Monday, March 10, 2014

My Thoughts on Investing

Buffett released his 2013 annual letter to shareholders just over a week ago and it contained a very interesting section on investing. After reading it, I would like to share my own thoughts on investing, which is provided in the following sections. Everything written here reflects my current investment philosophy and I want to thank famous investors such as Ben Graham, Warren Buffett, Phil Fisher, Peter Lynch, Howard Marks, Marty Whitman, and Seth Klarman for sharing their insights on investing. They shaped my thinking and provided sound guidance that all investors should follow.

Stock Investments Are Business Investments: 
"Investment is most intelligent when it is most businesslike" 
Ben Graham  
This is the same quote Buffett highlighted in his 2013 annual letter. Investors often do not think like business owners and fail to realize that the underlying security is a claim against a company. Stocks are the residual claims of underlying businesses (the value left after liabilities, such as debt,  are subtracted from assets), but investors often view them as alphabetical ticker symbols whose price moves around from 9:30 am-4:00 pm. If investors take the ticker symbols' point of view, they would be more interested in historical price movements or price volatility in order to make investment decisions. On the contrary, those who view stocks as actual businesses would be more interested in the underlying fundamentals such as future earnings/cash flows, the competitiveness of the industry the business operates in and the quality of management. Given there is constant chatter on the direction of "the market", it's difficult for today's investors to think like business owners. It's easy, or even unintentionally, to view stocks as ticker symbols in a fast moving market. However, I will illustrate with an example that shows it would be foolish to do so. 

Since Buffett used real estate examples, I will too. Imagine you are purchasing a home, what factors would you consider to evaluate your purchase decision? Some factors may include the location of the home, the number of bedrooms/washrooms, the square footage of the house, the furnishings and the proximity to public transit or schools. If your real estate broker told you that those factors are useless and you should only consider historical prices or price volatility, you would think he/she is from la-la land. It's plain silly to buy a home because the price is in "an uptrend". What's even sillier is if the real estate broker tells homeowners that they should buy homes that exhibit less price volatility, which is the definition of a safer investment under Modern Portfolio Theory. Why waste time analyzing past home prices or price volatility when it is better to focus on the fundamentals such as location and the quality of the individual houses.  If you buy a home in an excellent location and growing neighborhood, it's a no-brainer that the price would rise over time. While some home buyers might consider price trends or price volatility (especially during the height of housing bubbles like 2006 in US), the majority of home buyers only consider the underlying fundamentals when considering a prospective home purchase, without any thoughts on future prices or future price volatility. Hence, stock investors should act more like owners when considering prospective purchases similar to how they evaluate their home purchases. 

When evaluating stocks, thinking like an owner means evaluating the future productivity of the assets owned by the business. It's important to predict future earnings and cash flows instead of future stock price movements. Similarly, it's important to evaluate the competitiveness of the industry the business operate in instead of the current stock market condition. And finally, it's important to evaluate the integrity of the managers running the company instead of the speed your broker can provide in order to trade the company's stock. True owners would only consider the former statements while ignoring the latter ones. In theory, it is easy to see why evaluating fundamentals is important but it's more difficult to put into practice especially when investors are emphasizing short term performance. To quote Yogi Berra, "In theory, there is no difference between theory and practice. But in practice there is."  

How to View Market Prices (Correctly): 

In Buffett's opinion, there should only be 2 courses on equity investments: (1) How to value a business and (2) How to view market prices. I already discussed (1) in my prior article so I will focus solely on (2) in this section.  

Before I begin the discussion, let's focus on a few every-day examples. If you drive everyday and do not own a gas station, do you hope for higher or lower gasoline prices? Given the answer should be obvious, let's consider another example: if you are regular grocery shopper, do you hope for higher or lower produce prices? For both questions, the rational and obvious answer is lower prices. Now comes the final exam: If you are a saver who is not close to retirement (by at least 10 years), do you hope for higher or lower stock market. As Buffett pointed this out in his 1997 annual letter, most investors fail to answer correctly although there is no difference between this question and the preceding questions. Some may point out that savers should hope for higher markets because they will have more money to spend during retirement. However, I explicitly stated that the savers are not even close to retirement. Savers, who still have a stable income stream and wish to invest for the future, should hope for a bear market (lower market prices) so more stocks could be purchased on a bargain basis. If everyone rushes into retailer stores when there is a 50% sale, it is very confusing to see why the same group of individuals would rush out of the stock market when there is a 50% sale (2002 or 2009 sounds familiar?). There is no difference between shopping in the mall and shopping in the stock market. Doubling down is not a bad strategy. In fact, Fairfax Financial, ran by value investor Prem Watsa, uses the strategy of doubling down when buying and doubling up when selling (buying more when prices fall and selling more when prices rise). As Ben Graham reminds investors, "buy stocks the way you buy grocery, not the way you buy perfume" or in my own translation, "buy stocks the way you buy your own personal items, not the way you buy gifts for your significant other." 

