For Every Solution there is another Problem

For Every Solution there is another Problem

It is inherent in the nature of the markets that every solution to the problem creates a new problem.

Albert Peter Pacelli

The Stock market is a social, multi-faceted and self-correcting phenomenon. If we as individuals create our own reality, then the stock market is the product of millions and millions of thought forms all flowing together forming a river of energy that could go anywhere. It is folly to try to predict the direction it might take but that doesn’t stop people from trying. Investors, traders, momentum players, quants, academics, hedge funds, you name it, have all tried their hand at developing strategies to take money out of the market. And for awhile some do it but then they give it back. As soon as someone solves the problem of the market; the market adjusts and changes, creating new problems.This is the discounting nature of the marketplace in action. To discount is to take into account in advance and so lessen any effect thereof.

The markets continually change so that no formulated solution can beat them. Instead it makes more sense to ignore the market and focus on investing in individual companies that are investing in themselves. Its more boring than trying to predict the direction of the market but in the long run it is far more profitable. People forget that the original intention of the stock market was to allow people to invest in companies providing their management teams with seed money to develop and grow their businesses.

But human nature, being what it is, people will continue in their attempts to forecast what can't be forecast, but that is how the market teaches you, if you are willing to listen. If you aren't interested in learning these lessons, you will be continue to lose your money in the market which is unfortunate because the object of the game is to stay in the game. If you manage to stay in the game, making money will generally look after itself.

The other side of Capital Expenditures

The other side of Capital Expenditures

The amount of money a firm invests in itself (capital expenditures) may understate or overstate a companies free cash flows, as not all capital expenditures are created equal. The difference between investment in future growth and maintenance cap ex often goes unnoticed.

Maintenance cap ex are investments required for a company to maintain its current sales level.  A company that has a high level of maintenance cap ex is unlikely to generate higher free cash flows - even after it stops growing sales - since it will keep pouring money into fixed assets to keep existing sales from declining. 

These companies will usually have poor returns on invested capital since they are essentially investing money in their business to keep their revenues at an even level. This makes them them poor long-term investments and a lousy hedge against inflation. Most resource orientated companies fall into this category, think of oil and mining companies. Semiconductor firms too, would have high maintenance cap ex requirements as they constantly have to upgrade their product offerings.

If you invert your thinking about all of this (Charley Munger style) you could take advantage of this situation. Start investigating companies that sell capital equipment to these high cap ex firms. This will help these service companies generate a recurring revenue stream making it easier to predict their own growth rates in the future. This could make them interesting long-term investments. Check out the annual report of the high capital expenditure firms and find out who their suppliers are. These suppliers could be fertile ground for future investing opportunities.

The Risks of not being in the Market

The Risks of not being in the Market

People talk about the risk of being in the market but the risk of not being in the market escapes them. What I'm talking about is the time value of money which simply means that inflation will decrease the purchasing power of your cash over time. In other words a dollar in the future will buy less than a dollar would today. Even in a low inflation environment the longer time is allowed to erode away the purchasing power of your cash the farther back you find yourself.  Time is the leverage that inflation uses to rob you of your money's purchasing power.

When you make an investment be it in a stock, a bond, a house, a bank account its commonplace to compare your rate of return to the current risk free rate which is generally thought to be the yield on the government's ten year bond. At this moment the U.S. ten year bond yields 2.33 % while Canada's ten year bond yields a rate of 1.52. Historically speaking these rates are very low. The supposedly 'safety-first' investor putting his money in a one year GIC will be getting paid peanuts in return and find the purchasing power of his cash eroding away over time. 

Buffet has often said he likes to invest in 'productive assets' which brings us back to our definition of return on invested capital (ROIC)..." It is the ability of a company to create value. Value is created when a company's  return on capital is greater than the cost of that capital. Over time the additional return on capital can be re-invested in the business to help accelerate it's growth as an ongoing concern"

With current yields so low it just makes sense to invest in the stock market's 'productive assets" and protect yourself against the ravages of inflation. How to go about investing in the stock market is what this blog is all about. I wish someone would have taught me this simple but important concept back when I was in public school, it could have changed my life.

