to others steeped in the field.

Getting back to derivatives, often companies and investors use derivatives to neutralize, mitigate or hedge an underlying risk. For example, if I have a sales contract to be paid 1000 Euros per month for the next three years, and I want to neutralize any movement in the Euro/US dollar exchange rate, I can hedge this with a foreign exchange swap.  My counter-party may have the opposite problem of a US Dollar contract that he wants to hedge in Euros. Conceptually, it is as if each person agrees to wire his payments to the other. However, the mechanics are different.  Given that Wall Street does not work for free, there are costs to obtain a hedge.

You may have heard that derivatives are bad. In my opinion, a derivative is neither good nor bad: it depends on how it is used. A major problem with derivatives is they can become so complex that untangling them was akin to undoing the Gordian knot. Because of their inherent complexity, derivatives have all sorts of knock-on effects—risks, that investors do not understand until too late. Even Warren Buffett discovered this after his company, Berkshire Hathaway, bought a huge insurer called General RE. If he can’t figure this stuff out, we are all doomed.

Derivatives were instrumental to the financial melt-down of 2008, in large part because they created systemic risk, where layers of counter-parties were inexorably intertwined.

The easiest way to understand systemic risk is to think about it like dating a new partner. You are not just sleeping with them; you are sleeping with everyone they have ever slept with. 

Shorting a Stock. You may have heard the term shorting a stock. Most equity investors try to make money by buying a stock at a low price and selling it a higher price, i.e. “Buy low, sell high.”  Suppose there is a stock price that is irrationally high, and you want to profit from its collapse?  You can short the stock through your broker.

In terms of the mechanics, you have to borrow the shares (via your broker), sell them. Then buy them back at a future date (and at hopefully lower price) and return the borrowed shares to the lender.  It is still “Buy low, sell high,” but in reverse order.  With shorting you can lose your shorts because there is no limit on to how high the stock can rise.  When you go long, your loss is limited to the amount you invest.

The opposite of short is long.  A “long investor” is simply someone who buys and owns shares of stock. 

Myself, I am a long-only (as opposed to a long-and-short) public equity investor. I buy stocks on the expectation they will go up.  This is my swim lane. I am reasonably competent at assessing public companies, and have learned that in the long run stocks outrun bonds and most other asset classes.

I never short a stock, and I do not dabble in other asset classes, except to the extent I have cash sitting on the side-lines, which is effectively a fixed-income investment. I discuss my investing biases below.

Mutual funds, Exchange Traded Funds, and hedge funds are groups of investors who pool their money and have a professional manager invest the collective funds in one or more assets or asset classes. Asset managers are generally paid on the dollar value of assets they manage (called Assets Under Management - AUM), and not based on investment returns.  Hedge funds often have a “2 and 20” compensation scheme, where they are paid 2% of the asset value and 20% of the gains above a minimum (also called a hurdle) annual growth rate, typically 6%.

Thus, if a $100 investment goes nowhere, the fund gets $2. If the investment goes from $100 to $130 in one year, the fund gets: $2 plus 20% of the gain over 6% = ($30-$6)*20% = $4.80, or a total of $6.80.

If you don’t understand the arithmetic in the previous paragraph, don’t worry about it. The point is this: Wall Street excels at making sure Wall Street gets paid. For outsized gains, there is nothing wrong with outsized compensation. The problem is that most hedge funds can’t even keep up with index funds, which have a much lower fee structure.

It’s a good bet that if you sign up for one of these fancy funds, you are being played.

Along with many other Wall Street compensation schemes—or if you prefer compensation scams—this leads to the principal-agent problem, where the investor’s (principal) and manager’s (agent) incentives diverge. 

To understand viscerally how agents behavior can differ, think of the quotation attributed to the now-defrocked Larry Summers, “In the history of the world, no one has ever washed a rented car.”

As an example, a mutual fund with tepid results generates much higher fees than a small fund with excellent returns. Here the agent’s incentive is to gather assets and not to focus on investment returns for existing investors.

The principal-agent problem leads to many perverse incentives where Wall Street lines its pockets at the expense of investors.

One way to protect against this is to invest only in funds into which the managers have sunk most of their personal wealth—although this can be hard to determine. Managers don’t lead with, “Put all of your money here, while I slip out the back and invest my money elsewhere.” Usually the managers who are literally invested trumpet this in their communications to investors.  The managers who are silent speak volumes with their silence.

Continue to the next post

Throughout this write-up, I will refer to a fictitious house as an example to illustrate various financial concepts. Some of the assumptions about the house are completely contrived. My goal is to whisk away complexities that impede the analysis.

To understand the essential concept of a mis-priced asset, let’s assume there are two identical houses, with one exception:

House 1 just sold for $600,000. It is a 2,000 square foot house with a new pool.

House 2 is on the market for $300,000. It is an identical house next door, but no pool.

The cost of installing a pool is a $50,000.

Clearly there is a price mismatch here, because by adding a pool to house 2, the investor can spend $350,000 on an asset that was just priced at $600,000. 

It doesn’t take a Wall Street genius to figure out this is an arbitrage opportunity.

In a liquid, well-functioning market, such as the commodities market, this gap closes instantly.  The likely scenario is that House 2 will rise close to $550,000. There might be some discounting for risk—e.g. the town might not approve the pool permit—or to account for other costs, such as the cost for filing for permits, and to account for the risk that the pool construction costs exceed $50,000.

There is a class of investors called arbitragers who exploit dynamic micro price-mismatches, such as the differences between oil markets.  Arbitrage is quite different from value investing, but the motives are the same: how to pay less than $1.00 for $1.00 of assets.

The role of a value investor is to rise above the fray and identify assets that are mis-priced based on their underlying financial metrics—not based on the what last person paid to buy the asset. This involves not only avoiding tulip manias, but also having the courage to invest when the sky is falling. 

A general precept of value investing is to look at intrinsic value.  Intrinsic value is based on determining how much cash the investment generates net of ongoing business needs and in what time frame.  Note that cash generation is different than the profit that the company reports. We discuss these differences later.

Determining intrinsic value involves judgement and estimates. Intrinsic value has many nuances, and generally there is a range of intrinsic values, not one specific number. The range is driven by two broad factors: (1) your quantitative analysis and its underlying assumptions and (2) your narrative about the investment going forward. The quantitative analysis is primarily based on past data, such as the historical growth rate of the investment.

The narrative is your view of the future, and the narrative is key. For instance, car manufacturers are cyclical companies: their fortunes rise and fall in concert with the overall economy.  Are we at the top of the economic cycle or at the bottom?  What other factors should you consider?  If your narrative for investing in Ferrari is that it it will sell as many cars as Toyota over the next five years, you have an implausible narrative. A plausible Ferrari narrative is built around increasing unit production by 5% per year and raising prices by 10% per year over the next five years.

The quantitative analysis comes down the numbers. Intrinsic valuations focus on how much extra cash the investment generates, over what period of time, and with what certainly.  “Extra cash” means cash not needed to maintain or expand the business.

Many books and articles have been written about value investing.  I reference some key resources below. A more complete listing is in the Key Resources post at the end of this series of posts.

You may have heard the expression “time is money.” Indeed cash generated in ten years has different value that cash generation today—if for no other reason than inflation. To normalize this, a financial analysts discounts the cash flow back to today’s dollar value. More on that later. Rather than dive immediately into the weeds of discounted cash flow analysis, let’s take a simplistic example to illustrate the essential concepts. I’m taking many liberties to simplify the explanation to its bare essentials.

Suppose you want to buy a house for rental income. Your purchase price represents the investment you make. The rent from the tenant represents the cash coming from the investment.  Let’s make the following (unrealistic) assumptions:

1. The annual rental income is $10,000 and is paid at the end of each year.

2. The rent never changes.

3. The house will always have a reliable tenant, who pays the rent with 100% certainty.

4. As an owner, you will not have any costs, such as maintenance, taxes, improvements.  In other words, the rent is yours to keep.

5. You buy the house for cash on January 1 and sell it exactly one year later.

6. The price you receive on the sale is exactly what you paid, and there are no transaction fees. You will get your initial investment back with 100% certainty.

I acknowledge these assumptions are completely unrealistic.

How much is the house worth?

A.   If you buy the house for $20,000, then your one-year return is 50%.  You invest $20,000 and take out $30,000 ($20,000 return of capital + $10,000 investment income).  On this investment, you made 50% risk free.

B.   If you pay $200,000 for the house, then your return is 5%, again risk free. You invest $200,000 and take out $210,000.

C.   If you pay $2,000,000 for the house, your return is 0.5% risk free. You invest $2,000,000 and take out $2,010,000 one year later.

How much would you pay for the house?  $20,000 is a no-brainer, and $2,000,000 is a non-starter.

Your reaction to paying $2M may be a valid visceral response (as in "NFW”), but how do you move past the feeling you are being fleeced and get to an analytical foundation? Furthermore, what’s the threshold that you are willing to pay?  Is $100,000 too much? How about $425,000?

Determining the value of the investment is the task at hand. Value investors like to estimate the intrinsic value—based on the cash that can be pulled out of the investment—and buy at a discount, typically, 25% to obtain a margin of safety.

In this house example, how do you figure out the intrinsic value?  One way is to look at a comparable investment—and by that I don’t mean how much Joe down the street paid for his house. That assumes Joe knows what he is doing—not valid with the Joe’s I know. Comparing to Joe is a pricing action not a value analysis. Chasing Joe is what leads to Tulip Mania.

A comparable investment is another a one-year risk free investment.  For this, let’s use a one-year US treasury bill. (This is why a structured the house investment with my unrealistic assumptions above—to create the equivalent of a one-year risk-free bill.)

If the treasury bill yields 5%, then the value of the house is $200,000.  In order to get a payment of $10,000 per year on a 5% treasury bill, you would have to invest $200,000 , exactly the same as option B. above. ($10,000/.05 = $200,000.)

This gives insight into why when interest rates rise, stocks decline—the opportunity costs change. For example, if interest rates instantly go from 5% to 10%, the value of the house will fall from $200,000 because the cash flows are fixed at $10,000 plus the return of $200,000, the original investment.  A new investor will pay only play amount such that the payout is $210,000 assuming at 10% return. If the pay-out ($210,000) comes due in one year, the value today is $210,000/110% = $190,909.

If on the other hand, it is 50 years before the investor gets his original investment ($200,000) back, the value will fall much more precipitously—probably to around $100,000. There is a methodology to calculate this, but I’m too lazy to do so at this moment.

If Wall Street pitches you our example house at $500,000, you can bet your bottom dollar the sellers are not being altruistic. Champagne and caviar notwithstanding, you are being played. Wall Street was not built on winners.  

Figuratively, value investors try to buy a $200,000 house for less than $150,000 (a 25% discount) because they want a margin of safety. Margin of safety is what Ben Graham, the father of value investing, taught us.

This completes a very rudimentary financial analysis.  This is not a completely valid valuation.  I am just trying to illustrate some basic concepts.

In reality, actual financial analyses are more complex. Consider the following:

·       You have to pay taxes and transaction fees.

·       Inflation erodes the value of the cash you extract from the house. $10,000 in ten years is worth a lot less than $10,000 today.

·       You have to pay costs, such as maintenance and insurance.

·       Houses periodically need capital improvements such as new roofs and driveways.

·       They are not rented all the time.

·       You may have unreliable tenants who don’t pay their rent.

·       You can’t sell the house on demand.

·       When you sell the house, you don’t know how much money you will get.

A thorough financial analysis takes these factors into consideration and determines a range of intrinsic values.

At a first blush, the superficial analysis above is a screener to answer a simple qualifying question:

Is there enough margin of safety to even consider the investment? 

In our metaphor, if someone pitches you this house at substantially above $150,000, don’t waste your time going into the details.

Warren Buffett and other successful value investors are disciplined at quickly saying “no” quickly, and moving onto new investment leads. I call this channeling my inner assassin. I am as ruthless as an assassin in discarding investment leads. There are plenty of fish in the sea. Don’t waste time on marginal stuff. Move on to the next one.

Successful value investors are also patient, sitting on the sidelines and waiting for the right opportunity.

The house example is just that…a simplistic example to illustrate some basic concepts.

Useful Resources

Over one thousand books and many other works have been written on value investing. Most of them are garbage. I have put a list in the Key Resources section, but I highlight several here. If you want to delve in them, I suggest starting in this order:

·       The Little Book that Builds Wealth by Pat Dorsey.  This is an incredibly good book with an unbelievably stupid title. I held off on reading this for years because I thought it was a “here’s the secret formula,” type of book.  Hint: there are no secret formulas. Dorsey does not discuss value investing, per se, but he does discuss how to identify companies with sustainable competitive advantages.  A sustainable competitive advantage is to an investment what a tailwind is to a jet: everything becomes much easier, and more lucrative.  A company with a sustainable competitive advantage will have superior economics for a long period of time. Dorsey is also skilled at breaking investing into small, comprehensible concepts.

·       One Up on Wall Street by Peter Lynch. Lynch was a legendary investor in the 1970s and 1980s. In this book he writes incisively and hilariously about his approach to investing.  One Up on Wall Street was a phenom—a must-read in my opinion. His second book, Beating the Street, was incremental over his first, and his third book, Learn to Earn, I assume, was a waste of time. I never read it.

·       Warren Buffett’s annual shareholder letters from the Berkshire Hathaway website. Buffett has been the most generous person in the history of the investing. For over fifty years, he has freely given advice in his annual letters. Over his lifetime and posthumously, he will end up donating over $150 billion dollars to charities. Nobody else comes close. His letters have been repackaged along themes in books such as The Essays of Warren Buffett: Lessons for Corporate America by Lawrence Cunningham.

·       The Warren Buffett Way by Robert Hagstrom was my first introduction to the discounted cash flow models as a way of assessing an investment based on free cash flow.  This book allowed me to operationalize investment valuation, but my earlier models were crude and incorrect.  Aswath Damodaran, whom I discuss below, provided the scaffolding.

·       The classic tomes (or perhaps tombs) of value investing are Security Analysis and The Intelligent Investor by Ben Graham, the father of value investing. Graham developed the framework of looking at the fundamental financial metrics to identify and screen investments. Prior to Graham the prevailing approach to investment selection was, “Buy this sucker. It’s bound to go up.  I heard about it at a cocktail party.” These are good books, but I do not suggest starting with them. They can be daunting. They are good references to have on your bookshelf.

·       Aswath Damodaran, the New York University finance professor, has been incredibly generous in his teachings. His full MBA valuation course and other materials are all online.  If you really want to understand the nuts-and-bolts of valuation and how to handle various situations, such as convertible preferreds or companies operating in multiple currencies, Damodaran is your guy.  His teachings are spectacular.

He also has an enormous trove of useful data and many financial models (spreadsheets) that you can use for your analyses. Be forewarned: to take his online course, you need to have a rudimentary understanding of accounting, and you have to commit yourself to around 100 hours. However, this investment is very worthwhile.  This guy is unbelievable at taking gnarly situations and distilling them down to digestible concepts.

The Key Resources section at the back of this guide lists other sources of information and wisdom.

Libraries

And a word about getting books and materials. I am an avid user of my local library.  Very few books are worth keeping. The value of the library is that the book comes to you and more importantly it goes away: no accumulation.

Most of the time after I read a book I never want to see it again. I don’t need the endless bookshelves in my house to signal to my visitors how brilliant I am. Nobody comes to my house, and besides, I’m not that bright. Just think; I could have worked on Wall Street.

On the occasion where I want the book for reference or because I want it to read again, I will buy it online at Bookfinder.

Finally, libraries often have electronic access to useful databases such as Morningstar.

Continue to the next post

To paraphrase Peter Lynch in One Up on Wall Street, the worst time to invest in a company is when it is on the cover of Fortune Magazine. When stocks are abuzz at dinner parties, it’s Tulip Mania. This is your cue is to exit the investment, or the market completely.

Case in point: as I write this in May 2023, I saw a retrospective on a Fortune Magazine cover story from May 2000. (The timing is very prescient. I could not make this stuff up if I tried.)  Here’s a gem from the May 2000 article:

Suppose you were stranded on a deserted island and could own just one single stock. What would it be? Think about it for a minute. Would it be a stock that’s been battered this spring and is down 20% from its high? A stock that trades at more than 100 times earnings? A stock that’s already climbed around 100,000% since going public ten years ago, that’s already enjoyed one of the greatest rides in stock market history? The stock of a company that now faces unprecedented challenges in tough new markets dominated by the likes of Lucent and Nortel, plus a posse of red-hot upstarts?

Yup, that would be the stock. No matter how you cut it, you’ve got to own Cisco.”