I have provided  an excerpt from my prior article on Mr. Market, an allegory Ben Graham created to describe price movements in the stock market.
Mr. Market is an allegory of the stock market made up by Ben Graham, the mentor of Buffett. Mr. Market is a fellow who comes to you daily to quote prices of many businesses and he is happy to buy your interest in those businesses or sell his interest at the price he quoted. Mr. Market is very emotional. He sometimes quotes a ridiculously high price because he only sees the positive sides of those businesses. He sometimes also quotes a ridiculously low price because he thinks the business is worthless.
Warren Buffett reminds investors of two important facts about Mr. Market investors need to know and remember at all times:

1) You don't have to transact with him every day. Only do so if you can take advantage of his quotes. If he quotes a low price, you buy from him. If he quotes a high price, you sell to him. Most of time, it is simply better just to IGNORE him.

2) It is Mr.Market's pocketbook (pocketbook describes the book traders used to keep track of their stock inventory back in Graham's days), not his opinions that should interest you. Many investors think Mr. Market is correct on the valuation of businesses and follow his opinions.
Let's revisit the real estate example again. If you bought a house and your neighbor offers an exorbitant price to purchase your house, what would you do? Sell your house to him of course! It would be silly to suddenly become more enthusiastic about the value of your house and reject his offer. However, in the stock market, investors do the exact opposite. When Mr. Market offers a ridiculous valuation, they would suddenly believe their stocks are worth more and hold them tenaciously despite clear signs of overvaluation. The opposite is true in bear markets when investors join Mr. Market's pessimism and dump every stock holding. If you won't sell your house to a lunatic neighbor who quotes a ridiculously low price, you should not sell all your stock to Mr. Market when the stocks are clearly undervalued in a bear market. Once again, thinking like a true owner will avoid the mistake of selling undervalued companies and holding overvalued ones (note I used the word "company", not "stock"). 

Second-Level Thinking: 

This is a concept espoused by Howard Marks. In his book, The Most Important Thing, Marks described second-level thinking as deep, complex and convoluted while first level thinking as simplistic and superficial. For investors who want to achieve above average returns, their thinking should be deep and avoid common pitfalls. That deep thinking is called second-level thinking. Successful investors should be able to think at a higher level and consider all possibilities. First-level thinker, the majority of market participants, only focus on the obvious facts and fail to draw thorough conclusions. A common first level thinking is buy companies with a growing business or high earnings/sales growth. Without even considering the valuation or the competitiveness of the business, investors may lose a lot of money because of their flawed thinking. Nifty-fifty investors learned that lesson in the 1970s when they lost 90% of their money by buying stocks of the best 50 corporations. Many market participants still avoid in-depth thinking when making investment decisions. To quote Bertrand Russell, "most men rather die than think. Many do. "

Difference between first-level and second-level thinking: 
  • A first-level thinker would say "the company is a great company and has a great brand; hence let's buy the stock" (Too much focus on quality). A second-level thinker would say "the company does have a good brand but it's already reflected in the share price. With its shares trading at 50 times earnings, the stock is priced for perfection. Time to sell." 
  • A first-level thinker would say "the company is trading only at 8 times earnings and has a high dividend yield of 10%. Time to buy" (Too much focus on yield and low PE ratio). A second-level thinker would say "although the company trades at 8 times earnings, it's not a value buy because it faces double digit revenue decline and higher expenses over the next few years. When those two factors are considered, the stock is actually trading at 25 times earnings. With its dividend payout ratio at 90%, any large earnings decline would impair the dividend. There is no margin of safety with this investment. Sell." 
Accounting Shenanigans: 

There is an old accounting joking regarding the value of two plus two. According to the joke, the accountant's answer is "what number did you have in mind." This joke illustrates how accounting rules allow significant use of estimates. I will list two problems that investors should be aware of.