Random Thoughts on Investing

Random Thoughts on Investing

The problem with investing in this modern age is the amount of information that an investor has to sift through. The problem is really a matter of choice so I try to focus on the information that will yield the most utility. 

I ignore the macro environment and with it most of the madness that passes for information from the mainstream media. I concentrate on individual companies and even there I try to concentrate only on what really matters. It’s been my experience that randomness will play a huge role in your investment success, so you have to diversify your holdings but only to a point. And I believe in investing more heavily in some of my holdings than others. Extending my investing time frame to 3 years and more has helped me capture some of the inefficiencies that lie in the market. In fact one of the biggest advantages you can gain on the competition is to invest for the long term and filter out the meaningless noise from the media outlets. The longer you hold a portfolio of good solid stocks, the more the risk will go out of them, as the passage of time will erode away the risk of investing in them. By diversifying your stock portfolio and extending your holding periods you essentially are managing your risk (the risk of losing money) and managing your risk is the investor's number one job.

One great shortcut is to concentrate on companies where senior management owns stock in the company they run, better still if it is in the small/mid cap part of the market. When management invest in their own company they put themselves on the same side of the table as their stakeholders. 

And speaking of the small and mid cap stocks, that is where my investing dollars tend to go. I am not a fan of companies that get too big (institution complex) unless I see some resource conversion (spin offs, rights offerings etc) activity going on and I respect the senior management. There are always exceptions of course. In fact large companies that divest themselves of divisions (spinoffs) can be a good sign that management is interested in enhancing long-term shareholder value. Too many large firms only want to get bigger usually to appease the giant egos of their CEO's. 

As always experience will be your greatest teacher. You don't have to be particularly intelligent to be a successful investor but you do have to believe in what you are doing. In time the market itself will provide you with your scorecard.

Institutions and Institutional Thinking

Institutions and Institutional Thinking

If you don’t control your own thinking, somebody will control it for you

Neville Goddard

Institutional thinking is thinking that has been long established in a place, a law onto itself, a custom that people come to accept without, well...thinking.

Welcome to the world of inhuman resources, bureaucracies, consultants, consensus taking and endless unproductive meetings. Importance is stressed on fitting into your environment and not standing out. (hiding behind the drapes?) The bigger the institution, the more entrenched the thinking almost to the point of making it a religion (a system of belief). Individual and original thought is generally frowned upon as being both disruptive and harmful to it's status quo.

This type of thinking pervades the financial industry as well as the government, the educational and health care systems and of course the church. In short it is everywhere. If an individual is part of an institution he will be brain-washed, manipulated and even intimidated to fall in line and fit in.

It is the nature of institutions to control their surrounding environment and serve their own narrow interests, propagating the belief of themselves as being important and influential. Institutions largely control the news outlets and media to the point where the individual can't help but being engulfed by the shadow of their reach. If you depend on the media for your financial news chances are that your own self interests are not being met.

It pays to be aware of all of this so you can make an attempt to shield yourself from the manipulation that surrounds you. That being the case its important to have an investment philosophy or policy you believe in to keep you grounded when the markets are spinning out of control and the media is over hyping things. Be aware of yourself as an individual and invest accordingly. Your investment portfolio is an extension of both your creative thinking and of yourself as self-actualized being.

The Uncertainty of Future Cash Flows

The Uncertainty of Future Cash Flows

The main reason forecasts are in such demand is because everybody is facing an unknowable future. And this includes, not only investors but the senior manage of corporations as well. That being the case management teams face two major risks that should be considered and dealt with.

The risk that the future cash flows of the company will actually materialize and grow (competition might threaten the companies competitive position).

How much investment will be needed to keep the company going (return on capital)

To deal with these two issues the investor should examine the business model of the company.

Companies that have high recurring revenue usually exhibit lower sales volatility and greater predictability of their earnings and cash flows which helps management lessen the operational risk of running their business. It reduces the strain from growth since a company with high recurring revenue has to put forth a lot less effort to grow revenues. Companies whose customers need to buy their products or services on a consistent basis usually exhibit less earnings volatility thus lessening risk to both the company and its investors.