Cisco was a fantastic company. In the 1980s and 1990s I worked in the networking industry and I liked to joke, “I have worked for every company put out of business by Cisco.”  Cisco consolidated the market and mopped the floors with people like me.

Now let’s look at Cisco’s stock from 2000 to 2023.

Price on 11 February 2000: $45.80

Price on 18 May 2023:         $46.72

No stock splits during that period.

Now, let’s see if my goldfish can solve the riddle.

When it comes to picking stocks, Fortune might want to change its name to Misfortune.

In all fairness, Fortune’s job is to sell magazines. The best way to sell magazines is with swashbuckling narratives about corporate grand slam home runs.

That’s great. Here’s my advice: as an investor, you will be more successful looking in the shadows for opportunities where no one is looking.

Investment ideas are a dime a dozen, or really a dime per 10,000.   The first step is to screen out the junk. In my case, I screen out around 299 of 300 ideas that cross my desk.  I screen very aggressively based on a number of filters. 

For my initial screen, I use a website called ROIC.AI and look at the summary page, which has a lot of very useful metrics, especially ratios. Morningstar used to have a fantastic ratios page on their website, but the boneheads eliminated it—snatching defeat from the jaws of victory. 

If there is one metric that jumps out at me, it is a consistent and high return on capital (ROC), expressed as a percentage. ROC is a measure of the efficiency of the company’s internal investment, also called capital allocation. 

For every $100 dollars invested in the business, how many dollars come back per year as profit when all the bills—including taxes—are paid? The key to successful investing is to have a return on capital that exceeds the cost of capital over an extended period of time.  That’s far better than putting your money on the latest Wall Street roulette wheel based on the advice of your broker with his Jimmy Choo eyeglasses and spinning bow tie.

Let’s go back to our house analogy. 

My parents bought a house in 1959. We ended up selling it in 2005 after my mother died.

The US post World War II economy boomed for many decades, because the US had the only standing industrial complex after the broad annihilation of the rest of the industrialized world. During this period, I am guessing that US housing appreciated at 7% per year on average.

Let’s further assume that my parents borrowed 100% of the value of the house (which they did not). I don’t know the interest rate of their mortgage, but let’s assume it was 4%, which was typical for that period.

To simplify the analysis and illustrate a key concept, let’s ignore any taxes, any maintenance and upkeep costs, and the the deductability of mortgage interest .

In this scenario, their cost of capital is 4% and their return on capital is 7%.

If the house value had appreciated only at 4%, they would have been treading water, because they were borrowing at 4%. Although the nominal value of the house increases under this scenario, the economic value is unchanged. At 4% appreciation, the nominal price doubles every 18 years. So, 36 years later the price of the house would have doubled and doubled again. However, in real value my parents would be no further ahead.

However at 7% appreciation, they have accumulated significant real wealth over this extended period of time.   

The 3% spread between the return on capital (7%) and the cost of capital (4%), as small as it seems, can result in huge wealth creation when compounded over long periods of time. If you able to get a higher spread, for example 10%, your real economic wealth explodes over long periods of time. This was Anne Schieber’s genius

This point is worth repeating.  The way to build real wealth is not to subscribe to Wall Street’s circus atmosphere. The way to build wealth is to buy and hold investments for extended periods of time where the return on capital consistently exceeds the cost of capital.

As Charlie Munger, Warren Buffett’s business partner, put it:

Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return -- even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you'll end up with one hell of a result. 

Obtaining a return on capital that exceeds the cost of capital is what every company seeks. In realty, few achieve it.  

Here is a counterexample.

In 2015, Sergio Marchionne, the late CEO of Fiat Chrysler, gave an eye-opening financial presentation available at this link: Confessions of a Capital Junkie

For decades the auto industry has been dominated by testosterone filled megalomaniacs who fashion themselves as “car guys.”  That’s great for capturing the cover of Fortune magazine, but turned out to be abysmal for investors. 

Marchionne, a bean-counter with charisma—admittedly an oxymoron—gave a financial presentation that became a wake-up call to an industry that had been asleep at the wheel for over eighty years. The presentation landed with a thud. His basic thesis was that the emperor has no clothes. For decades, the auto industry has failed to earn its cost of capital. Investors have been throwing good money after bad. The same can be said of the airline industry. 

In our house analogy, this behavior is tantamount to buying more and more houses, financing them at 10%, when they continue to appreciate at 7%. The empire building may make for great headlines, but it is lousy economics.

It is easy to determine ROC, which is reported by various financial services such as ROIC.AI and Morningstar. But how to you determine a company’s cost of capital?  That is a little trickier. 

In the house example above, I employed a sleight of hand by assuming my parents financed the whole purchase with a 4% mortgage. I also ignored that interest is tax deductible. With my simplifying assumptions, we got a cost of debt of 4%.  Since all of the capital is debt, the cost of capital is also 4%.

In reality Cost of Capital consists of two components: cost of debt, and cost of equity. Most companies have some borrowings, so their cost of debt is relatively easy to ascertain from their 10K filing document, the annual report that they are mandated to file with the US Securities and Exchange commission. We’ll get back to determining the cost of debt a little later.

But what s cost of equity?  What does that even mean?

Just as mom and dad did not borrow the full amount for their house, companies have some equity (think of it as a down payment) on their balance sheet.  However, first, we have to discuss what is a balance sheet.

The balance sheet identifies what a company owns, called assets, and what it owes, called liabilities.  Liabilities are financial obligations to third parties. The difference between these two is the equity.

Suppose you buy a house costing $100,000, but put down $20,000 and borrow $80,000.  Capital is the sum of the equity and debt used in a company. In this example, the total capital is $100,000.  The liability is $80,000. The difference, $20,000. is the equity.  Suppose our house were a corporation, and at the end of the year, the net profit was $10,000. This (called retained earnings) gets added to the equity, and the equity grows from $20,000 to $30,000. 

In this example, the return on capital is 10% ($10,000/$100,000), and the return on equity, which is expressed as a percentage, is 50% ($10,000/$20,000—based on the amount of the starting equity). The return on equity is very high, because of financial leverage: 80% of the capital is debt. That works well, until it doesn’t. If there is a downturn and the house does not rent, you go bust.

A lot of companies have juiced their return on equity by taking on huge debt and/or by using the debt to buy back much of their stock. Moody’s Corporation, for instance, has negative equity—essentially it owes $110,000 on a $100,000 house. It can do this because it has a reliable earnings stream which it can use to pay the debt—and lenders are willing to lend based on its cash generating power.  In my book, that’s like the guy down the street who has the latest fancy SUV, but is two paychecks away from homelessness. There is no margin of safety. As Rick Mears, the Indy 500 winner said, “To finish first, you must first finish.”

Equity can also grow by selling more stock. However, the return on equity—the existing $20,000—is 0.  Our mythical $100,000 company could earn $0, but the equity could increase if the company sold another $10,000 of stock as new shares, in which case the ending equity is $30,000, as above.  However, this situation is not remotely similar to the company that earned $10,000 on a starting equity of $20,000. In the second scenario there are more shares of stock. This is a far inferior result for shareholders compared to the company that earned 10% return on capital.

Return on Capital is the best measure of the financial efficiency of an investment.  Two similar companies, say clothing retailers, with significantly different returns end up being very different investments. Ross Stores for instance, has world class metrics for retailers (return on capital, operating margins, sales per square foot), and I use Ross Stores as a benchmark for measuring other clothing retailers.

Return on Capital is a useful metric for financial efficiency because it incorporates both debt and equity. Unlike return on equity, return on capital is not affected by the ratio of debt to equity.

As an aside there is a variation, called Return on Invested Capital (ROIC), which is an even better measure. Some companies, such as Apple, have huge amounts of extra cash sitting on their books. This extra cash weighs down the return on capital results because it adds to the denominator in the ROC calculation. Return on Invested Capital eliminates the excess cash and looks at how much a company earns on the cash invested in running the business.

Let’s park Return on Invested Capital, and focus our analysis using Return on Capital, for the sake of simplicity.

We have talked about returns of various types and asserted that a company builds wealth when its return on capital exceeds its cost of capital. As mentioned above, capital has two components: debt and equity. 

Pivoting back to our discussion on debt, the cost of debt is fairly easy to ascertain. Almost all companies have some debt and their annual report states the interest rate they pay on that debt. In fact, many companies have different tiers of debt—long term debt to finance their buildings and plant, unsecured debt to finance their working capital and the like, and perhaps debt in different currencies. A company probably does not have a single interest rate. A conservative approach is to use the highest interest rate (versus a weighted average of all interest rates).

Technically, one should use the marginal cost of debt—the cost of borrowing the next dollar. As a practical matter, this can be hard to ascertain. It can also vary by the currency of the debt. For instance, debt in Argentinian pesos carries a much higher interest rate because investors need to offset currency inflation. As a simplifying assumption, my suggestion is to use the highest cost you see reported in the debt table of the 10K or use an average cost as reported in the 10K.

That covers the cost of debt, but what about the cost of equity, i.e. the down payment?

Presumably the down payment that my parents put on their 1959 house was free: it had no associated explicit cost. After all, they did not have to pay interest on it. It was money they had in their checking account, or perhaps in investments. 

The cost of equity comes from a synthetic calculation used to determine the opportunity cost for making this investment versus investing in an approximation of alternatives. The cost of equity may not be an explicit cost, but it is a very real one. Here is how to think about it.

Let’s assume that my parents held a mix of stocks in the Standard & Poors 500 that they sold for their down payment. For the sake of simplicity, let’s ignore any tax implications. As a further simplification, if we assume the S&P 500 had an average annual return of 10% for the past 50 years, then 10% could be a proxy for the cost of equity.

Assuming they put 20% down and borrowed 80% of the house price, their weighted cost of capital (WACC) is calculated as a mix of the cost of equity and cost of debt:

Cost of Equity * proportion of equity to capital + Cost of Debt * proportion of debt to capital

(10% * 0.2) + (4%* 0.8) = 5.2%

However, this formula is flawed because the interest on debt is tax deductible and we did not adjust for this.

The revised formula is:

Cost of Equity * proportion of equity to capital + Cost of Debt * proportion of debt to capital * (1 – tax rate).

If the tax rate is 21%, the weighted average cost of capital (WACC) is 4.5%.

You can find various WACC calculators online if you want to try this out.

The second analysis above is also flawed because the cost of equity omits a number of factors like the risk-free rate, the country adjusted risk free rate, and beta.  Aswath Damodaran discusses these issues in his online courses. There is a thing called the Capital Asset Pricing Model (CAPM) which some investors use to “compute” the cost of equity.

Critics of CAPM assert that this approach gives a false sense of precision for something inherently fuzzy—false precision may not give an accurate result. Additionally, precision does not imply accuracy.

There is a difference between precision and accuracy. When I go to the doctor’s office, the staff asks me to step on a scale. The scale is very precise, giving a result to the nearest ounce. The problem is that the result is not accurate, because it includes my body weight and the weight of my clothes. If I show up in my hiking gear having just eaten dinner, the measurement will be completely different than if I show up wearing my scuba gear. Both measurements are precise, but neither is accurate, because neither reflects my actual body weight.

Don’t assume CAPM gives you anything accurate.

Absent calculating a falsely accurate WACC, I suggest a placeholder—use 10%—at least in your initial investment screening.

Another issue is that companies have different costs of capital depending upon their financial strength. A company with huge debt and poor operating profits will pay a higher interest rate, just as a subprime borrower has to pay a higher mortgage rate.

There are also adjustments if a company has a lot business in inflationary foreign currencies. 

In terms of costs of capital, it turns out insurance companies have very low costs of capital. This is because they use borrowed money called float. Uncle Warren learned this lesson when Berkshire Hathaway bought it first insurance company, National Indemnity.

Here’s a little sidebar on insurance. Buffett writes extensively about the topic in his shareholder letters.

The way insurance works is that the customers, called policyholders, pay for premiums up front. At some point in the future they submit their claims—basically get their money back. The insurance company invests the assets, earns a return, and pays the claims from the assets. If the insurance company has an underwriting profit (i.e. premiums exceed the sum of the claims plus the overhead) the company is being paid to hold the customer funds. This is equivalent to a negative interest rate.

As a rule of thumb if the return on capital exceeds the cost of capital, over the long term an investment will be worthwhile. If the reverse is true, the investment is usually dreadful.

The counter-argument is that it is always possible that a greater fool will come along and buy your investment for a premium, but don’t bet on that.  If you believe that, let me sell you my tulip collection.

BETTER TO BE ROUGHLY RIGHT THAN PRECISELY WRONG

In doing your financial analysis, don’t go crazy estimating the weighted average cost of capital. 

My suggestion is to use a WACC of 10% as a placeholder to see if an investment passes muster. Just based on this, you may be able to eliminate 90% of your investment leads.

As a rough screening-criteria, I look at companies with a return on capital exceeding 10%.  My initial assumption is that the WACC no more than 10%.  Let’s put it this way: a company with a return on capital of 3% is swimming upstream.

In investment analyses, you may see the terms discount rate or hurdle rate.  For all intents and purposes, these are synonymous with WACC.

Regarding the cost of capital, the essential question is:

How much does the company need to make for this investment to be worth my time?

Because of the risks involved, you may require a higher hurdle rate for an investment in Russia than for one in Switzerland.

The Value of Percentages and Ratios

The value of metrics such as ROC, ROIC, and WACC is they are all percentages.  This allows us to compare Google to 3M to Sam’s Cigar Stand. I have mentioned the website ROIC.AI before. Their summary screen presents all sorts of ratios and percentages. This is extremely useful, especially for screening out investments. 

I have mentioned before that I look at around 300 leads for each investment. Maybe the ratio is 400 to 1, I’m not sure. I quickly dump stuff that does not fit. When it comes to screening out investment leads, I’m channeling my inner assassin and always assuming there are more fish in the sea.

Here’s the bottom line: competitors with sustainable competitive advantages have superior economics over long periods of times. You want to find shareholder friendly companies meeting this criteria. Shareholder friendly means that insiders are not siphoning off the moola for themselves. Generally, this means finding companies where the insiders have a significant stock ownership.

One screening criteria I use, is to look the investment lead relative to a best-in-category competitor. If I hear about a new clothing retailer, I will go to the website ROIC.AI and compare the metrics of the investment candidate with Ross Stores, a world-class leader in retailing. 

Is Foot Locker a worthwhile investment?  Let’s see:

From 2005 to 2022 their operating margin averaged 8.31%.  The ROC averaged 15.81%.

For Ross Stores, from 2005 to 2022 their operating margin averaged 11.41%.  The ROC averaged 26.4%.

Ross Stores had superior economics for the past fifteen years and probably for the next fifteen years.

So, why don’t I just invest in Ross Stores and be done with it?

Here’s why: I’m a slow learner.

Actually, the answer is more nuanced, but I’m still a slow learner.  It gets down to the price of the shares. At what price is the stock worth buying?  

In our house analogy, our house generated a return of $10,000 per year, and we determined a fair price of $200,000 and a bargain at $150,000.  Suppose I was offered a house with better economics: a return of $10,000 the first year and increasing at 10% per year after that. Should I pay $3 million for this house? Probably not.

You have to buy the right asset—one where the return on capital trounces the cost of capital—and you have to buy it at the right price. Ross Stores is on my watch-list, and if the price is right, I will likely buy.

The price of Ross Stores was right in the midst of the Covid pandemic, and I did not buy. This was a conscious decision. Given that the world was shutting down, I was uncomfortable jumping in because it was not clear to me low long retailers would be closed. This gets to the issue of certainty, which is one of Buffets four investment factors.

Call me chicken if you want. And yes, I do commit errors of omission—the one’s that got away—but I find those errors more comfortable than errors of commission.

YOUR PANIC IS MY OPPORTUNITY

Superior companies do go on sale from time-to-time, usually as a result of some adverse event. The most skillful investors can assess ex-ante, with reasonable accuracy, if a company has encountered a temporary set-back or is in the early stages of melt-down.

Sometimes the melt-down is company specific (e.g. GE), and sometime it is industry specific (e.g. the newspaper industry).

Warren Buffett made a huge bet in in the early 1960s on American Express during the famous salad oil scandal. I won’t repeat the full story here: read about it online. The gist of the story is that a division of American Express got hoodwinked, which led to a loss and a gigantic a breach of corporate credibility.

How could these idiots let that happen? Are there more cockroaches that we can’t see running around the kitchen?  Those were the fears of the moment.

Everyone had their hair on fire and was running for the exits. The stock nosedived.  Buffett assessed the situation as, “this too shall pass,” and made a massive investment in the company during its darkest days. He did not do that on a lark. He did his homework.  I’m guessing he looked at the balance sheet to determine if the company had enough resources to weather the scandal. He also spent an evening standing at the cash register at a fancy restaurant to observe if dinners were still using their American Express card to pay for dinner (they were).  He made a calculated bet the company would bounce back.