(1) Non-GAAP Measures:

I wrote an article on the problems of Non-GAAP measures but I would like to illustrates a couple of main points (readers are strongly encouraged to read my prior article). First of all, non-GAAP measures are not evil but management is starting to manipulate these measures to paint a better picture. One of the main problems is the extensive use of non-GAAP measures in earnings reports. The problem is most acute when the non-GAAP measures is spelled exactly the same as a GAAP measure. For example Operating Earnings and Cash Flow From Operations are items on GAAP financial statements. However, I have seen many companies using non-GAAP yardsticks that are exactly spelled the same as the GAAP equivalents. They only warn the reader in a tiny line on the bottom of the page that these measures are non-GAAP measures and do not conform to GAAP rules. The non-GAAP copies often ignore a few bad stuff. i.e. non-GAAP Operating Earnings may ignore a loss on a small segment and non-GAAP Cash Flow From Operations may ignore certain negative working capital changes. I'm not arguing to eliminate these non-GAAP measures but the way they are spelled deceive investors especially the amateur ones. Therefore, be on the lookout for non-GAAP copies of GAAP measures. Investors should understand how these non-GAAP measures are calculated.  Companies are required to show the adjustments in their 10-Qs and 10-Ks. 

If the non-GAAP measure paints a rosier picture of the company's finances, watch out! As social media and internet stocks keep on soaring, many analysts needed new measures to justify the high valuations. The managers and investor relations officials of those company are more than happy to help with this endeavor. One non-GAAP measure invented for this purpose is net earnings excluding stock based compensation. The rationale is these expenses are non-cash expenses and do not create a financial burden because the company simply issues the shares to pay its employees. Investors who buy this logic need an accounting 101 lesson on what is the definition of an expense. Stock based compensation is a real expense because it is an economic cost incurred through the business operation. By assuming stock based compensation isn't an expense, investors are basically assuming the employees are working for free since the majority of the compensation in these social media companies are in the form of stock, not cash. 

If [stock based compensation] aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?  Warren Buffett

Finally, because these non-GAAP measures are not regulated, companies are free to change the definition of the metric. A common trick used in the past is to change the definition so the non-GAAP measures appear healthier, i.e. changing the same-store-sales definition from measuring sales at stores that opened for at least 13 weeks to 11 weeks. Another example is to change the definition of "subscriber" to show a faster subscriber growth. To avoid scrutiny, companies will make the change when they file their 10-Qs, which is often a few days after they unofficially announce their quarterly results. Given managers know not many investors actually read 10-Qs, these non-GAAP measure changes almost go unnoticed. Therefore, I highly suggest investors to actually read 10-Qs although the information contained in it should be similar to the earnings press statement released a few days earlier. However, if you notice a definition change in one of the non-GAAP measures, re-evaluate your investment thesis immediately. A company with repeated disclosure problems is a sell candidate. 

(2) One Time Items:

One time items are notorious for their manipulative uses. Unlike revenue and expense recognition, management have more leeway regarding the classification of one time items. By re-arranging lines on the income statement, management can receive a different reaction from investors because they often look above the line, which is an industry lingo for lines above the EBIT or operating earnings line. Anything below the EBIT line, which includes charges for discontinued operations or extraordinary items, are ignored because investors consider those items unimportant. Hence, management will attempt to stuff a few small expenses in the extraordinary items line so the company can meet earnings expectations. Although investors should ignore a few large one time items, such as loss on sale of a division, they should not ignore one time items if they occur on a regular basis. 

There are many other manipulative tricks management can employ to fool investors but I included just two main issues I believe are most prominent in today's market. Management can still play some old tricks, such as inaccurate revenue recognition or improper capitalization of operating expenses so investors should still keep their eyes open. Overall, trouble can be avoided by avoiding companies with weak reporting and management. An ounce of prevention is worth a pound of cure.

On Efficient Markets: 

Many readers might have heard this joke before: an economics professor and a student are walking down the road and both see a $100 bill on the ground. The student wants to pick it up, but the professor encourage him not to. According to the professor, if that bill was real, somebody would have picked it up by now. Unfortunately for the professor, the student got $100 dollar richer by not following the rule of the efficient markets. 