The purest form of recurring revenue involves periodic licensing fees that follow upfront product purchases. This license model often appears in the software industry, where customers pay an upfront installation charge and subsequently make monthly or annual payments for maintenance, support and upgrades.

Outside the software industry, the more common form of recurring revenue is the service model: when repair and maintenance revenue can be expected on products sold but whose timing and extent are more uncertain, To fend off third-party service companies, management often implements long-term service contracts with large customers who pay a fixed annual fee

Service models can be further strengthened when costly and long-lived equipment needs to be upgraded or maintained rather than being replaced. And sometimes the breakdown of equipment purchased can be so critical to a customer they can little afford a delay in their operations. This often ties the customer closer to the service contract of the company offering the service.

Temptations

Temptations

Patience is a highly sought virtue. To be patient is to wait, to be able to mentally insert a wedge between a linked stimulus and response and so place a stop on repetitive, habitual, often destructive behavior. Patience gives you a moment to access, step back from the brink, and bring yourself back into balance.

The idea is that we restrain our will to stop an impulsive or destructive action (often based on short term relief from tension or instant gratification) and in doing so, turn our energy in a constructive or creative direction – to use our will in a directly beneficial way. Patience, then, is the mental reflection of the restraint of will.

Dr. Gerald Epstein


There are many temptations out there to do the wrong thing at the wrong time. Dare I say...the worst thing. Stay vigilant and above all else “be aware” of what is going on around you; Stay focused on your core principles that have been honed by the hard experience you have gained while in the market. If you find yourself becoming emotional, step back and do nothing. Take a walk out in nature, relax and regain your composure.

Good investing takes discipline and patience and I don’t want to gloss over those two words. Discipline is a system of rules, or a systematic method, a control obtained by enforcing compliance. Patience is the ability to wait til your environment presents you with an opportunity to take advantage of your process. It is operating in the eternal now which is part of your awareness of being.

Its important to keep those two things in mind because there is so much bad advice out there waiting to snare the unknowing investor that it can be difficult to keep one self grounded in the reality of doing the right thing for your own long term good.

The constant noise and manipulation from the media will buffet the individual investor to the point where he becomes lost and out to sea. You have to insulate yourself from these negative influences. Again I draw upon the metaphor of acting like a cat. Be solitary in your investing decisions. Don’t discuss what you are doing in the market with anyone. Chances are, whatever they say to you will only introduce doubt into your mind and doubt is the devil, instead draw upon your own hard experience that you have accumulated over the years. When you lose money in the market it is a hard lesson but it is a lesson learned well. That will be one of your most important resources.

Life Cycles of Companies...Growth Companies (Small and Mid Caps)

Life Cycles of Companies...Growth Companies (Small and Mid Caps)

Along with the dividend growers, this is my favourite part of the market to invest in. They can be a diverse group, the smaller growth companies while more established than the microcaps are still in the early stages of their growth and can display erratic metrics. Make sure their balance sheets are not too levered and insist upon positive cash flow from operations. One of the very best signs is when the management of these companies decides its stable enough to pay a dividend. This is a major capital allocation decision and management teams don’t make them lightly. The institution of a dividend is an indication that management is confident about the future prospects of their firm.

The midecap growth companies get more of their value from investments they expect to make in the future and less from investments they have already made. The value of their growth assets is both a function of how much growth is anticipated but also the quality of that growth. It is the return they make on the capital they have invested in their business. Remember our definition of return on invested capital (ROIC).

‘Return on invested capital is the return a corporation makes on every dollar of capital invested in the business (both equity and debt). Good companies will have ROICs in the mid teens. It is the ability of a company to create value. Value is created when a company's return on capital is greater than the cost of that capital. Over time the additional return on capital can be re-invested in the business to help accelerate its growth as an ongoing concern. It ties in closely with management's ability to allocate capital efficiently.’

ROIC is a key metric when measuring the growth potential of these companies as is senior management’s ability to allocate capital effectively in order to fund that growth in the future.

As these companies invest their excess capital in growth assets (intangible assets?) their free cash flow can be erratic. High one year, low the next or even negative. In this case it pays to track their cash flow from operations, which is the cash that flows in and out of the business as it relates to the operations of the company. It should be steady and growing.