There are no sure things in life. Buffett is genius at figuring the odds. The American Express investment worked out handsomely, but as he readily admits they don’t all go that way. In his annual letters he has the humility to admit and discuss his face-plants.

As I write this in May 2023, regional banks are melting down. The FDIC has taken over several mid-sized banks, and there may be more to come. This is a “baby with the bath water” scenario where the stock prices of most regional banks have dived. 

Are there diamonds in the rough?  Yes.  The problems that have affected the failed banks—a mismatch between the maturity of their assets and their liabilities—have not affected all banks.  However, there other factors as well, such as collapse of net interest margins-the difference between the interest rates banks collect from their borrowers and what they have to pay their depositors.

In situations like this, I may make very selective investments and do so in increments to dollar-cost-average as the stock price goes down. Generally, I jump in too early because I have been eyeing these companies for a couple of years.  I know this about myself, which is why I invest in stages.  I am also lousy at picking the bottoms. 

Continue to the next post

Strategic Mumbo-Jumbo

Anyone who has spent time in corporations soon learns that everything is labeled as strategic.

HR wants to have a strategic offsite to discuss the color of the paper dessert plates for this summer’s employee picnic.

Sorry, that’s not strategic. This is example of a marginalized group trying to scratch its way into the central corporate narrative. It’s like a little boy in a Charles Dickens’s novel with his nose pressed against the plate glass window desperately looking into the sweet shop.

In a money-making enterprise, only four things matter:

1. Delighted customers

2. Sales

3. Operating Profits

4. Free cash flow

Everything either supports those four, or it is completely superfluous.  Of course, companies have to do things like uphold the law, respect employee’s dignity, be good corporate citizens and the like.  That stuff is baseline.

The next time a corporate type hits you with strategic mumbo-jumbo—such as in investor communications, just think to yourself, “Oh, this is a money losing activity that he is trying to justify.”  You won’t be far off in your assessment.

Capital Allocation

In Buffett’s judgment, capital allocation is the CEO’s most important job.  What the heck is capital allocation?

The concept of capital expenditures is discussed below, but suffice it to say that in their early years both Google and Facebook spent billions of dollars—far faster than money came in the door.  Each of them went for a landgrab in an important emerging market. They did this brilliantly building barriers to entry and ultimately developing thriving cash-gushing businesses. However, for every Google there are 10,000 crash-and-burn start-ups.

In vivid contrast to conquering cyberspace, Buffett owns scintillating businesses such as Acme Brick and Dairy Queen.  He invests much later in a company’s life cycle when there is higher certainty and the business produces more cash than it consumes.

In these businesses, the question is, “What does the company do with all the moola coming in the door?”

The CEO’s conundrum is more nuanced than “Do I buy a new Rothko for headquarters or send a dividend check to the shareholders?”  Peter Lynch had a very pithy articulation of this problem, which he called the Bladder Theory of Cash Management and I paraphrase as:

The more cash a company has, the more urgency to piss it all away.

There are only five uses of excess cash:

·       Reinvest in the business

·       Acquire another business

·       Retain in the business

·       Pay down debt

·       Return to shareholders as dividends or stock buybacks

The best use depends upon the situation. Continuing to invest in the business should be driven by the marginal return on capital. In the case of the auto industry, as previously discussed Sergio Marchione CEO of Chrysler and Fiat identified that the auto industry returns fell below the cost of capital, destroying shareholder value. In this case, the best choice is to return the capital to shareholders in the form of dividends or wrapping up the business and selling the divisions and assets.

Here is the difference between return on capital and marginal return on capital. The company may have a great average overall return on capital (ROC), but the next investment may yield an ROC less than the current baseline, even though the marginal return on capital may be above the cost of capital.

The difference between ROC and marginal ROC has been Walmart’s dilemma for decades. Their return on their next store is significantly less than the return on each new store in 1969. That is because the world is awash in Walmart stores, and the next one will likely cannibalize sales from an existing store.

CEO capital allocation is important both for what it is, and for what it signals.  For Apple, given their cash position, putting a new Rothko on the wall is a rounding error of a rounding error. However, the Rothko sends the wrong signal to the troops. That stray signal has a force-multiplier effect.

As outside passive minority investors, how do we get a sense of the company’s capital allocation skills?

There is no one answer to this question. You just have to start looking and follow the breadcrumbs. By the way, investing is a lot of detective work.  Nobody puts up a bullseye, like the Target logo, that says “Invest Here,” except Wall Street when it wants to fleece gullible investors.

In terms of capital allocation, one clue may come from the CEO letter in the annual report (discussed below). However, take the CEO letter with a grain of salt. Just like friend’s bragging rights at the cocktail party about his splendid European vacation, CEO letters are all about signaling. What companies say and what they do often diverge.

Don’t believe me?

A company formed in 1985 claimed revenues exceeding $100 billion in 2000. By now you may be asking, “How do I invest in this one?”

Here are the four values listed in the company’s lobby:

• Integrity

• Respect

• Communication

• Value

Care to guess the company name?

Enron

In terms of discerning capital allocation skills, another clue come from looking at headquarters in person or on Google Maps Streetview. Is HQ a Taj Mahal or a dump?  One of my best investments is located in a small town sixty miles outside Edmonton, AB Canada. From Streetview the headquarters looks like a thrift clothing store. I’m guessing there are no Rothko’s hidden there.

Another clue comes from a company’s acquisitions. Most acquisitions, especially the “big splash” ones featured in the financial press are ego driven—and dreadful for investors of the acquiring company. Companies overpay for acquisitions, which ends up on the acquirers balance sheet as Intangible Assets and Goodwill. We discuss these concepts later.

As Buffett reminds us, corporate staffs have a predilection to do financial limbo-dancing to justify any acquisition the CEO wants.

Microsoft’s acquisition of Nokia’s phone business was a doozy. Here are the numbers:

·       In 2013, Steve Ballmer, Microsoft’s CEO, announced a $7.9B acquisition.

·       The acquisition added massive amounts of Intangible Assets and Goodwill to the balance sheet. Accounting intangibles are “pretend” assets akin to believing the story of Snow White. See discussion below.

·       In 2015, Satya Nadella, Microsoft’s new CEO, announced a $7.6B impairment charge (more on impairment charges below). This is a 96% write-down of the acquisition price. assets.

Ouch. 

My guess is that the Nokia failure forced Ballmer’s ouster. 

The Jockey or the Horse

Pat Dorsey, the author of one of the books I recommend above, believes that the horse is more important than the jockey. By this he means that investors should focus on the inherent competitive advantage of the business rather than who is running it. He discusses structural competitive advantages which are difficult to displace. An example is Visa, which has built a network of tens of millions of merchants and billions of card holders.  Their incumbency is very difficult to displace.

Buffett tells us:

When a manager with a reputation for brilliance tackles a business with a reputation for bad economics, the reputation of the business remains intact.

Notice in this quote Buffett is silent on the value of the jockey.

My opinion is that a good horse is necessary, but not sufficient. The best jockey can’t make “Old Bessie” win the Kentucky Derby, but a lousy jockey can screw up a racehorse. Time and again, we have seen a good CEO turbocharge a business that has inherent competitive advantages.  One needs to look no further than Steve Ballmer’s reign at Microsoft versus Satya Nadella’s. Ballmer was dancing with two left feet, while Nadella is Fred Astaire.

Continue to the next post

In analyzing any potential investment, the financial statements are the Rosetta stone.  This is not a full course in accounting, but it is important that you understand the guideposts. 

You have to understand that accounting is not a absolute statement of the facts. It is a characterization of the numbers. As an investor you need to know not only what the numbers are, but what the numbers mean.

By way of analogy, if you buy a house in Florida, some realtors may pump up square footage by including all space “under roof.” Your job is to discern if the quoted square footage is just the air-conditioned space, or if it includes the lanai, and the garage.

In their legal financial filings, companies report in good faith various numbers, have to make judgements, and have to discuss the key assumptions supporting their disclosures. Legal financial filings have to comply with accounting standards (generally GAAP or IFRS—more on those later). Even in the context of GAAP or IFRS numbers, there is room for discretion, but not outright fraud.

The financial statements in docuents such as the 10K, the company’s annual report filing with the US Securities and Exchange Commission, are legal documents. The reporting is very august and dry because CEOs and CFOs don’t want to go to prison.

In addition to the GAAP or IFRS numbers, companies often make supplemental disclsoures in a way that is similar to historically-based fiction. The umbrella term is “adjusted results” or some synonym.

This reporting is like a Peter-Pan shadow dancing on the wall. It is both based on reality and weirdly disconnected from it. We’ll come back to that later.

The most important elements of the financial statements are:

·       The Balance Sheet

·       Income Statement

·       Statement of Cash Flows

1.    The balance sheet describes what the company owns (assets), less what it owes (liabilities) and what is left over (equity). Assets - Liabilities = Equity.  As it’s name implies, the balance sheet has to balance. The balance sheet is a snapshot. It describes the statement of accounts on a specific date, for example 31 December 2022.

2.    The income statement presents sales and expenses of the company over a period of time, for instance from 1 January 2022 to 31 December 2022.  Expenses are aggregated and presented in stages.

Professor Damodaran has his own excellent post on how to think of the income statement here:

In the post, he has this key figure which summarizes key aspects of the income statement:

Most income statements have the following elements, along with my fabricated example to make things concrete:

-      Revenues represent the economic value of what the company sold.

-      Cost of goods sold (COGS) quantifies how much it cost to produce the stuff that was sold.

-      The remainder of revenues less COGS is called gross profit.  Expressed as a percentage this is gross margin.

Example: IF XYZ sells $100 Million of widgets and it costs $60M to produce the widgets, the gross profit is $100-$60 = $40M.  The gross margin is $40M/$100M = 40%. Gross margin is important because it allows comparisons between vastly different size companies, e.g. Ferrari versus Toyota. 

-      From gross profit, the company subtracts the overhead of running the business, sometimes called Sales, General, and Administrative (SG&A) expenses.

-      The remainder is operating profit. The corresponding percentage is operating margin, (operating profit/revenues). This is another key percentage and is useful for comparison. Above we saw above Ross Stores has a superior operating margin to Foot Locker over an extended period of time. This indicates that Ross Stores has a sustainable competitive advantage and is likely to be a superior investment over time.

-      From operating profits, the accountants subtract interest expense for the debt that the company has to service.

-      The result is pretax profit (and corresponding pretax margin)

-      Next come taxes

-      After subtracting taxes, the company has a net profit (and corresponding net margin).  This is the “bottom line.”

Here is an example

In reality financial statements are more complicated.

In addition to operating profits, companies may have non-operating profits (and losses).  For instance, a company may have a building bought decades ago that the company recently sold for more than the accounting value on the balance sheet. This transaction creates a one-time gain which has nothing to do with core operations.

Most companies also produce a statement called other comprehensive income (OCI).  OCI is a “sidebar” to the income statement and is intended to identify other types of gains and losses.  For instance, if a company reports its financial results in US Dollars and has a bank account in France denominated in Euros, the US dollar value of that account will ebb-and-flow based on exchange rates. The change in reported dollar value is reported in OCI. 

There are potential snakes-in-the-grass which show up in OCI and not in the income statement. For example, pension shortfalls can show up here.

For companies, such as banks and insurance companies with extensive financial assets and liabilities, the quarterly change in value of these assets and liabilities can be significant. Generally, financial assets are categorized in three different ways: (1) trading securities, (2) available for sale (AFS), and (3) Held-to-maturity (HTM). Depending on the classifications, the change in value is reported in three different ways. Companies can—and do—play games on this front.

Changes in the value of trading securities, for instance the securities that Merrill-Lynch holds on its own accounts (as opposed to customer accounts), are reported in the main income statement.

Changes in value in available-for-sale securities are reported in OCI. The change in value in held-to-maturity securities does not have to be quantified, but has to be noted in the notes accompanying the financial statements.

Think of HTM this way. If I own a Picasso painting that I am not planning to sell for thirty years, I don’t care about its vacillating value quarter-to-quarter.

Trust me, disclosers report only the bare minimum required, without ending up in prison. As an investor, you need to be a detective, read the tea leaves, and make some reasonable inferences.

Silicon Valley Bank, the bank that failed in early 2023, employed this sleight of hand by classifying most of its investments as HTM. HTM means the company has no intention of selling the investment but will redeem it when the investment matures. That’s nice, but did not reflect reality.

Silicon Valley Bank had massive losses in their HTM investment portfolio of long-term US Treasury bonds. Because the bank claimed these investments were classified as HTM, the losses were reported minimally in the notes. The problem is SVB was unable to hold out long enough when the depositors fled for the exits.

The point is not to freak if you see numbers show up in OCI or when you find a puzzling disclosure in the notes.

This is your cue to dig deeper—especially if there are large variations year-to-year. There may be a problem, and it is better to run this to ground while other investors are on the beach sipping pina coladas oblivious to the imminent underwater volcano.

3.    The Statement of the Cash flows describes the moola coming into and out of the company over a period of time, for example from 1 January 2022 to 31 December 2022. 

This statement has three major sections: (a) cash flows from operations, (b) cash flows from investing, and (c) cash flows from financing.  For Warren Buffett, the cash flow statement is key to his evaluation. He seeks companies that throw off lots of cash from operations, and don’t need to re-invest tons to keep the beast breathing.

Conversely rapidly growing companies, for instance Google in its early days, burn through cash even if they report “profits”. Cash flows from operations and new investments can be wildly negative. Google made up the gap from cash flows by raising billions of dollars in the early days.

Cash flow statements are probably the most important aspect of the financial statements because cash never lies.

Cash flow is different than earnings shown income statement, primarily because companies distinguish between expenses and capital expenditures.  This requires a quick brief discussion on accounting.

An expense is money that the company spends on a good or service that has no economic life, for example a business trip.  A capital expenditure is money that the company spends on a good or service that does have an economic life, for example a new factory. 

To wrap your head around this concept, assume on day one the company has $200 million in cash. On day two, the company has a new $200 million factory and no cash.  From an accounting perspective, the company did not spend the money but rather converted one asset from one form (cash) to another (plant, property and equipment).  In theory, on day three, the company can sell the factory and get its money back. However, over time the machines in the factory wear out, and will need to be replaced.  If the accountants declare the factory has a ten-year life and no residual value, in theory the factory depreciates at the rate of $20M per year.

Theory is nice, but reality is more complex. Accountants need a framework to estimate the declining value of the factory. This is an accounting model, which may not reflect actual economic value, but is intended to provide a reasonable estimate.  This is one example of a good-faith characterization of the numbers.

For example, the factory might last longer than ten years and thus the actual economic losses are less than $20M per year, even though the company reports $20M per year. Alternatively, the company might exit this business after a year—with 90% of the “value” of the factory still on the books, even though no buyer will pay 90% for the moth-balled factory. A buyer might be willing to pay, for example, only 40 cents on the dollar.

In that case accountants will adjust the value on the books, and have a quaint expression: an impairment charge. I call it a f___ up.  Impairment charges are supposed to be non-recurring.  A company with a series of impairment charges may be masking some underlying flaw.

In any case, the company takes what is called a “non-cash charge,” where the assets gets written down and loss shows up on the profit and loss statement, but no cash changes hands. In the example above, if the company sold the factory after one year for $50 million, they would take a non-cash impairment charge of $180-$50 = $130 million. The $130 million write-off affects the balance sheet immediately. However, the cash went out the door long ago when the factory was built.

On the normal course of business, capital expenditures are recovered through depreciation charges which show up in the income statement (as expenses for the year) and statement of cash flows (as cash-flow positive recoveries). This is one reason why understanding the cash flow statement is important.

A Shallow Dive into Acquisition Accounting

The cousin to depreciation is amortization.  If tangible assets—factories, machines, computers—depreciate, intangible assets amortize. 

What is an intangible? It is most often intellectual property that has enduring business value. The Coca Cola logo, a registered trademark, is an intangible asset. Mickey Mouse is an intangible for Disney. Microsoft’s software used in the latest version of Windows is an intangible.

Because of an accounting quirk, the cost of internally developed intangibles are generally expensed, even though the intangible has enduring business value. However, acquired intangibles are capitalized and amortized.

Without getting into the deep weeds of accounting, when a company (Company A) acquires another company (Company B) for more than the equity value on Company B’s balance sheet, Company A will end up with (a) goodwill and (b) intangible assets on its books. Collectively, these are called intangibles. Yes, the terminology is confusing.