As a refresher, efficient markets theory states that the market should reflect all available information. Why is the market efficient? It's partly due to the actions of market participants who constantly search for mis-pricings. The value of most assets should revert to intrinsic value immediately after  major announcements - such as earnings announcements, corporate restructurings, M&A etc.-   if there is a large number of market participants buying and selling the assets. However, there are limitations that may prevent price discovery. There could be limits on short selling and  market liquidity. Furthermore, a lack of interest among market participants to conduct price discovery operations in certain asset classes (i.e. micro or small cap stocks, distressed debt etc.) also creates inefficiencies. These price discovery limitation will prevent the certain asset classes from being efficient. 

I'm not a big fan of the efficient markets theory although I do admit that the prices of major asset classes are frequently efficient. Readers should note that I used the word "frequently" and not the word "always". From time to time, investors can discover mis-pricings even in a well-covered space such as large cap stocks. Despite over 50 sell-side analysts covering Apple, none upgraded the stock or raised their price targets when the price hit $400 last April. The stock outperformed the S&P500 by a whopping 35% in the next 8 month. Even the price of a company with a $500 billion market cap can be inefficient. Markets are not comprised of machines but of people. The efficient market theory assumed all investors are rational and analyze the facts correctly. However, investor's rational judgments are often overruled by the emotions of fear and greed. They don't incorporate all the available information in their decisions and often make mental short-cuts. As Dale Carnegie famously said, "We [humans] are not creatures of logic, we are creatures of emotion."

Therefore, I believe markets will be inefficient from time to time and will offer mouth-watering opportunities for investors. Although I detest the efficient market theory, I encourage professors and academics to keep promoting the theory. The Buffett quote below explains why.

"We are enormously indebted to those academics [who promote efficient markets theory]; what could be more advantageous in an intellectual contest - whether it be bridge, chess or stock valuation- than to have the opponents who have been taught that thinking is a waste of energy" Warren Buffett 

Diversification or Diworsification: 

Should investors place all their eggs in one basket or spread the eggs among many baskets? The answer should depend on whether you have the knowledge and will to spend the time to search for investment opportunities. For most non-professional investors, I would highly recommend an extreme diversification policy. This involves buying ETFs - like the SPY, XIU, IWM etc-  that hold over hundreds of stocks. Because non-professional investors do not have the knowledge or will to select undervalued stocks, spreading out the bet is a wise choice.

However, for those who have the knowledge and are willing to take the time to select undervalued securities, I believe an extreme diversification policy is foolish. If investors mirror the approach of the mutual funds, they would find themselves owning over 100 stocks. If they own over 100 stocks, how would they know what companies they actually own? Imagine a man telling his wife that he wishes to diversify his marriage by marrying more women. If he really found the woman of his dream, why would he want to diversify? The logic is simple and it should be extended to investing. If investors found a few excellent companies, they should concentrate their positions.  Although it is dangerous to own only a few stocks, I would suggest owning 10-30 stocks in a portfolio. Studies have shown that the co-variance (measurement of correlation between the stocks in a portfolio) significantly decreases after the number of stocks increases from 1 to 10. The decrease from 10 stocks to 30 is very marginal and the decrease beyond the 30th stock is so small that it isn't even worth it. 

Diworsification is a word made up by famous investor Peter Lynch who condemns the practice of diversification. Owning too many stocks is akin to owning an index fund except the transaction cost is much higher. (why try so hard just to be average?) A concentrated portfolio may actually decrease risk because investors would exercise more prudence when they select their stocks. Pick a stock just like how you would pick your future spouse. In the final analysis, diversification can be summarized nicely with a Buffett quote, "diversification is a protection against ignorance."

To Sum it Up: 

Investment is most intelligent when it is most business like. It's worthy to repeat that phase because investors can achieve higher returns by thinking like an owner.

By thinking like an owner, investors would:
  • Have the proper attitude towards market price fluctuations
  • Think at higher levels regarding factors that influence the underlying businesses instead of factors that influence market prices
  • Understand that markets are not always efficient and those who have a superior insight of the underlying business can achieve abnormal returns
  • Understand the importance of a concentrated portfolio and realize that diversification is really diworsification 


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