Look for firms that can maintain their operating margins in the face of increased competition. Stay away from firms that trade off lower margins for higher growth. 

Scalable growth is best. As firms become larger, growth rates will decline. Look for companies that are able to diversify their product lines and cater to a wider customer base as they grow. Senior management's ability to allocate capital is vital. If you find me repeating this theme its only  because it is fundamental in judging profitable growth companies.  

Since markets incorporate  the value of growth assets and accountants do not  these companies will often trade much higher than their book values and speaking of book value it is a very good sign to see the book value per share of a company increase year after year. This is something that Buffet himself likes to see. It means the shareholder's value in the company is increasing over time.

An increasing dividend is one of the very best of signs.

Finally time is on your side with these companies. If they disappoint in delivering earnings the stock of the company will often be punished by short term orientated traders and sold off. That is the time to move in and buy it while its on sale. Buy right and sit tight.  


Resources

The Little Book of Valuation

Aswath Damodaran

Life Cycles of Companies...Young Growth Companies (Micro Caps)

Life Cycles of Companies...Young Growth Companies (Micro Caps)

Young growth companies usually range from start-up companies with little revenue and no earnings that are testing out the market for their products and second-stage companies that are moving on to profitability.

Most young growth companies tend to be privately owned and funded by their founder/owner who are usually backed by venture capitalists.

When these companies go public, they offer investors great profits if their potential is realized, but in turn present great risks as there is little operating history to go by. Expenses are associated with getting the business established, rather than generating revenues so they are usually operating at a loss. Many don’t make it and fail but the chance of  establishing a position early provides potential for great profit if the company takes off. An additional problem is the trading illiquidity of their stock as there is usually few number of shares traded (small float).

Further uncertainties revolve around lack of revenue growth, missing target margins and the risk of key people leaving.  

To offset these risks investors should insist upon the following characteristics...

The company should be aiming for a large and growing  market to absorb their projected revenue growth. 

Profit margin targets should be met so that expenses can be contained. 

Access to capital is critical for these young firms so they should have large cash balances as well as some institutional sponsorship. 

Since key individuals and founders are critical to the success of the firm, there should be a solid bench to back up key personnel.

Finally the enterprise should have products that are difficult to replicate wheather that be through technology, patents or brand name marketing



Resources

The Little Book of Valuation

Aswath Damodaran

Shareholder Expectations, Low and Otherwise

Shareholder Expectations, Low and Otherwise

We’ve talked a lot about capital allocation and how it relates to the intrinsic value of the company. But not all management teams allocate their capital very well. Nor do they invest for the long term good of their firm. Some in fact do just the opposite and over time destroy shareholder value by putting more emphasis on meeting their earning projections for the upcoming quarter.

The financial industry is obsessed with short term performance. Fund managers are expected, at the very least, to match the performance of their peers (index hugging). In other words the industry mantra has become, “we can all go down together but I can’t let them go up without me”. This in turn has put a lot of pressure on the manage teams of individual companies to make their quarterly numbers. If they don't the stock of their company gets hammered. This has produced a lemming like response in the industry where investors (traders?) flock from one stock to another in the hope of superior price performance. 

A management team might cut funding for research and development so they can be assured of hitting their earning targets for the next quarter. The senior management team of another company may insist on not cutting funding for these same initiatives and see the stock of their company punished and sold off when they miss their quarterly numbers. 

The result of all of all of this can feed on itself where the expectations of companies who constantly meet and beat their quarterly earning numbers are expected to keep performing the same way. This in turn puts a lot of pressure on management to make further cuts in their discretionary investing and even to misreport their numbers. Investor expectations can get raised to the point where when the company finally fails to meet it's numbers, it's stock can crash. Meanwhile at the firm where management misses their numbers but continue to invest for the long term, they can often surprise to the upside and smash their expected low numbers when their long term initiatives finally bear fruit.

The moral of the story is invest in companies who invest in themselves. Invest for the long term and invest in companies who invest for the long term. When you invest for the long term you will make fewer investment decisions and that can only be a good thing.

Intangible Assets and Capital Allocation

Intangible Assets and Capital Allocation

Capital expenditures are the amount of  money a company invests into its operations to sustain and grow its business. It can be divided into two separate areas.