Intangibles are exercise in accounting fiction, just like Cinderella and the handsome prince. Here is an example to make the issue concrete:

Company B has $100 in assets and $90 in liabilities, and therefore $10 in equity.  The $10 is also called “book value.” Company A buys Company B for $120. The problem is Company A is paying $120 for $100 in assets. In this scenario, Company A assumes assumes all of Company B’s liabilities ($90) and paysthe owners of Company B $30 for their $10 in equity.

Company A paid $30 for $10 in book value, an excess of $20. In the merged entity, the collective assets and liabilities get added up. The problem is that there is $20 of equity unaccounted for—the premium Company A paid to Company B’s shareholders.

As we said before, a balance sheet needs to balance. Here’s the accounting sleight of hand. In merger and acquisitions transactions, the $20 excess gets allocated to two categories: Intangible Assets and Goodwill.

These are synthetic (read “pretend”) assets added to Company A’s balance sheet so that it balances after the transaction.

In general, but not always, intangible assets are amortized, and goodwill is not. Amortization charges show up explicitly as a recovery on the statement of cash flows.

Serial acquirers often have large intangibles on their balance sheet. A company with increasing intangibles on its books is generally making a lot of acquisitions. The way this is sold to investors is that the premium is justified based on “synergies” and acceleration of profits.

Often, but not always, a series of acquisitions with lots of intangibles is a sign of poor financial discipline. Everybody's whistling in the dark until the you-know-what hits the fan years later and the company takes a huge impairment charge. You don't want to own shares in a company playing this game.

I guard against undisciplined serial acquirers by looking at the ratio of intangibles to shareholder's equity. Both goodwill and intangible assets are reported in the balance sheet as long term assets. I add these numbers up. If intangibles exceeds 20% of shareholder equity (also reported on the balance sheet), generally I move on to the next investing lead.

One needs to distinguish between economic intangibles and accounting intangibles. They are not the same. Warren Buffett discusses this distinction in his letters when waxing about the brilliance of the See’s Candies acquisition in the early days of Berkshire Hathaway.

Economic intangibles act as levers for extracting exaggerated profits downstream. Accounting intangibles sit on the balance sheet like a turd: smelly, inert, and useless. 

Over the long run, a company making prudent acquisitions will grow retained earnings faster than intangibles so that intangibles as a percentage of equity should not expand like a balloon. Looking at the ratio of intangibles to shareholder equity over time can provide insight into whether a company’s past acquisitions have been financially prudent.

Accounting is a way of reporting financial information. It is a good-faith characterization, nothing more.  It is not the truth, but attempts to model the truth.  It is not as fictionalized as the latest Disney movie—with the exception of studio accounting which really is an act of fiction. Accountants have to make judgements.  There is a fair amount of latitude, but it is not the Wild West.

GAAP and IFRS

Just as we have standard rules for driving our cars, there are accounting standards for reporting the numbers. The two major standards are GAAP (Generally Accepted Accounting Principles – used in the US) and IFRS (International Financial Reporting Standards – generally used internationally). GAAP and IFRS are similar, but do have some significant differences (driving on the right side of the road versus driving on the left).

Some of these differences are described here: https://www.footnotesanalyst.com/comparability-is-crucial-for-informed-investment-decisions/

It can be tough to compare a US company reporting under GAAP with a European company reporting under IFRS.  GAAP and IFRS are not perfect, but they are the best we’ve got.

If PepsiCo reports under GAAP and Nestle under IFRS, it may be an oranges to clementines comparison.  However, you should be able to compare Nestle’s 2021 results with its 2022 results because they both use the same standard.

Companies are required to report in GAAP or IFRS in the annual reports and related filing documents (Form 10K in the US).

Going Off the Rails

In addition to GAAP and IFRS, companies often report supplemental numbers with names like EBITDA, EBITDAX, Adjusted EBITDA.  When these show up, hold on to your wallet.

Management usually justifies this supplemental reporting with some sentence like, “In management’s opinion, these measures more accurately reflect the true performance of the company.” 

I’m reminded of Charlie Munger’s quip:

Show me the incentive and I will show you the outcomes.

In general, companies are trying put the numbers through a financial house of mirrors in order to make investors think Donald Trump’s physique looks like Tom Brady’s.  What the process really does is make the company look good to boost executive compensation.

Golly, what a surprise.

My advice; stick to GAAP (or IFRS) numbers and make your own adjustments, not the ones the company suggests.

Continue to the next post

Here are the four major asset classes I mention above (but in reverse order)

• Investment real estate

• Commodities and Energy

• Fixed Income

• Equities

Some people are adept at more than one asset class. It is rare that someone masters all four.  For me, I am an equities guy. 

Investment real estate tends to be highly leveraged: huge deals with razor thin margins, financed with cheap debt.  Not my gig. 

Commodities and Energy investors generally exploit derivatives, such as futures contracts, and other sudden-death instruments.  Again, not my thing.

Wealth managers often steer clients to mix of stocks (60%) and bonds (40%). The pitch is that stocks and bonds counterbalance each other.

Bonds – Heads You win. Tails I lose.

Bonds are fixed income investments, where valuations run counter to interest rates. 

Bonds are priced to yield. If you have a bond paying 5%, and interest rates shoot to 10%, no one will pay you full price for your bond, because they can get twice the yield with a newly issued bond. As interest rates go up, the value of the underlying bond goes down and vice-versa.

A bond is a type of a fixed income investment, just as it a bank CD or savings account. Fixed income is the broader category.

Most bond investors have no idea what they are buying. A bond (technically called debenture) is a security obligating the issuer (i.e. borrower) to pay the creditor (i.e. investor) a consideration (interest and return of principal) based on specific legally enforceable terms and conditions. This is similar to a home purchaser (borrower) who borrows from a bank (creditor). The bank issues the mortgage with terms and conditions.

For fixed income these terms and conditions are called covenants. it is important to understand them in detail.

Few bond investors know that covenants even exist, and only 1% of investors have ever read the covenants. The covenants describe what happens when investors have to call in the sheriff—figuratively speaking.

About twenty years ago, I looked at bonds in a company called Level 3, a communications company, that was covering the country with conduits (tunnels in the ground between cities) containing  next generation fiber optics. Level 3 had a very glib CEO who was adept at painting a glowing picture of the company, and its inevitable march towards industry dominance.  I knew Level 3 from my day job. I had heard the CEO speak at many industry conferences.

Level 3 and their ilk (next gen communications companies) offered several competitive advantages over the incumbents: the brain-dead Baby Bells, the remnants of the US phone system of the previous seven decades.

The Baby Bell playbook was to (1) stymie innovation through regulatory jousting and (2) extract economic rents for as long as possible. The next-gen companies were building a new infrastructure with significant cost advantages, and had different attitude toward delivering value to customers.

Despite the appeal of the next gen companies, I was skeptical of the Level 3 CEO’s pitch. My own private assessment was that the emperor had no clothes. My private joke at the time was, “Level 3 is a company that digs holes in the ground into which investors pour billions.” 

Their bonds became distressed, trading at 40 cents on the dollar. Since I smelled a potential opportunity, I wanted to get a copy of the bond covenants. My sense was that if this thing went belly-up, the bond holders would have claims to valuable assets, such as the fiber in the ground and the rights-of-way.

I was unable to find the information online, and I’m sure if I had called my friendly financial adviser with his Jimmy Choo glasses and spinning bow tie, his response would have been:

“You said the company is called Level 3? Help me out here. How do you spell 3?” 

Better to call my goldfish instead.

I happened to know Level 3’s head of investor relations, and he kindly sent me a copy of the documentation via the post office, and not email.  This should have been a tip-off given that this company was covering the US with high speed fiber. I missed the cue. Oops. Go directly to Wall Street, do not pass go, do not collect $200.

In any case, I read the covenants, and it was clear that if that the holders were entitled to…a big fat nothing. The rights described in the covenants were utterly vacuous. If this thing blew up (as it seem to be doing), the bond holders would be left holding a bag of air.  There was no there there. 

Jimmy Choo glasses and spinning bow tie notwithstanding, I passed on another Wall Street can’t-miss opportunity.

Not all bond offerings are this empty, but it has been my experience that covenants of bonds are generally structured to benefit the issuer, i.e., “Heads You win, tails I lose.”

For example, many bonds are callable, meaning that if interest rates decline, the issuer can call the bond. Issuers can refinance their debt at a lower rate, much like a homeowner refinancing a mortgage.

In a normal capital market, if interest rates go down, the bonds skyrocket and the bondholders can sell the bond for a huge gain. No such luck with callable bonds. The company calls the bond and pays it off (at the issue price—perhaps with a slight premium, not the market price) and issues a new bond at a lower interest rate.

Conversely, if interest rates go up, the bonds plummet, and the bond holder is caught holding the bag. This is an asymmetric situation where the bond holder is bearing all of the interest rate risk.

Heads the issuer wins. Tails, the bond holder loses. Why would I invest in this type of garbage?

Of course, Wall Street will tell me to hedge my risk with a derivative. Yes, but who pays for that? Santa Claus? Maybe Mickey Mouse if I am lucky.

No surprise that Wall Street is out to make a quick buck from gullible and dis-engaged investors. Bonds are a case in point. When the company issues the bond to the market, their investment bankers flog it to unsuspecting investors—both institutions and individuals—who can’t be bothered to understand what they are buying. 99% of investors willingly sit down at the poker table wearing blindfolds.

Your job is to be vigilant and channel your inner assassin with every investment “opportunity” that comes along. The ones with big red bows tied around them are probably lousy deals.

I don’t like to play games, where ex-ante, I am likely to lose. See my discussion below about companies with two-classes of stock.

The Reach for Yield

Convents aside, there is another catastrophic problem with fixed-income investments, including bonds, late in the economic cycle—towards the tail end of a booming economy just before the economic dump-truck vomits its load. 

It’s called “reach for yield.”  Investors, desperate for a higher interest rate neglect to assess risk. This another case of investors playing poker with their eyes closed.

Here is a part of an email I wrote to a friend in 2009.

Bonds, particularly high yield—aka junk—tank with market meltdowns.  This occurs because there is a rush to liquidity and a flight to quality.  A rush to liquidity occurs because people are typically overextended late in the economic cycle and need to get out.  In other words, if I buy a McMansion and I can barely afford the mortgage payments on my salary, and then when I get laid off from my job, I'm screwed and have to conduct a fire sale. 

Concurrent with the flight to liquidity is a flight to quality.  A flight to quality occurs when people realize their Russian Bonds really are not worth what they paid—and basically, the investment is garbage. You get a sense of when it is late in the cycle (just before the bubble bursts) with increased credit spreads.

Bonds and other fixed income instruments pay an interest rate in proportion to what the market perceives as the relative risk. When everyone is happy, investors don't demand a large difference between, say Swiss bonds and Greek bonds.  There is plenty of money sloshing around the system and investors lose their discipline. When things are headed for a crash, the spreads widen.  Whereas before a Swiss bond might yield 0.25% and a Greek bond 2.25%, later in the cycle, the yield for Swiss bonds will go to 0.125% (or even 0% or negative) and the Greek bond will go to 8.125%.  So the spread has widened from 2% to 8%.

Concurrently, there is a system-wide liquidity crises, as happened with the US housing meltdown in 2008.  That's because everyone has been living like Donald Trump: they want to show up to Met Gala in a limo, but don't have enough cash to pay for diapers until their next paycheck.

The Level 3 bonds discussed above are in a subclass of debt called distressed debt.  Distressed is when the bondholders have already called out the sheriff. The bonds go into default, the company may head into bankruptcy, and the bondholders create a committee to represent the interests of all bondholders.  Think of this committee as the equivalent of your friendly homeowner’s association board.

There are investors such as Howard Marks and Seth Klarman who are very adept at navigating distressed situations. The nuances of their world are beyond my pay grade—outside my circle of competence. 

I even extend this caution to post-bankruptcy restructurings. A few years ago, I looked at a company called Garrett Motion, that emerged from bankruptcy.  As part of the accounting catharsis, the company was recapitalized.

Recapitalization is the corporate equivalent of being held back in school and having daddy pay off your debts.

The company has to issue fresh new equity and several different tiers of debt. Marks and Klarman were investors in Garrett Motion. Given the complexity of the capital structure, I passed on Garrett Motion.

Because I am individual investor, I can opt out of games that are too hard for me to play. This is a variation on the circle of competence awareness.  I put all distressed debt, and even, restructured companies in the “too hard” pile and move on.

Continue to the next post

Equity represents the ownership of stockholders who have a residual claim on the assets of the corporation after all other claims have been settled.

Since I have spent my career working in enterprises, I am comfortable with this turf.  I feel comfortable analyzing companies and making bets on them. Full disclosure: I don’t get it right every time.  I have my strike-outs, and I have my home runs. Mostly, it’s singles and doubles. One thing I have learned is that if I have a winner, I stick with it as opposed to taking a quick profit. I gravitate towards low-key compounders, companies in boring businesses with track records of consistent high returns on capital.

As an investor I gravitate towards US and Canadian companies. I do a lot of screening and analysis and am a “Goldilocks” investor, meaning if things are not quite right, I move on.  The majority of things I review (95%) are junk and get screened out immediately.  Great investors are ruthless when screening out investments.

I am a buy-and-hold investor who seeks long term compounders. I am not looking to flip a stock based on the latest quarter’s earnings per share and whether it exceeds analyst expectations. I don’t listen to analysts or care what they think. Most of them are idiots.

What I am looking for are good companies with sustainable competitive advantages in businesses that I can understand. A company with a sustainable competitive advantage has superior economics and industry dominance.

Since I am an individual investor, I don’t need hundreds or even dozens of companies.  In fact, keeping track of all of that would send me to the loony bin—don’t inspire me.

Some of my exclusion criteria include:

Low return on capital

Massive amount of stock dilution though recent fund raisings

IPOs – Initial Public Offerings are timed and structured for sellers, not buyers

Wobbly operating margins or profits

Excessive debt, relative to operating income or equity

Two-class stocks

This last one is a pet peeve, and requires an explanation. Like bond covenants, this is another instance where investors have been anesthetized against their own best interests.

A number of companies have two (or more) classes of shares.  Generally, these are companies that were started many years ago by Grandpa (or Grandma) and went on to to be very successful, issuing shares on the stock market through an initial public offering. 

Examples include: Estee Lauder, AO Smith, NewsCorp, Google, Facebook, and Canadian Tire.

In a two-class stock, the economic rights and control rights are divorced. Class A shares, typically the ones the family owns, account for 5% of the capitalization (money put into the company), but control 90% of the seats on the Board of Directors. (As I discuss below, I’m not keen on Boards.)

Class B shares, the ones being offered to the public, may account for 95% of the money, but control only 10% of the Board Seats.

The problem with a two-class stock is that outside investors cannot purge incompetent or entrenched board members or management. There is no recourse. Essentially what the company is saying is:

1.    Invest your money and trust us.

2.    Now that we have your money, go sit at the children’s table.

Let’s digress and talk about the US Department of Justice (DOJ).

Only about 1% of the criminal cases brought by DOJ ever go to trial. 99% of cases settle pretrial. It is precisely because the DOJ can take the case to trial that 99% settle before they get to court.   

The same is true in companies with fights over Board control. Boards are supposed to represent shareholders.  De facto most Boards are patsies and obsequious to management.

As an outside-passive-minority-investor (that’s code for a powerless schmuck) with a few hundred or few thousand shares, I understand that I am just sitting on the sidelines watching the game. I am never going to launch a proxy fight. However, I find it disconcerting that no one can launch a proxy fight and throw the rascals out. Lack of investor recourse gives the Board and management a sense of impunity—as if they don’t have it already.

The usual justification for a two-class stock is, “We want to make sure the company is for the benefit of the long-term shareholders.” 

That’s BS. 

Here’s why: an alternative is tenure-based voting.  AFLAC, the insurance company with duck mascot, has such approach. Shares held for more than four years have ten votes per shares; shares held for less than four years have one vote per share.

With the exception of Berkshire Hathaway, I have stayed away from all two-class stocks.

I suggest you develop your own screening criteria.  A fellow named Ash Anderson has articulated this set of criteria based on a book called Buffettology:

·       Consistent earnings

·       Manageable debt

·       High return on equity

·       High return on invested capital

·       Company should produce cash

·       Company should not be issuing new shares

·       Earning yield exceeding the 10-year Treasury

·       Outsized cash returns

This set is intended to approximate the screening that Warren Buffett uses. By the way, it is not necessary to emulate Warren Buffett’s investing style. 

Although my investing criteria are not cast in concrete, they are very similar to the list above. I am also interested in companies that sensibly buyback shares and reduce the share count. 