Maintenance expenditures are made to maintain the company’s current operations. They are the ordinary operating expenses a company inccurs to sustain its business. They tend to be fairly predictable in nature.

Growth expenditures are not necessary to the current operation of the company but are made to help grow the business in the future. (read intangible assets). Growth Capex then, is the deployment of capital for the purposes of generating organic growth. It is discretionary spending that will demonstrate senior management's ability to invest for the future growth of the business.

Since it can be difficult to breakdown a companies capital expenditures, Its often best to just focus on the way senior management are allocating their discretionary capital.

Management is usually thinking strategically when they make investing decisions involving their advertising and marketing budgets thus increasing the companies scope and influence in their industry. Research and development spending often mean sacrificing the street's quarterly earning targets in return for increased revenue growth in the future. Putting money aside for major merger and acquisitions targets can alter the strategic direction of a firm and enhance investor return in the long run. Share repurchase and dividend decisions again involve thinking in terms of years instead of months (quarterly earnings). Good luck finding any of these intangible assets on the balance sheet.

Capital spending in R&D as a percentage of sales, is increasing every year reflecting the shift in the underlying economy. M&A is the largest use of capital period. This isn't monopoly money we're talking about. The capital allocation skills of senior management is crucial to the long term success of the firm.

The capital allocation ability of management can be further observed by reading the bios of senior management. How have they handled managing investments in the past?  Effective capital allocation involves a different skill set than what is required from operating the company on day to day basis. If management is allocating capital effectively they will be incentivized to own significant portions of their own companies stock. Check the proxy statement. Incentives should be built into the option packages that reward long term performing metrics.

The New Economy and Intangible Assets

The New Economy and Intangible Assets

The Nation’s economy has changed a lot over the last 50 years. Half a century ago, our biggest companies extracted coal from the earth and forged I-beams in blast furnaces. Today, the prime creators of wealth for many firms are brands, patents, customer service, licensing agreements, distribution routes, intellectual property, innovative technology and even imagination. All of these are “intangible growth-producing initiatives that didn’t exist years ago.

Traditional accrual accounting treats investments made in these "intangible assets" as operating expenses (expenses that generate benefits only in the current year) whereas a manufacturing firm who put investments in plant, equipment and buildings is treated as a capital expense (expenses that create value over many years).

Accountants assume that the benefit made in investing in research and development (technology, pharmaceutical firms), brand name advertising (consumer companies) and training and recruiting (consulting firms) are too uncertain to project into the future so they are treated as operating expenses. Because of this earnings, cash flows and capital expenditures tend to be understated in these "new economy" companies.

The traditional accounting measures of book value, earnings and capital expenditures can be misleading when applied to firms with intangible assets. These intangible assets are rarely valued properly on the balance sheet as the standardization of financial statements does not allow for the recognition of these vital growth inducing initiatives. It's important to remember that investing in a company involves much more than just reading their numbers; it is also about going beyond the numbers and trying to get a sense of the real company.

This area is fertile ground for the intuitive investor who reads the annual report and begins to feel things that go beyond the reported numbers. This is where the narrative of the company comes into play (business model, industry structure, capital allocation history of management. 

The Price you Pay

The Price you Pay

Look for safety in the price you pay

Marty Whitman


We've talked a lot about concentrating on the underlying value of a stock as opposed to its selling price. When the markets tank people are concerned about selling off their assets and fleeing for cover. Having said that, the price you pay for an asset is important. Why? Because it ties in closely with having a "Margin of Safety". https://nivag18.blogspot.ca/2016/04/normal-0-false-false-false_8.html

If you pay a low price for an asset you will be better equipped to shield yourself from the emotions of the market when it goes haywire and sells off. Because your original cost base is low you will be mentally and emotionally more secure with the asset you hold even if it goes down in price. This is an important psychological point. You can be a master at analyzing a company's fundamentals. A whiz at technical analysis and reading the charts of the companies you hold, but if you are not psychologically squared away, none of it will matter.

It pays to be a patient, disciplined  investor, waiting to get the price you want for an asset. Think of a cat waiting in the bush for just the right moment to ponce on its prey. Now think of a dog who sees a squirrel. The dog will run blindly ahead with no hope of catching the squirrel. When it comes to investing in the stock market, act like a cat, not a dog.

Now nothing in life is straight forward and that applies to the stock market as well. If there is an exception to the above rule it might be the company that has great metrics and allocates their capital so efficiently that it never sells off much even when the market goes down. These companies (often referred to as quality growth companies) are rare but if the business is attractive enough you might want to pay up for it. This is especially true with companies whose management allocates their capital effectively. It takes good judgement to transverse these waters. Good judgement comes from experience which comes from bad judgement. So for most investors it will be a work in progress.


Good investing will always be more of an art form than a science no matter what the quants might say.





 

The Madness of Crowds 2

The Madness of Crowds 2

So what’s wrong with selling off my positions if the market is tanking? Well, quite often you will find yourself selling out at very the bottom. Such is the pernicious nature of the stock market. It seems to have a life all its own where its sole function is to seek out our character weaknesses and feed off of them. It reaches a point where everybody gives up at once because they just can’t stand it anymore. It’s called capitulation, when everybody who is going to sell has already sold to the point where the tiniest bit of buying pressure pushes stocks up in price. The shell shocked public remains on the sidelines still trying to piece together what’s left of their shattered psyches. Next thing you know the market surges up and the stocks you once held in your portfolio have gotten away from you.

Remember why you bought your stocks in the first place. I’ll repeat part of the first paragraph of my last post…

'Okay, you've done your trend analysis on the essential metrics of a company. You've read and studied their business model and their competitive position within the industry in which they operate. You have studied the results of the way management allocates its excess capital.  You have patiently waited to buy the stock of this company when the marketplace put it up on sale. You have repeated this process over time and have bought several other stocks to build up an attractive, diversified investment portfolio filled with productive assets bought at reasonable prices. You've done everything right and feel good because although not all of your holdings have worked out, on the whole your investment portfolio has performed well and you are making good money.'

The price of a stock or a market of stocks in the short term is dependent  on the supply and demand of capital which in turn is influenced by how investors feel at the time. The price of a stock or a market of stocks in the long term is dependent on their intrinsic value (the present value of their future cash flows).

To make money in the stock market, think like a capital allocator, focus on the long term. Take advantage of the short term nature of other investors and buy their stocks when they are selling them off at a discount to what they are worth. 

The Madness of Crowds

The Madness of Crowds

When you are as old as I am and you’ve been through as many booms and panics as I have, you’ll know that to lose your position is something nobody can afford; not even John D. Rockefeller.

Elmer Harwood

Okay, you've done your trend analysis on the essential metrics of a company. You've read and studied their business model and their competitive position within the industry in which they operate. You have studied the results of the way management allocates its excess capital.  You have patiently waited to buy the stock of this company when the marketplace put it up on sale. You have repeated this process over time and have bought several other stocks to build up an attractive, diversified investment portfolio filled with productive assets bought at reasonable prices. You've done everything right and feel good because although not all of your holdings have worked out, on the whole your investment portfolio has performed well and you are making good money. 

Then, it happens, the stock market breaks and heads sharply lower. You know this happens every once in awhile and your confident that although your portfolio is taking a hit you have you the good sense and experience to hold onto your positions. The market rallies but begins to flag once more. It sells off again but its sharper this time and people begin to break and head for the exits. You don't like it but you've seen this before and hang onto your holdings. Then the market caves in bringing out the forced sellers who have to liquidate their assets to meet margin calls. Everyone heads out the door at the same time and panic reins in the streets of the stock market. You see the money you've invested in your stocks disappear fast. Another flagging rally and the market heads lower again. You're down maybe 20 or 25 percent from the top. What do you do? You tell me you hang on of course. But this is just a theoretical exercise. You are comfortably sitting at home reading this. What if it really happens and there is blood in the streets.

There are powerful psychological and biological forces that govern human behavior. This is accentuated in large crowds of people where their innate animal impulses are multiplied and feed off of one another. Remember if we create our own reality, http://nivag18.blogspot.ca/2017/03/

then a crowd will do the same if only because it will have the energy of everybody in that crowd fueling it. The careful, deliberate, civilized individual gives way to the animal cravings of the beast that lives in the heart of every crowd.