A Sidebar on Stock Buybacks

Not all buybacks are sensible. Often companies buy back stock well above its intrinsic value. This is poor capital allocation. In their regulatory filings (10K and 10Q) companies have to report how many shares they bought back and for how much. I suggest comparing the average prices per share to the current stock price. More importantly, compare this to your assessment of intrinsic value.  You will be surprised how boneheaded most companies are in buying back their own shares.

If you are interested in learning more about financially sensible share buybacks, I suggest you read Chapter 11 of Expectations Investing, (see Key Resources). The authors go through examples of prudent and imprudent buybacks, showing the arithmetic with buybacks done below and above intrinsic value.

Here is a is a less-than-perfect hack for screening out companies making poor buybacks. On ROIC.AI I look at a company’s per share book value for the past 15 years.  Retained earnings increase overall book value and and therefore should increase per share book value. A declining per share book value coupled with a declining share count may indicate that the company is imprudently buying back shares.  If you see this, it’s worth doing a more thorough analysis based on your estimate of intrinsic value.

If you want to get a sense of the effective use of share buybacks and issuances, read The Outsiders (see Key Resources) and pay attention to Henry Singleton at Teledyne. This guy will make your head spin.

Back to Selection Criteria

Buffett suffers from a issue that does not befell the average individual investor: the tyranny of success.

The amount of capital he needs to invest at a whack is so large it limits the universe of companies available to him. He is a whale, and the average individual investor is a minnow—or plankton.

For example, a company with a market capitalization (total number of shares outstanding times the current trading price) of $500M that goes to $10B over five years is an enormous success.  Such an opportunity won’t move the needle for Buffett with over $200B of cash sitting on the sidelines.

Your Job: Become a Detective

Finding any viable investment is a job for a detective.  It requires turning over hundreds of rocks. There are no shortcuts.

In terms of sourcing ideas, I graze very widely. I am guessing I read about 200 pages of online content per day, from major news organizations, value investing blogs—really any source.  Another source is 13F filings that document trades made by high profile investors.  Dataroma and other websites aggregate these filings in useful ways.

Peter Lynch, in One Up on Wall Street, discusses the “amateur’s advantage.”  An individual investor may uncover a lead in the course of everyday life.  Lynch talks about someone who notices a local company that doubles the size of its factory, and doubles again.  Lynch himself would accompany his family to the Burlington Mall outside Boston to look at store traffic and which cash registers were ringing.  He did not run off on Monday morning with his next buy, but it gave him ideas and insights.

Since I am so cheap, I take notice when I am getting gouged and the vendor is able to get away with it.

Have you recently bought a candy bar in an airport?  Notice how they only have the jumbo size?  That’s a shakedown and an example of economic rent. Of course I still get annoyed, but I also take a note to investigate the seller to see if it has outsized profits.

In the case of airport concessions, most of the excess profits end up with the airport authority. Airport authorities run monopolies, some of which are public companies. They may be good investments—certainly compared to airlines—but most port authority bureaucrats are anything but shareholder friendly. Do your homework.

I want to emphasize one thing: not every investment lead is a viable investment.  Everything needs to be scrutinized. That’s your job. The guy with the Jimmy Choo glasses and spinning bow tie ain’t going to do it.  He is still trying to figure out how to spell 3 after the phone call about Level 3 bonds.  As Peter Lynch puts it, buying a stock without looking at the financials and doing your due diligence is like playing poker without looking at the cards.

Here’s an example: Live Nation

Live Nation has created a tollbooth for live entertainment. It’s even stymied Taylor Swift, and she is the financially savviest person in entertainment today.  Their fees are obscene, and a major annoyance for all attendees. You would think they would be printing money.

Is Live Nation a viable investment?  No. Every time I have looked at their financial statements, I get the impression they are trying to emulate the economics of the Post Office. To put it politely, this company is not “shareholder friendly.”

This bears repeating:  finding a potential investment and deciding to invest are two very seperate actions. Do your homework.

In terms of leads, I’m not interested in what the talking heads on TV or online have say or the latest forecasts. That stuff is useless. I’ve never heard an interviewer hold an analyst accountable by saying, “A year ago you said such and such would happen. That didn’t happen. Why should we believe you now?”

As Buffett so eloquently put it:

Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.

With all of the ideas that come over the transom, having a screening criteria using a tool like ROIC.AI is the most productive way I screen out the junk. Channel your inner assassin and kill the junk immediately. I discuss the idea of a deal funnel in a later post.

Once I have an idea, my next step is to go the company investor relations website and download the latest 10K. The 10K is the document that companies are legally required to file yearly with the US Securities and Exchange Commission. Foreign companies file similar documents with their financial regulators.  

Annual Report

Some people use the term 10K synonymously with the company annual report. They are not the same. Often the annual report incorporates the 10K—in the back as if it is an afterthought. Regrettably, most investors consider it that.

The annual report is a highly produced glossy document, leading with the picture of the beaming CEO sporting a Julia Roberts smile. On page 2, there is a glowing letter with cliché language about, “How well your company is doing, our challenges ahead, and why we are so optimistic about our future.”

The rest of produced section has pictures of happy white people—with the occasional person of color thrown in so that the company can project it really does believe in diversity—and fancy graphics that show lines going up and to the right. This section is all about values signaling and has little substance.

Here is what is really going on: the company is trying to shape the narrative, the way a lobbyist tries to shape legislation.

In terms of the letter, CEOs rarely write the letter themselves. Buffett is an exception, and his letters are a masterclass on investing.

Generally, the letter is the product of investor relations and expensive outside consultants who try to spin a rosy picture never bothering to mention that you are seated at the children’s table—or more aptly in the rumble seat of the Clown car.

A lady named Laura Rittenhouse has built a career and written a book about CEO letters. She claims there is a high correlation between various aspects and topics in the letters and subsequent company results. My own bias is that the CEO letter and financial results are both reflections of endemic company culture, and nothing more.  I would certainly not invest based on Rittenhouse’s “candor score” of the CEO letter, but reading her candor score may be useful.

Far more insightful than the CEO’s letter in the annual report is reading another filing document called the proxy statement, especially the section on executive compensation. 

Roger Lowenstein, a financial journalist and book author, wrote a scathing article in the Washington Post, The (expensive) lesson GE never learns. In this article, Lowenstein describes how GE constantly changed its yardstick for determining executive compensation as the company vanished into oblivion. I find Lowenstein’s approach far more compelling the Rittenhouse’s analyses.

In any case, I don’t start with the glossy section of the annual report, because I want to form my own opinion before being influenced by the propagandists. You have to remember: these people are trying to justify their existence and keep their jobs.

Continue to Next Post

All public US companies are legally required to file certain yearly legal documents with the US Securities and Exchange Commission. The most important annual filings are the 10K annual report and the annual proxy filing (SEC DEF 14A Proxy Statement). Foreign companies file similar documents with their financial regulators. Here I discuss the 10K, but the same principles apply to foreign filings. Companies file a 10Q quarterly. This is a quarterly update to the 10K.

Before we dig into the 10K, a quick note on the Proxy Statement. It used to be brief and dry document that disclosed information on executive compensation, executive bios, Board of Director bios, and the voting classes of the stock. They typically were less than twenty pages long. Over the past decade, they have become elaborate and complex filings, going over one hundred pages.

I think of them as the corporate disclosure equivalent of a gender-reveal party. In my opinion, they have become bloated documents designed to extend the brand—let us tell you how your Board and Leaders are working so hard for you—and to obfuscate the facts that have to be disclosed legally.

Okay, let’s pivot back to the 10K.

The 10K is your key to digging into the opportunity.

In terms of the 10K, the SEC prescribes a standard table of contents. Companies are also required to report the numbers according to an accounting standard, generally GAAP or IFRS (discussed below). A company’s language in the filing is very dry legalese for the reason that the company can get sued for getting it wrong.

Many company investor relations websites supplement the 10K with press releases, company presentations, and other documents. These supplemental documents tend to be more hype-y. 

I always start with the filings document (i.e. 10K) to get the least biased view of the company. Remember: managers are trying to justify their behavior and keep their jobs. This bias is most pronounced in their spin documents such as the quarterly presentations to Wall Street analysts.

Despite its being in dry legalese, the 10K is important.

Yogi Berra, the tongue-twisted baseball catcher of the 1960’s, had an inspirational quote, though at the time he didn’t know is applied to the capital markets:

You can observe a lot by just watching.

The 10K is your opportunity to watch.

For example, for several months before the Silicon Valley Bank collapsed the information was hidden in plain sight. SVB was required to report unrealized losses in the held-to-maturity investments in the notes to their financial statements. This stuff matters, and 99.5% of investors don’t bother to watch. 

Understand that the company couches and downplays bad news. If the company does not disclose material facts and events, the CEO and CFO can be criminally liable and go to prison—although this rarely happens.

The company does not present bad information like the Target logo. In all of my years, I have never seen a 10K that read:

For the sake of analytical clarity, we have consolidated all of our fraud into Exhibit E.

Rather what companies do is they move the information around into notes, footnotes, or into the Proxy statements. They act like a little boy pushing his peas around the plate so that mom does not notice his is forsaking his vegetables.

Your job as an investor is to be vigilant and extract (and possibly analyze) the clues. The breadcrumbs are there and it is your job to track them down and make inferences. This role is similar to a national security intelligence analyst who picks up clues about bad foreign actors before the war starts.

Here are the major sections on the 10K.  Not all of them are useful.

Item 1; Business.  This gives an overview, and is useful.

Item 1A: Risk Factors.  On balance this section useless. It looks like it was written by a team from HR and the legal department.  It is a “catch-all” to identify any potential risk associated with the business so the company can say, “We told you so.”.

For example, did you know that the World Health Organization declared a pandemic in March 2020?  That one escaped me.

To be sarcastic, the less traumatic disclosures read something like this:

The company does not currently have a Boise, Idaho office. However, if it did have a Boise  office and if there was guest in the office, and if the office manager spilled hot coffee on the guest, the company could be subject to litigation.

Noted.

Item 2: Properties.  This might be useful especially if the company has a key factory in China or Ukraine. This type of risk would likely also appear in the Risk Factors section (another section) as a potential vulnerability.

Item 3: Legal Proceedings.  Here is a disclosure I’ve never seen:

The company is currently being litigated into oblivion. You would be an idiot to invest.

Any substantive information on legal proceedings is pushed to the footnotes of the consolidated statements, in the hopes no one will notice.  Follow the bread crumbs on this one. There could be a venomous snake in the grass.  In the notes, the company will likely downplay any risks. However, companies are required to disclose material risks and events. Material means significant: if investors suddenly discovered the fact, would the disclosure move the stock price.

If the company has Damocles sword hanging over its head for a contingent financial liability, such as an outstanding lawsuit, the company must take a financial reserve (add to a rainy-day fund), if it looks like the company will lose a lawsuit. The reserve amount must be in good faith; otherwise it could be fraud, and the CEO, CFO and auditors might end up in prison. In any case, they’d lose their membership to the country club, which would be a real problem. (This is euphemistically called reputational risk.)

Item 4 has two subsections

·       Mine Safety Disclosures

·       Information about our Executive Officers

This is a weird combination, and the existence of mine safety disclosures is odd in itself. I have never read a 10K where a company actually had something to disclose about mine safety.

Information about executive officers is generally bland in substance and is limited to the top few executives in the company. There is another section where, the company hopes investors don’t notice; key information is pushed elsewhere in the 10K or in the proxy statement.

Item 5. Market for Registrants’ Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Now we are starting to get into the substance: the number of shares, the classes of shares, dividend information, information on stock buybacks etc.

See discussion above about two-class stock companies. My bottom line: stay away from companies with two (or more) classes of common stock. Some companies may have common and preferred stock. The latter is a hybrid of stock and fixed income.

Generally, companies issue preferred stock when they are in a position of weakness. The existence of preferred stock is not always a red flag. Professor Damodaran (see Resources) has material on how to value preferred stock in order to understand its impact on the value of the common stock.

Item 6. Reserved. 

For what I’m not sure.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

This is one of the more substantive sections of the disclosure. The language is august and the tone is dry. If you were to read this section aloud, you might sound like Al Gore hosting Saturday Night Live. 

The MD&A puts words to the numbers reported in the financial statements, and provides some insights on the why the factors behind the results. For example, did sales drop because the volume was off, or the company got hammered on price, or because the exchange rate changed? 

Item 7A. Quantitative and Qualitative Disclosures about Market Risk.

Unlike Item 1A (Risk Factors), this section usually covers issues and topics of interest. This section has a fair amount of overlap with 1A.

Item 8. Financial Statements

This is the substance of the 10K disclosure. Don’t get snookered by reading only the financial statements. You need to also go through the associated notes with a fine-tooth comb. 

An analyst more astute than I found unexploded bombs in the notes of the 2022 10K filings from Amazon and Microsoft.

The analyst spotted that both companies had extended the useful lives of their IT equipment for their cloud services. This is a big deal because each company has been investing tens of billions of dollars into their cloud businesses. It seems that miraculously, the computers suddenly started lasting longer. I guess Harry Potter waved his magic wand over them.

Here is my assessment of what is really going on: they are cooking the books.

Extending the life has the effect of reducing their depreciation expense and boosting each company’s earnings.  That was very sneaky, but perfectly legal as long as it was disclosed, which it was in six-point font in footnote 137 of Exhibit AZA.

Item 9.  Changes in and Disagreements with Accountants and Accounting and Financial Disclosures.

This is where the auditors weigh in. The auditor language is standard, with a lot of CYA hedges. Starting a few years ago, auditors also had to disclose—in typical CYA language—any material risks they found in the reported results.  This can be interesting to read, but again, the language is toned down so that investors don’t freak and run for the fire exits, but also so the company (and auditors) can say, “We told you so.”

Item 9A.  Controls and Procedures.

After the passing of the Sarbanes Oxley (SOX) act in 2002, the 10K also required CEOs and CFOs to certify that the company has appropriate financial controls in place.  Before SOX, executives at several companies were incredulous when caught with arguments along the lines of, “Gosh, I think I don’t remember, and I didn’t know had to tell the truth in the filing document. I had no way of knowing the numbers are bogus.”  A few (too few) guys went—and died—in jail, a good outcome in my opinion.

Item 9C. Disclosure Regarding Foreign Jurisdictions that Prevent Inspections

I have no idea of the real purpose of the section, and don’t recall seeing anything other than “Not Applicable”

Item 10.  Director, Executive Officers and Corporate Governance

There is never any substance here. It is all kicked over to the proxy statement on the assumption that shareholders won’t bother to look. Go look.

Item 11. Executive Compensation

Again, this one is kicked over to the proxy statement.  The company has to disclosed the compensation of so-called Named Executive Officers (NEO), generally the top five people in the company.

On the topic of executive compensation, I won’t invest in a company where the NEO package smells like jail. I don’t know how to quantify this, but I know it when I see it.

I have some overall comments on the topic of trends in executive compensation. 

Over the past sixty years, executive compensation has kept pace with things like Princeton tuition and healthcare costs. It happens in little yearly changes. Over the course of a generation, it’s become the wealth of 1000 cuts—the execs get wealthy and the shareholders end up with the cuts. On balance, US executive compensation is over the top. 

I’m not a Bernie Sanders type advocating “Tax them into oblivion,” though I am empathetic with his passions.  That’s great politics, and may be appropriate policy, but it is lousy economics if you want to raise a lot of money.

However, I hate the limbo dancing used to justify executive compensation.  Warren Buffett has written extensively on how odious he finds compensation consultants.  Earlier I mentioned Roger Lowenstein’s 2018 article in the Washington Post on GE compensation. Lowenstein strikes me as a full-throat capitalist and not a Bernie wannabe. I find his argument credible.

When I look at executive compensation, I am more interested in how s/he is paid than how much. Additionally, I look at the ratio of the CEO to number two exec’s pay. Anything higher than 2.5 to one is a yellow light. Ten to one is a flashing red light and usually means the CEO is a megalomaniac with the Board in his pocket.  In the case, CEO compensation is indicative of a much larger problem: poor Board governance. My advice: dump this company and go for your next opportunity.

On a related note, I recently was looking at making an investment in a small bank in New York. The aggregate compensations of the top few (five I recall) executives was around 25% of the entire operating profit of the company. The amount of compensation was ridiculous: these guys were being paid as if they ran JP Morgan. My conclusion: this company is not shareholder friendly. I lost interest in the company and moved to the next potential investment.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

This is another section kicked over to the proxy statement.  What is relevant here the number of shares executives and Board members own.  How much skin in the game do they have?  If their ownership (as a percentage of their net worth—which one can only rarely determine) is minimal, you will likely have the principal-agent problem discussed earlier. With minimal ownership, they probably won’t have your best interests at heart as an outside-passive-minority-investor.

As a counterexample, I have an investment in a community bank near Boston where the CEO and his family own 30% of the stock. It is a single class stock. Shortly after I bought in early 2023, the price tanked about 30% because of a net interest margin squeeze. I kept buying as the price went down. I’m a slow learner. I can guarantee you they feel my pain and our financial interests are aligned.

Item 13. Certain Relationships and Related Transactions and Director Independence.

If there are any insider deals, they have to be reported here.

This is one where I eliminated considering an investment with Amerco, the parent of U-Haul, the truck and trailer rental service. This was several years ago, and here is my recollection of the situation.

I learned that Amerco’s controlling family had a side deal, for U-Haul storage that the family owns outright as separate company. The storage company is being fed from the U-Haul rental company. This is a sweet deal for the controlling family, but a lousy deal for shareholders.  If you see something like this, don’t walk. Run.

A note on this point.  Sometimes the best way to solve a problem is to avoid it in the first place. This is why I am ruthless about eliminating companies that fail to meet my selection and ethical criteria. There are plenty more fish in the sea.

On a related topic, if I have experienced ethical lapses as a customer of a company, I will not invest in them. In the late 1990s, I had a horrendous experience with American Express, in their Corporate Card division, and I felt they had violated ethics and decency with me as a customer raising a good-faith dispute. The issue was not even addressed until the CFO of my employer, a Fortune 500 company, got involved, at which point all of the sycophants lined up. I won’t buy Amex stock, or have anything to do with them as a customer.

Many customers have reported unethical, and illegal behavior, from Wells-Fargo.  This company is also in my black list.

Life is too short to put up with this crap. Just move on.

Item 14. Principal Accountant Fees and Services

This is another one that is kicked over the to proxy statement. It is a disclosure on how much the auditors were paid to write all their CYA statements in Item 8, and any other consulting fees they were paid.

Item 15.  Exhibits, Financial Statement Schedules

This section includes references, and often clickable links, to other material disclosures and agreements. I have occasionally run these to ground where I have a concern about some issue mentioned in the 10K with “oh by the way” nonchalance.

Some investors are more diligent than I and regularly read through every one of these related agreements. I am too lazy, or perhaps more politely, don’t consider it a good use of my time.

Item 16. Form 10K summary

In this section, the key executives and directors sign the form saying they have reviewed it.

Proxy Statement

The annual Proxy statement is also full of useful information.  I have discussed executive compensation above.  In addition, the proxy statement discusses voting rights, such as multiple classes of stock. 

Continue to the Next Post

• Understand your circle of competence

  I discuss this earlier in this Substack.

• Know your resonance points

  This gets down to given your investment style, for instance which stage of a company’s life cycle is an appropriate investment. I spent my career in IT technologies, but I eschew tech investments for a number of reasons: (1) I am lousy at picking winners early in their life cycle, (2) too crowded—everyone is looking for the next Facebook and pushing valuations sky high, and (3) I like companies at a later stage with stable predictable cash flows. I may miss the next Google, but I will also avoid the next FTX or Theranos.

• Channel your inner assassin

  Have your own investment qualification framework. Ruthlessly discard the junk.

Investment qualification comes the down to (1) relentlessly eliminating leads that don’t fit your investment criteria and (2) having the patience to wait for the right opportunity. The objective is to invest in only truly exceptional companies and pay a price that has a margin of safety. Charlie Munger likens it to waiting along the banks of a stream with a spear, waiting for the right fish to come along.

One approach is to have an investment funnel. Readers with sales experience may be familiar with the concept of a deal funnel. The unwashed masses enter the wide mouth of the funnel, and the closed business comes out the bottom neck of the funnel. Deals “fall out” for any number of reasons: customer’s needs are a poor fit with your company’s capabilities, customer has a lack of budget, there is a change of management, you lose to competition, etc.

This funnel metaphor is also great framework for evaluating investment opportunities. Safel Niveshak, an investment blogger has a great stock selection framework shown here:

At first, his graphic may be overwhelming, but focus on major filters from top to bottom:

• Circle of competence

• Financial Stability

• Wide Moat

• Price

I won’t repeat his blog. He does a great job of articulating his process here.

In evaluating potential investments, here is some of what I do:

• Screen out the junk. I screen based on my inclusion criteria (e.g. high ROC) and exclusion criteria (e.g. dual class stocks). Screening is based on my criteria, some of which I have discussed above.

• Read the 10K.  The essential question my mind: Is this a company I would ever want to own?  Or is it like Uhaul?

• Look at competitive companies.  On occasion, I will identify a company, only to discover there are stronger competitors than my initial lead, e.g. Foot Locker versus Ross Stores as I discuss above.  Companies with sustainable competitive advantages always have superior economics and most often have dominant market positions.

I often look at employee reviews on Glassdoor. This can give an insider’s view on things.  Glassdoor reviews can often be bi-modal: love-em or hate-em. Dispassionate employees don’t bother to write reviews.

On this point, I have dodged a couple of bullets by reading employee reviews.  One bank in the mid-south, run by a fellow and his wife, had a toxic work environment based on fear and loathing. In another case, I was mystified by a medical device manufacturer in the Mountain States had never pierced $80M in revenue over 15 years, despite a massive total available market. It turns out the CEO was a control freak who could not scale, and had not built a management team.  In cases like this, the CEO can, at best, recruit only the c-team. It takes a strong leader to attract strong talent.

No-go investment decisions can come quickly. However, I rarely get to a decisive go decision immediately. I am inherently an impatient person, and my go-slow has become a learned behavior.

Feeling inclined to make an investment and feeling compelled to invest now are not the same thing. Some of my options are:

1.  Not now because of a corporate event. 

For instance, in 2021 Organon spun out of Merck, but had limited operating history as an independent company.  I am a “wash, rinse, and repeat” investor who likes certainty in corporate operations—a proven business, consistent operating history etc. Organon lacked a long track record as an independent company. I put it on a watch list to review in 2022.

Now, bear with me as I go on a bit of a rant.

In 2022, I took Organon off my list completely. When Merck spun Organon out in 2021, it was saddled with massive debt. I should have figured this out when I first reviewed Organon, but I failed to do so.

Loading up a spin-out with bone-crushing long-term debt is a neat trick of most parent companies.

The play-book is as as follows: prior to spin-out the subsidiary takes on a huge amount of non-recourse debt—debt that cannot revert to the parent. The parent moves this cash to the parent as a dividend. The dividend may be an internal dividend and not necessarily paid to stockholders of the parent company.

The parent spins out the subsidiary with bone-crushing debt. The new spin-out now spends the next twenty years getting out from behind the 8-ball.

My issue is that the spin-out did not benefit from the debt in the form of new investments. This is an exercise in pillaging. It is all legal, because it has been fully disclosed in the appropriate filings, which 99% of investors don’t bother to read.

Figuratively speaking, if you want to be saddled with paying child support for someone else’s kid, by my guest. I just move on to my next investment lead.

2.   Not now because of an external event. 

I mentioned Ross Stores and the Covid shutdown earlier.

3.  Not now because of an external condition. 

For example, buying an auto manufacturer at the top of the economic cycle is a recipe for disappointment.

Another example is when I looked at banks in 2021 and 2022. I felt uncomfortable that the economy was at the wrong part of the interest rate cycle. Given that interest rates Fed fund rates were at 0, all interest rates had to rise.

My sense is that rising interest rates would be problematic to the operations of the banks for two reasons: (1) banks that kept long-term loans on their books would see the value of these assets crash, (2) banks that sold their loans generally make their revenue based on transaction fees (e.g. points). With rising rates, transactions would fall, and the bank revenue would plummet.

I was not prescient enough to anticipate the Silicon Valley Bank meltdown, which hinged on a mismatch between the maturity of their assets and liabilities.

4.   Love it, but the company is too expensive; price relative to value offers no margin of safety.

Watch Lists

Assuming my qualified stock gets through my maze, I proceed to do a DCF valuation on the company.  Aswath Damodaran’s teachings have been instrumental in my nut-and-bolts evaluation.  Sometimes the stock price is too close to the intrinsic value—insufficient margin of safety—at which point I put the stock into a watchlist I have created on Google Sheets. My Google sheets will trigger a notification if the stock comes into my price range.

I have a second watch list, which is time driven. For example, for Organon mentioned above I created a follow up date (about a year out) to re-evaluate the situation.

The mouth of my deal-funnel is very wide, with a high amount of attrition between initial awareness and initial investment.  I am sure with my approach there are a lot of errors of omission (false negatives), and many stocks get away.  In one sense, I don’t care because I only need ten to fifteen investments to meet my objective.

I am looking for GARP (growth at a reasonable price) compounders which I can hold for a very long time.  I have had my longest holdings since 1994. Most investments may be two or three years old.

Pulling the Trigger

The previous section gives my perspective on what to buy—or more importantly about what to avoid.  This section is about when to buy.

For me it’s a judgement call. I don’t have a codified algorithm on when to make an initial investment.  However, as I have said before, I am a Goldilocks investor. I buy only if the planets align. Often I will kick an interesting candidate down the road with a “not now” prognosis.

As an individual investor I am not under pressure to “put cash to work,” and I don’t need hundreds of investments—just a dozen or so boring companies with not so boring economics.  To paraphrase Peter Lynch,

Invest in businesses any idiot could run because someday one will.

Come to think of it, I need to call Peter for my next job opportunity.

As I have said before, I have sniffed at Ross Stores for years, but never invested—because of the price relative to the value.  If you look at their stock price for the past thirty years, you can see why I really do need to call Peter.

Determining a Company’s Value

For value investors, ascertaining the (net present) value of a company entails assessing the amount of resources available to investors after the company meets its obligations and requirements for the future of the business.

Think about it this way: how much moola is left over for the owners. Note: this is not reported earnings.

To figure out the value, Buffett promotes a concept he calls ‘owner earnings’ and states this as:

These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges ... less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.

Let’s tease that apart:

·       Start with: Reported earnings are just that, net earnings in the income statement.

Back in the day, you good take the reported net earnings number and run with it. However, you make need to take a slight detour to get to adjust your reported earnings input for the owners earnings calculation.

Bear with me on this slight detour.

If a company owns minor positions in other companies, one has to make an adjustment. Berkshire Hathaway, for example owns dozens of positions in companies such as Coca Cola, Moodys, American Express etc.

A few years back, the folks at GAAP who set accounting standards required that changes in valuations even for unrealized gains and losses get put through the income statement and flow into reported earnings. For instance, because Berkshire Hathaway owns stock in American Express, Apple, Moodys and many others, the changes in valuation of these investee companies needs to flow Berkshire’s income statement, even if Berkshire does not sell any investee stock.

This clutters the analysis. I advocate backing this out to get to a more accurate valuation of a company’s earning power from core operations.

To get to this number, you will need to back out the unrealized gains and losses and adjust them by the investor’s (e.g. Berkshire’s) tax rate.

An example may help:

Company A reports operating income of $1000. This is a pre-tax number and reported in the income statement as operating earnings or EBIT.

Company A owns stock in Microsoft and Ford. During the year, Company A had $300 in unrealized gains in its Microsoft position, and $170 unrealized loss in Ford for a net unrealized gain of $130. This number is also-pretax.

Company A’s marginal tax rate is 22%. The company also report interest expense of $50.

Here’s the arithmetic:

Reported operating income: $1000

Back out gain/loss from stock positions: $130

Subtotal: Pre-tax income from core operations: $870

Subtract interest expense: $50

Subtotal: Pre-tax income: $820

Subtract tax burden on $820 at 22% $180.40

After tax income to use for owner earnings: $639.60

We can now exhale and get back to the owner earnings calculation. In this example, $639.60 is the “reported earnings” input we need for the rest of the calcuation.

·       Add: Depreciation, depletion, and amortization appear from the cash flow statement.  These are “recoveries” from previous significant investments, called capital expenditures. These are added because the cash went out the door years ago when the company paid for the factory, but since depreciation, depletion and amortization are reported as expenses, they provide tax relief.

·       Subtract: the average amount of capitalized expenditures. This is real cash the company has to invest to build new factories and replace worn-out equipment.

Damodaran and others add models to taken into account incremental working capital needs. 

Explaining incremental working capital requires a sidebar discussion.

Think of working capital as the money the company needs sloshing around the system for day-to-day operations. A manufacturing company buys inputs, puts the inputs though a manufacturing process, puts the finished product in inventory, waits for an order, ships the product to the customer and then waits for customer payment. It turns out the tooth fairy doesn’t provide the money to make that happen.

As companies expand, their working capital needs grow just as it takes more to feed a growing teenager versus a growing baby. Both may be be growing at the same percentage rate, but the amount of additional food is vastly different. Changes in working capital capture this effect for companies.

Over the past twenty years, analysts have promulgated a metric called the cash conversion cycle (CCC) to capture the effect and normalize working capital to sales. CCC is very useful because it is a ratio and allows us to compare Intel to 3M to Sam’s Cigar stand. CCC is the time in days it takes for a company to go from cash, through the entire production, sales, and collection cycle and get back to cash.  Look at Investopedia to get a definition of the inputs into the cash conversion cycle calculation.

The cash conversion cycle is also happens to be good indicator a company’s power, both upstream with vendors and downstream with customers. CCC may be an indication of a sustainable competitive advantage. An old line steel manufacturer with no upstream or downstream leverage may have a cash conversion cycle of 200 days. Such a a company has poor leverage with customers who have many substitute choices.

Often large companies bully their vendors by negotiating long payment terms, e.g. 120 days or longer. However, the company collects from it customers very quickly. This vastly reduces working capital needs—at the expense of both vendors and customers. Only companies with vast market power can get away with this by browbeating both vendors and customers into submission.

In fact some companies—for example Apple, Dell, and Amazon—have a negative cash conversion cycle: their customers pay them immediately (with a credit card) and they pay their vendors on extended (e.g. 120 day) terms. This has the effect of creating a lot of excess cash that, in theory, can be distributed to investors. Sound good?

Not so fast.  These are liabilities, and current liabilities as well. Vendor financing is to manufacturing companies what float is to insurers. At some point—for instance when sales taper off—the chickens come home to roost. With falling sales, the cash outflow accelerates and can create a liquidity crunch. Beware of this phenomenon.

Discounted Cash Flow

Aswath Damodaran, the NYU finance professor, has developed the scaffolding I use to reduce my valuations to practice.

The core of the analysis is called a Discounted Cash Flow (DCF) evaluation. Instrumental to any DCF evaluation is calculating the net present value of future cash flows. What the heck is that?

DCF is a framework for converting potential future cash flows (in or out) to a value today (or a future value). It is an attempt to equate cash coming in and out in the future with cash coming in and out today.

Think of it this way. 

If you have a child born today, how much money will you need to fund his future college education?  For instance, suppose you had sufficient resources to set aside the amount on the day junior was born: you have a pile of money that is going to grow over the next 18 years to fund college. Figuring out that number requires making a number of assumptions:

• What is the cost of one year of junior’s future college today? NC State is a lot less than Harvard.

• How much will costs increase up over the next 18 years?

• How long will your kid be in college? Is he going to go to community college for two years and then a full college for the next two?  Conversely, is he going to be on the six-year program at an expensive private college majoring in cannabis sampling?

• If you don’t have the full amount the day junior is born, when do you invest your money and in what increments? Hint: To capture the power of compounding do as much as you can afford early on.

• What is your expected investment return?

• What about the taxes on your investment gains?

All of those factors determine how much money you need to fund your child’s future college expense. 

Assuming you started with a specific amount today (your “down payment”) and then committed to periodic contributions, how much do you need to contribute and how often to have a target amount when junior matriculates to college?

The DCF calculation for valuing an investment is a variation of this movie run in reverse. DCF figures out given a certain cash flowing into the company over the next period (e.g. 10 years), how much is the company worth today? We call that assessment value.

A company’s market capitalization is the current share price multiplied by the the number of shares. That is called pricing, and may be completely disconnected from value—like Tulip Mania. Compare value and pricing and if value exceeds pricing, you may have a bargain.

DCF is a general analytical frame work to compare the current value of the asset against future cash flows.

Financial analysts do this financial calculation all the time to look at the relationships between current value and future cash flows. They are two sides of the same coin, tied to each other by the underlying assumptions of the DCF model.

Examples: (1) pricing annuities (2) determining pension resources needed for future obligations, (3) determining how much to charge for a life insurance policy, and the like. 

DCF calculations are also used to figure lump sum payments for lottery winners.

We have all heard the story about how “Joe the Plumber” won $20M in the lottery.  The screaming newspaper headlines notwithstanding, it turns out Joe did not win $20M. What he won was a cash flow of $2M per year for the next 10 years. The $2M payment in year ten is worth much less than $2M today because of nine years of inflation, or alternatively, because Joe did not earn interest on the money during these nine years.

Winners who take a lump-sum payment get a lot less than $20 million. Obviously taxes are one factor, but the other factor is the time value of money. DCF calculations help reconcile these two different cash flows.

One key point is this: Joe’s lottery ticket has a very different value than a company with identical cash flows of $2M per year for ten years—because at the end of year 10, Joe’s lottery ticket is worthless, and the company has value (called terminal value) as an ongoing enterprise.

To value a company, one needs to do the inverse of this: look at the future owner earnings to determine the present value (actually a variation called net present value). Only then can you determine the value of a share of stock and compare it to its current price.  How much are those future cash flows worth given the company’s cost of capital?

Is Wall Street trying to sell you a $200,000 value house for $500,000? After all, someone has to pay for your stockbroker’s Jimmy Choo glasses and his spinning bow ties. In case I haven’t made my point: Wall Street wasn’t built on winners.

The best way to estimate net present value is to use a financial model. Financial models are only as good as the thinking and assumptions behind them.  If you are convinced your investments are going to skyrocket like Amazon did in the 2010s, you probably need only $2.32 to fund junior’s college.

Aswath Damodaran, the NYU finance professor, is the go-to guy for figuring this out. He has developed a number of models. However, using a model is like driving a car: you need to know what you are doing before turn yourself loose.

Take Damodaran’s online MBA valuation course.  His course steps through the process and he has downloadable spreadsheets which are phenomenal templates for doing your own analysis.

There are other simpler DCF models online, and you might want to start with these, even though they are limited.  Damodaran’s are much more nuanced, and through his online courses and other materials you will be able to navigate various corner cases, such handling convertible debt or companies operating in multiple currencies.

One of my pet peeves about DCF analyses is the terminal value. The term “terminal value” sounds like a bad Arnold Schwarzenegger sequel but it’s not. It is the residual value of the company after the analysis period, typically the next ten years. The problem with our analysis is that the terminal value creates a huge swing factor in the valuation of your potential investment.

Here’s the concept. Valuation models typically look at owner earnings for a ten-year period and discount the cash flows back based on the weighted average cost of capital (WACC), hurdle rate, or some other threshold.  Recall this threshold answers the question, “What is it worth for me to even bother with this investment?” Recall our objective is to find investments where the return on capital exceeds the WACC. The value during the ten-year period is determined by the extent to which ROC exceeds WACC (as a percentage) and the the amount of excess cash in dollars that the business is throwing off.

The other major component—indeed the determinant—of the valuation is the terminal value of the firm after year 10. Unlike Joe the Plumber where his lottery winnings are worthless past year 10, the ongoing company has real value.  The question is: how much?

For their terminal value, most DCF models use a thing called the Gordon Growth Model. I won’t go into the specific rationale behind it. Look it up on Investopedia.

The mechanics are to take year 11 “owner earnings” and divide them by the difference between to the cost of equity (r) and the perpetual growth rate of dividends (g).  (Take this on faith.)

Here is a tangible example to show the swing factor of the terminal value;

Example 1:

Year 11 owner earnings $100.

Cost of Equity = 6%

Growth Rate = 1%

Terminal value: $100/ (.06-.01) = $100/5% = $100 * 20 = $2000

The 5% denominator bolded in the equation above is called the capitalization rate.

Example 2.

Let’s tweak the cost of equity.

Year 11 owner earnings $100.

Cost of Equity = 2%

Growth Rate = 1%

Terminal value: $100/ (.02-.01) = $100/1% = $100 * 100 = $10,000.

In this instance, the capitalization rate is 1%.

$2000 versus $10000. Which terminal value should I use? Time to call my goldfish.

The valuation analysis is very heavily dependent on the terminal value, which itself is extremely sensitive to the capitalization rate, which itself is based on assumptions ten years out for which we have little or no evidence today.

The calculation is riddled with speculation.  Change your assumptions, and you get wildly different results. Bruce Greenwald, an author mentioned in the Key Resources Section, discusses this issue at length.

Most DCF capitalization rates end up being around 3%, equivalent to a multiplier of 33.3.

To be conservative, I use a capitalization rate of 7% (or 10% to be even more conservative).  Purists may recoil in horror because my approach fails to account for thee specifics of each company’s situation. Yes, my approach is crude. However, in the end, it adds to my margin of safety.

After You Buy

I have seen neophyte value investors say something like, “I bought the stock last month.  Why hasn’t it gone up?”  Short answer: it takes time.

Here are some possible reasons:

1. Because the world doesn’t care what you think or do. 

2. If you are an investing genius, it is going to take some time for the world to catch up.

3. You are no investing genius

4. The company doesn’t execute as you thought—though it usually will take you a few years to figure the company is run by a bunch of boneheads..

5. You are wrong. Your analysis or thesis is wrong. (Join the club.)

My assertion (nothing more) is that you should not expect prices to adjust in less than three years. My understanding is three years is the time frame Peter Lynch had in mind when he bought a security.  Of course, you need to monitor your company’s progress against your investment thesis.

Continue to Next Post

Anne Scheiber rarely sold, and she seemed to do all right.

My style is to invest in reasonably priced compounders which grow into perpetuity and always have an intrinsic value above their current stock price.  That’s a nice idea, but such a company is rare.  To get a sense of this, look at the lists of Fortune 500 companies in 2000 and in 2020. The lists are radically different.  Capitalism is dynamic. That’s the opportunity, and that’s the peril. The Rip Van Winkle investor is a myth.

On the other hand, if the company—or sector—turns into Tulip Mania, I’m headed out the door. In “frothy” markets stock brokers are so ebullient they can’t decide which Jimmy Choo glasses to wear, bow-ties are spinning maniacally, and investors are comfortably numb. I’m happy to sell into a melt-up. However, I decide to sell on a case-by-case basis.

Just as our DCF calculation can identify under priced assets, it can also identify overpriced assets. I’m willing to hang in there, as long as the company continues to execute and maintain competitive advantages.  My inherent bias is to let my winners run.

In his letters, Buffett discusses how—to his eternal regret—he sold Capital Cities when the stock went sky high, only to watch it triple, and triple and triple again. 

The reality is the stock prices don’t go straight up. They are like roller-coasters. They can head up and up and up. In smug self-satisfaction, you pat yourself on the back on your brilliant choice. And then it drops at terrifying speed, and all you want to do is bail—not a good idea in either a stock or 60 mph roller coaster.  Take a look at the history Amazon’s stock since it went public.

Some reasons to sell include:

·       An irrational rise in price with an insufficient change in the underlying economics, e.g. Tulip Mania.

Here’s an example:

I owned a stock in an asset manager that I had held since the 1990s. In mid-2021, the stock headed straight up. In one quarter, the company’s operating margin (operating profit as a percentage of revenues) was 48%. Translation: the company was printing money. This was not sustainable and well above baseline, which had been around 42%, still a spectacular number.  

After the second quarter in 2021, the company had so much money they distributed a bonus dividend equal $3 per share. Wall Street was cheering. Bow ties were spinning at warp speed. 

Here’s the problem.

The company is an asset manager. It buys and sell securities for a living. Why didn’t they use the extra cash to buy back their own stock rather than issuing a special dividend? I took this as a cue to review my DCF, and walked to the exits, selling 75% of my position over the next month. My only regret is that I did not sell my entire position.

·       A change of strategy, particularly strategies that are the “flavor of the month” type; these almost always bad. Companies are chasing the latest trend, or management is suffering from shiny-ball syndrome, like a baby in a playpen.

Sometimes a change in strategy is not bad. You may have heard of a company called Apple that built computers and then decided to build a mobile phone.

·       A change in the economics for the company. This does not have to be a radical change, but can be gradual. An example in my portfolio was a restaurant franchisor which kept making acquisitions. Growth can be great, but it has to be the right growth.  In this case, the operating margins kept declining in small decrements: it was not a wash-out. The changes occurred after a new CEO, who happened to have been the company’s previous CFO, took over the company.  He is a nice guy and obviously understands DCF, but the results were turning tepid.

·       When a company sells out. If the insiders are looking to get out, you should too.

·       A failure in your analysis.  You got it wrong.  Metaphorically, not every kid in your kindergarten goes on to be a Rhodes Scholar. Face reality and move on.

·       A drop in management credibility.  There are two types of people in life: people who deliver results, and people who rely on excuses. Actually, life is more subtle, but you get the point. Quarterly earnings calls where the management reverts to “The dog ate my homework,” are a good reason to exit your investment.

Continue to the Next Post

I am far more focused on the company operations than the stock prices. I really don’t care what the talking heads on TV (or online) have to say.  Most of them are idiots anyway, advancing a specific agenda, and with knowledge that is five miles wide and a millimeter deep. Besides, no one goes back to them six months later and asks them to account for their past predictions. We live in the distraction economy and reward morons who spew one bold projection after the next, with no retrospective accountability.

As for macro-economic forecasts, there is the old joke that economists have predicted eight of the last five recessions.  As Peter Lynch said about forecasts:

If you spend more than 13 minutes analyzing economic and market forecasts, you've wasted 10 minutes.

For my investments, I have an earnings spreadsheet with the approximate dates when the companies announce quarterly earnings (90 days since the last earnings announcement).  I don’t trade on news, so I have no interest in jumping online the nanosecond the earnings are published.  

In time—generally within a week of the earnings release—I will review the announcement, 10Q filing document, and the transcript of the quarterly earnings call with analysts.  I start with the 10Q if it is out, so I don’t get biased by management propaganda laced throughout earnings press releases and quarterly presentations. My goal is to check-in on the company in an unbiased manner, and then update my valuation spreadsheet.

Quarterly Earnings Calls with Analysts

The Quarterly Earnings Call is when the senior executives have a scheduled call with Wall Street to discuss their company’s quarterly financial results. The quarterly call is weird beast and regrettably does not offer investors much insight. I don’t listen to quarterly calls, but I review the written transcripts, which are published online a day or two later.  

I have closed out positions based on the transcript, when I decide the management team is disingenuous, or just plain clueless. Often this comes when they continually change key result areas, or when they are trying to justify a huge expensive initiative based on a silly and implausible use-case. (News flash, dear reader. It turns out Blockchain is not going grow to ten times GDP in the next three weeks. Nor is AI. Remember Big Data? How about IoT or VR?) The issue is the erosion (or vaporizing) of management credibility.

Let’s discuss the structure of the quarterly call. Here’s how it works.

Usually about a month after the end of quarter, the company releases its quarterly earnings just after the end of the trading day. Thirty minutes later, the company has prearranged conference call with industry analysts where a couple of members of the management team review a slide deck. Anyone can listen to the call—this is a legal requirement—but only invited Wall Street analysts can ask questions.

The is an example of the company using selective access to keep people in line. Note my earlier comments about access, proximity, and exclusivity. This is the same manipulation at an institutional level.

In terms of mechanics, the company distributes a slide deck concurrent with the analyst call. The head of investor relations hosts the calls and gives the standard caveats about forward-looking statements.

The CEO gets on for a few minutes and gives the ‘strategic overview’ of the business and the quarter. Another executive, typically the CFO, or sometimes the COO, gives more detailed review of key financial and operating metrics. 

The slide deck typically lacks a “wash, rinse, and repeat,” consistency from quarter to quarter. Having this might invite inconvenient comparisons and corner the management team with embarrassing questions from a shrewd analyst. Another legitimate issue is that the business evolves from quarter to quarter, so last-year’s warmed-over dinner may no longer be appropriate.  

Then there is a 30-minute Q&A session where each analyst is allowed to ask up to two polite questions.  At the end of the 30 minutes, the execs thank the analysts for their participation, and everyone goes away.

It is all very controlled, polite, scripted and sterile.

I’m not expecting an episode of The Jerry Springer Show, but as an investor I’d like something more authentic.

What’s really going on here? 

Here is my harsh assessment: the quarterly analyst call is nothing more than an exercise in Kabuki Theater. 

If the quarter went well, the undercurrent is “Your management team did a brilliant job and executed flawlessly. By the way we need a raise.” 

If the quarter did not go well, the tone is, “We faced significant impediments that hobbled us for doing our job. By the way we need a raise to stay invested in the company. Seriously, it’s not our fault.”

Oh, and did I mention we need a raise?

Here’s the ugly truth: candor is not the management team’s motivation. For legal reasons management is prevented from wholesale fabrication.  However, the management team’s real motivation is to set the narrative with Wall Street lest things go awry. The whole thing is not a con job, but is often a spin job.

Hosting a quarterly call is tantamount to having a press conference the day before you have to testify before Congress: you get your story out first.

Note that the pacing and the structure of events.

1. The call happens a few minutes after the public earnings release. The freshness of the information keeps the analysts off balance and gives them little time to dig into the results and formulate probing questions.  An alternative approach would be to have a press release at the end of trading on day 1 and then have the analyst call just before trading day 2, fifteen hours. This approach would give analysts a change to digest and analyze the report. No such luck.

2. Analyst call participation is by invitation; the company is using access to keep the analysts in line. Do you have the audacity to ask the CEO an embarrassing question? You get booted from the club.

The analysts ask only softball questions and do so in a diffident manner. A typical question steeped in analyst-speak is something like:

I appreciate you faced FX headwinds this past quarter. Can you give us some color on guidance for the rest of the year given your product mix in Europe?

Here’s the translation:

It sounds like you guys screwed up because you had not anticipated the strength of the US dollar.  Why should we believe your European forecasts for the rest of the year?

In my fantasy, I’d like to ask the question this way:

Guys, last quarter you said this would be a walk in the park. Obviously, you screwed up. I know this, because your competitors attained 20% growth even though they faced the same strong dollar. So why should anyone believe your pipe dreams? By the way, how soon are you going to get fired so someone else, who actually knows what they are doing, can right the ship?

Something just dawned on me: I now know why I am not a Wall Street analyst.

Alas, we have to be polite.

And so it is with analysts. 

There are few reasons for this. First, many of them are young buck MBAs trying to build a career. Making enemies of senior industry executives can be career limiting.

There is a power imbalance. The company executives are VERY senior in rank to the analysts, who are often star-struck that they are actually speaking to the Big Cheese. This creates diffident behavior. It’s Wall Street’s version of a 22 year-old intern working in the West Wing.

Moreover, the analysts eventually do get the last word. They have editorial control over what they report to their clients.

Analysts are not in the same power position as journalists conducting a presidential debate. As a result they cannot unleash on the spin-meisters.  It is one of the limitations of the format.

Some analysts do (rarely) ask the question that prompt me to think, “Wow, that’s’ a great question. I wish I had thought of that.”

Accept analyst calls for what they are and don’t rely on them too much.

By the way, I don’t give sell-side analysts much credence. In my opinion, most of them are whores.

Board of Directors

I’m not a fan of Boards of Directors as a governance body. Most of them are AWOL.  In theory the Board represents the shareholders, the owners of the company. The management team, especially, the CEO works for the Board, and indirectly for the company owners. 

In theory, theory is the same as in practice, but in practice it isn’t.

I am not a big fan of individual Board members either. Generally they are charter members of the “What’s in it for me?” club.  On balance, they have cursory duties, for which they are paid handsomely.   

Some Boards are “whore boards”, meaning membership is more about signaling than about substance. These Boards are populated with former US Cabinet members and Senators and other prominent celebrities, who have little business experience or anything to offer beyond branding.

The average Board member is a lapdog, not a rottweiler, not that I am a big fan of rottweilers. They can be unnecessarily aggressive and disruptive. On the other hand, someone has to hold the management team accountable. 

Most companies also carry “D&O” insurance. Director and Officer insurance is coverage that protects Board members from getting sued by disgruntled shareholders. In my opinion, this makes them feckless. If they were personally liable for their misdeeds, they would take their fiduciary duties more seriously. .

Guess who pays for the insurance? You got it. The company, using money that would otherwise be available to shareholders. Golly, what a surprise.

Notably Berkshire Hathaway does not have D&O insurance, so their board members have skin in the game.

In general, I have found Boards only act under duress when the personal reputation of the individual Board members is at stake. Otherwise, they are too deferential to the management team.

One positive trend in Board governance is the emergence of independent directors, and bypass reporting, where executives are sanctioned to engage with Board members directly and outside of the CEO’s control. This alternative channel is a positive move. An example of this is the CFO and finance team reporting directly to the Audit Committee. I find this a healthy trend.

The Annual Meeting

This is another corporate charade.

Legally, a public company must have an annual shareholder meeting once per year. Most Board members and CEOs view the annual shareholder meeting as a necessary evil, something akin to unclogging the toilet on Christmas morning because no plumbers are available.  

Here’s how the meeting works.

A few weeks prior to the annual meeting, the company mails a proxy to the shareholders of record allowing them to vote on a small selection of issues such as election/re-election of Board members and confirmation of the auditors. The proxies are mailed at the last possible moment to maximize non-response, although online voting has helped alleviate this issue.

Directors are elected by a plurality, not a majority, of votes.  Most Boards take a page out Kim Jung-un’s book where he always manages to capture 104% of the popular vote in every “free-and-fair” election. 

Noted.

Board elections are about as undemocratic as possible.  It is a system designed by and rigged for the insiders. In reality most disgruntled shareholders vote with their feet.

The official part of the annual meeting, the procedure of recording the votes, is a tense process like a courtroom waiting for arrival of a violent defendant constrained in manacles.  There is a lot of formality around motions, seconds, official vote tallies. All of this has been rehearsed by the management team and their lackeys. The official meeting is commenced and closed as quickly as possible like a guillotine dropping. This is the thwart any gadflies from disrupting the official proceedings. 

Once the official part of the meeting has closed, the insiders exhale knowing they have a “Get out of jail for free” card for the next twelve months. Talk about Kabuki theater.

The next part of the meeting is usually the CEO giving a presentation on “how well your company is doing,” glossing over any ugliness, and spinning an episode of historically-based fiction. This performance is like watching a Peter-Pan shadow dancing on the wall. It is sort-of true, but weirdly disconnected from reality.

The next section is for shareholder questions. Generally, shareholders are respectful, but they are not always on good behavior, unlike the financial analysts in the quarterly earnings calls. I have never seen the proceedings descend into a barroom brawl, but there can be tense exchanges. Regrettably, despite this, most Board and Management are tone-deaf to the notion that they actually work for the shareholders.

In general, the CEO will deflect any ugly questions and offer glib responses to any probing inquires.

In larger companies, there will be a cadre of protestor-shareholders whose primary goal is to use the annual meeting as a public forum to air their pet political grievances, which typically have little to do with the company’s core business. 

Almost all annual meetings have gone virtual, so it is possible to attend from your desktop. Here is an added bonus: you can now be frustrated from the comfort of your own home. How exciting!!!

This completes the series of posts on how I invest. The next post is a list of key resources.

My key messages are:

• You can do this. The average Wall Street puke is not that smart or that capable. He’s just a schlub trying to make a quick buck from gullible investors.

• Own your future.

• Investing is one way to obtain financial independence—or at least financial resilience and flexibility. Doing so will reduce your blood pressure.

• Investing successfully takes commitment and time. Read the books in Key Resources (and others) and take Professor Damodaran’s online valuation course.

• Investment research is solitary and has to be brutally analytical. It is not a social activity. Trust your gut. If you are feeling pressured to ‘be a player,’ you are being played. Walk away or at least step back and contemplate your decision.

• You have to be a detective. Investments don’t show up on your doorstep with a big red bow tied around them. If they do, beware.

• Be skeptical and scrutinize things. Great investors say ‘no’ over 99.9% of the time.

• Good investors use a lot of triage (i.e. ‘not now’ a lot). With rare exception do you need to make an investment the minute it shows up on your radar.

• Your ideal scenario is an exceptional asset reasonably priced. This combination is extraordinarily rare.

• You don’t need many investments. A dozen should suffice.

• Look for companies with sustainable competitive advantages, as evidenced by long term superior economics. Often these companies also have a dominant market position.

• Look for shareholder friendly companies. Such companies typically have meaningful insider ownership. These companies often buy back their stock opportunistically—only when it is below intrinsic value.

The author, Alex Danco, does a brilliant job of articulating an emerging phenomenon and the reasons for it.  As he states,

What is the access economy? It’s a term I use to describe a phenomenon we’ve all experienced and that I believe will help define the future, yet is surprisingly un-articulated today. The access economy is what emerges when access to (x) becomes cheap, satisfactory, convenient and reliable enough that the premium on ownership of (x) disappears. 

Note the particular emphasis I’ve placed on the word emerges: the principal reasons why I believe the access economy will become such a defining feature of my generation have less to do with our non-dependency on ownership and more to do with the emergent behaviour that results. We already see examples of this behaviour today: Airbnb, Uber, Netflix, Codecademy, Elance and Starbucks are examples of companies that natively understand this phenomenon, and whose business models work because of their users’ emergent behaviour.

Here is the link: https://alexdanco.com/2015/02/02/the-rise-of-the-access-economy/

On Bullshit in Investing

Below is a link to the best article I have read on how Wall Street fools investors and fools itself.

Noahpinion

On bullshit in investing

The epic crash in stocks and crypto has been the big financial story of 2022. When the Fed raised rates, it exposed a lot of bad investments — as Warren Buffett once said, “Only when the tide goes out do you discover who's been swimming naked.” But it would be nice if investors could recognize the too-good-to-be-true stuff before the big crash, so as no…

Read more

4 years ago · 175 likes · 39 comments · Noah Smith

Key Resources for Learning about Investing and How to Value Investments

• The Little Book that Builds Wealth by Pat Dorsey. I suggest you read this book first. It is little, as it’s title suggests, and gets to the essence of investment valuation absent all of the Wall Street doubletalk.  

• One Up on Wall Street by Peter Lynch. This book is phenomenal.  I would read it after Dorsey’s book.

• Warren Buffett’s annual shareholder letters from the Berkshire Hathaway website.  Find them and read them. Full stop.

• The Warren Buffett Way by Robert Hagstrom was my first introduction to the methodology that Buffett uses to evaluate investments. It goes beyond platitudes and gives a glimpse under the hood.  

• The classic tomes of value investing are Security Analysis and The Intelligent Investor by Ben Graham, the father of value investing, who developed the analytical framework of using financial metrics to assess investments.  Prior to Graham the prevailing approach to investment selection was, “Buy this sucker. It’s bound to go up.  I heard about it at a cocktail party.”  These books are good reference books, but I would not use them as an introduction to investing. They can be intimidating right out of the box. They are very dense. Then again, maybe my problem is that I am very dense.

• Aswath Damodaran, the New York University finance professor has been incredibly generous in his teachings. His full MBA valuation course and other materials are all online.  This guy is a gem, and his materials are spectacular.  I don’t suggest buying his books. His best material is online.

  You will need to understand the fundamentals of accounting before tackling Damodaran’s online valuation course. I suggest looking online, but I don’t have a specific suggestion. (I learned accounting well before the web—around the time Martin Van Buren was president.) You might want to poke around Khan Academy Cousera and other sites to see what they have to offer.

• Howard Marks, a founder of Oaktree Capital and investment writer, deserves special mention. He writes periodic memos, which you can find here. I find his writing insightful, if not always actionable. Like anything the quality of his memos varies. Some are okay. Some are good. Occasionally he unleashes a gem. Here is one on value that I particularly like.

• Wikipedia and Investopedia are great online resources for definitions.  Do you need to brush up on the difference between Return on Capital, Return on Invested Capital, and Return on Tangible Capital Employed?  Wikipedia and Investopedia are great resources.

• ROIC.AI. This is a very useful website to which I subscribe. It has a great one page summary of key company statistic including ratios such as operating margins, return on capital, and return on equity. There are other services similar ROIC.AI, but I found this one to be the most useful for me.

• Dataroma. This site reports the 13F filings for high profile investors. Institutional investors in the US managing more than $100M have to file 13F forms quarterly with the US Securities and Exchange Commission, detailing what securities they bought and sold. Dataroma does the best job of aggregating 13F forms and presenting the summary information. I go to Dataroma periodically to get investing ideas.

  Put a note in your calendar to check Dataroma on 15 February, 15 May, 15 August, and 15 November. These are key reporting dates.

  Dataroma’s information is broken down by investor (Buffett, Klarman, etc.). In particular I look at new additions as well as significant additions to existing holdings. These are ideas, and need further investigation and scrutiny. They are merely leads that warrant follow up. You need to do your homework and not just accept someone else’s conclusions blindly.

• For a discussion of investment screening approaches, I recommend Safal Naveshak’s blog here. In it he shows his screening criteria and discusses it in detail. Read and study it.

Here are some additional books I highly recommend:

•  The Essence of Warren Buffett: Lessons for Corporate America by Lawrence Cunningham.  Cunningham has reorganized Buffett’s investor letters into themes.

• Margin of Safety by Seth Klarman.  This is a good read from an investor with a long track record.  Copies in print are difficult to find and very expensive. I’m not sure why the publisher has not printed a second edition.  With a little searching, you can find a PDF online.

• Common Stocks and Uncommon Profits, by Phil Fisher. I finally added this book to my bookshelf. It is worth reading and getting as part of your library.

• Value Investing: from Graham to Buffett and Beyond, by Bruce Greenwald and others. Greenwald has a number of keen insights. This book is worthy of space on the bookshelf. In particular, Greenwald has a useful discussion on why the traditional calculation of a company’s terminal value (using the Gordon Growth Model) is flawed. His approach takes the terminal cash flow and divides it by the cost of capital. Read his book for details.

• The Outsiders by William Thorndike.   Thorndike did a study of various—often idiosyncratic—CEOs who were spectacular and unorthodox in capital allocation. Since a CEO’s capital allocation abilities are so essential to the long term health of a company, understanding this skill is crucial in terms of an evaluating companies.

• Expectations Investing by Michael Mauboussin and Alfred Rappaport. This book inverts DCF analysis. Traditional DCF analysis looks at future cash flows and discounts them back to present value. On this basis of the DCF, you decide if the investment is worthy of buying at its current price.

  Expectations Investing asks, the opposite question: given today’s price, how long will it take the value to realize that price given the underlying economics of the business? The authors also have a website with step-by-step analysis and models, using Dominos Pizza as a tangible example.

  On the topic of stock buybacks, Chapter 11 is extremely useful for understanding when buybacks destroy value and when add value for existing shareholders.

  More generally Mauboussin has written extensively about investment valuation throughout his career. He has many keen insights. If you search his name, you will find links to many of his writings.

  Valuation Approaches

  1. In terms of valuation approaches, NYU professor Aswath Damodaran is the Godfather. I mention him above.

  2. Michael Mauboussin is also excellent. I mention his book Expectations Investing above. He also has an associated website where he steps through a valuation of Domino’s Pizza using his approach.

  3. In 2014 when Mauboussin was at Credit Suisse he wrote an incredibly valuable paper Calculating Return on Invested Capital: How to Determine ROIC and Address Common Issues. The original link for the paper is broken, but if you search for his name and the paper title, you should be able find a copy online. He looks at ROIC from the left side and right side of the balance sheet. The numbers should be consistent and give you another look in the economic efficiency of the investment.

  4. Above I mentioned Bruce Greenwald and his approach.

  5. Finally, I ran across a Substack author Moatmind who has a very interesting approach along with a Google Sheet showing an implementation. Moatmind’s approach is interesting because he eliminates a number of assumptions in traditional DCF models. These assumption can lead to wildly varying (and inaccurate) results. Here is a link of his analysis of Crocs:

     Moat Mind

     Crocs (CROX) Valuation: DCF & IRR Analysis (+ Google Sheets Model)

     Crocs (CROX) presents a compelling value opportunity, with strong cash flows, a resilient brand, and significant upside potential based on our DCF valuation and IRR analysis. Below is a structured breakdown of the key insights covered in this report…

     Read more

     2 years ago · 6 likes · Moat Mind

  Often I use Moatmind’s approach to cross-check results I get from running Damodaran’s models.

Caveat Emptor

This may come to you as a shock, dear reader, but in life not all of the children are above average.  It turns out that the average child on average is…average.

And so it goes with books, websites, blogs, Substacks and other materials.

I search value investing Substacks extensively. I am not a big fan of Substacks with content behind paywalls. If the author is so good as an investor, why does he need to make a living selling subscriptions? Besides, I have found a few where the author re-packages recommendations from other Substacks, an approach I find dishonest.

Searching for viable investments is a needle-in-the-haystack process. There is a huge amount of online material. Most of it is garbage. In reading materials I graze widely—and dispose of quickly. I read probably 200 pages of material per days. I continue to graze wildly because occasionally I come across something useful, and even more rarely, something spectacular, like the Benn Eifert article I mention above.

For instance, on one blog in 2020, I came across a post on Orphan Stocks, stocks that are not followed by any Wall Street analysts.  The blog mentioned specific companies, which I further qualified. One in particular stock caught my eye, but I held off on investing because its valuation was very high: there was no margin of safety.  I finally began to invest in mid-2023.

There is a lot of triage in my investing approach.

Returning to books, there is a genre which I describe as investing odyssey books.  Generally, these have the theme of “I was lost, but now I am found.” I don’t find this genre especially useful. Here is a review I posted on Amazon:

I borrowed Gautam Baid’s "The Joys of Compounding" from my local library. I am glad I did not purchase the book. My review of the book is lukewarm.

"The Joys of Compounding" is another investing odyssey book about learning at the feet of Ben Graham, Warren Buffett, and Charlie Munger. It follows in the footpath of similar books written by other value investors such as Guy Spier’s "The Education of a Value Investor" and Monish Pabrai’s "The Dhando Investor."

A good author doth not necessarily a savvy investor make.

Case in Point: I have a particular disdain for Pabrai. For many years, he has traded off—what I believe to be—his cursory relationship with Charlie Munger, with a lot of “Charlie and Me,” photos, quotes and other paraphernalia. You would think these guys are roommates.

His rhetoric outruns his results. If Pabrai’s 13F filings are any indication of his investing prowess, I can summarize him in four words: big hat, no cattle.

Nevertheless, I liked his book.

Let’s get back to Baid.

Baid’s investing epiphany is personal, but it is not necessarily instructive for the rest of us. His voice sounds like the latest cohort of gobsmaked teenagers who breathlessly claim their generation is the first to discover sex. Their very existence belies their claim.

Unlike so many of his Wall Street brethren who were minted in New Canaan, who were branded at Phillips Exeter, Harvard, and Wharton, and who effortlessly rose through the ranks of Brown Brothers Harriman, Baid grew up on the wrong side of the railroad tracks—indeed the wrong side of the world. His life story is a heart-warming Horatio Alger narrative around overcoming daunting odds by grit, perseverance, and determination. In a world where zip-code is destiny, Baid escaped. Good for him.

Regrettably his book is not as compelling as his life story.

Readers have who have read extensively by and about Graham and Buffett will not find a lot of new information in "The Joys of Compounding". This is old information organized around personal revelation and evolution.

The book starts slow; Baid spends an inordinate amount of time on topics such as the value of extensive reading. He goes over the same ground again and again and again. I’m a slow learner, but even I can figure out something by the tenth time an author explains it to me. Baid also tends to pontificate.

I was hoping to find lessons based on what Baid has learned thus far in his career. I was disappointed from the lack of insights resulting from investing successes—and more importantly—failures. I did find one, which I photocopied for further study.

Baid discusses two investments in Indian companies making graphite electrodes. A graphite electrode is a consumable used in the production of steel in electro-arc furnaces. It is a minor cost component—about 3% of the cost of production—but essential to steel production. A graphite electrode is to steel production what a wick is to a candle. Without it, nothing happens. Because graphite electrodes are sold into a cyclical industry (steel production), the stock prices of graphite electrode manufacturers tend to exhibit cyclical behavior.

At the bottom of the economic cycle, Baid made two concurrent investments, one in a market leader and the second in a market laggard. He learned an important investing lesson. As the business cycle rose, the laggard’s stock price rose much faster and further than the market leader—a counterintuitive outcome. He found this perplexing until he thought it through: the issue has to do with baseline expectations.

When it comes to US Presidential administrations, it is fair to say that George W. Bush exceeded expectations much more than George Washington. That is because Bush’s baseline started so low. Surely, you have heard the joke that Crawford Texas was missing the village idiot, but that the authorities found him in Washington.

The stock price of two graphite electrode companies went through a similar evolution. Assuming the market has priced in the financial status of each at economic cycle’s bottom, a laggard that moves through the cycle from an operating loss to a modest operating margin has done much better than a leader that doubled its operating margin. Because the laggard’s expectations are so low, the stock price has an exaggerated response to the earning gains through the cycle.

I have invested for years, but this simple insight had eluded me. Mea culpa: I am currently invested in a US graphite electrode manufacturer and getting my head kicked in. (Note: I may be from Crawford myself.) My investment is either going to be a masterstroke or a face-plant—probably the latter. Baid’s insight may not save my butt on this one, but his experience is relevant and helpful.

On balance, I found Baid’s book decent but not spectacular. The book is published by Columbia Business School Publishing, but don’t let that bamboozle you. Some books from this publisher are so sloppy they make your local high school newspaper look like the "New York Times".

Subscribe now