When the stock market plunges, the need for relief from anxiety creates such a strong pull that everyone will be driven to liquidate their holdings at the same time, so they can survive, like the drowning man who will reach out to grab anything to save himself.

It's important to bear these things in mind before they happen and to set up some sort of safety mechanism to save yourself from yourself when there is blood in the streets. One way to do it is as follows...http://nivag18.blogspot.ca/2017/04/normal-0-false-false-false_98.html

Invest in What’s in Front of you: Capital Allocation

Invest in What’s in Front of you: Capital Allocation

Management’s ability to allocate capital productively is probably the most underrated subject in all of investing. It is management's most important function. Capital allocation is what the management team does with the free cash flow the business generates. If it is invested efficiently the return on invested capital will over time, stay up in the mid teens or even higher. If management is fulfilling this responsibility a dollar invested in the business will be worth more than a dollar invested in the market. This means that the present value of the long term cash flow from an investment exceeds its initial cost. The proper goal of capital allocation is to build long-term value per share.

A company can choose to  allocate capital in the following ways...capital expenditures for growth, (research and development, mergers and acquisitions and advertising and promotion) or they can distribute cash to the shareholders through dividends and share buybacks.

The best way to determine if managers are good at allocating capital is to review the results of their past decisions. The best capital allocators are good and patient stewards of the shareholder's assets and often own shares in the company aligning themselves with their shareholders. They think and act like long term owners of the business. They gear both their strategic and tactical decisions toward maximizing the long-term intrinsic value of the business, even if it means forgoing lucrative short-term financial rewards or incurring the displeasure of the short-term-orientated analysts on wall street. It takes strong leadership to sacrifice near-term earning to make prudent investments that will enhance the company's long-term competitive position. In contrast, a management team that obsesses over quarterly earnings probably has something other than enhancing long-term shareholder value in mind, they are more likely to be interested on hitting their short-term numbers that have been written into the options they hold. Always check the proxy statement to see if the options held by management reward short-term incentives rather than the long-term.

I'll be writing about free cash flow, return on invested capital and capital allocation in future posts as I think they are the three most important things in investing. And remember invest with what is in front of you and don't try to predict anything. Concentrate on your process and the outcome will look after itself.  

Invest in What’s in Front of you: The Business Model

Invest in What’s in Front of you: The Business Model


The two basic questions to ask yourself when first reading about a companies business model is…What does it really do, and how does it make money?

To understand how a business operates, read the business description found in the annual report. If you find this too daunting a task, go to their website and poke around there. A good company who wants to attract investors should make their information transparent, understandable and easy to access.

What products and services are being offered? 
Who are the customers the business is offering their products and services too?
What specific customer needs are being filled by the products and services the business is offering?
How much do the customers depend on what the business offers?
How big and growing is that particular market?  
How many competitors are there in the companies targeted market?
How strong or entrenched are these competitors?
How does the business plan to make money from their product and service offerings?
How does the company plan to grow its business?
How does the company plan to control the costs of operating its business?
How much does the business depend on their own suppliers? 
What is the nature of the relationship the company has with its own suppliers?
How has the business evolved over time?

Answering these basic questions is always best. Remember to focus on the companies customers, competitors and suppliers. Keep things simple and clear. Understand the broad brushstrokes because the devil is in the details. And remember about the 'marginal utility of information'. Focus on the basics you need to know. Use your intuition. How does the description of the companies business model feel to you. Read the companies letter to the shareholders. Is it easy to understand? Does it leave you with any particular impression?

Read Management's Discussion & Analysis (M,D&A) of their business. There you will find disclosures regarding recent developments, trends, products, competition, and financial position of the company you’re interested in. There are legal filing requirements that management must adhere too, so they’re much more apt to be honest and deliberate in their discussion of the companies’ prospects than they are in the media.

Invest in What’s in Front of you: Important Metrics

Invest in What’s in Front of you: Important Metrics

As a follow up to my previous post I want to say that I try to invest in what’s in front of me. When I wrote about “the marginal utility of information” awhile ago I listed seven things I look at when I’m investigating a company. Four of the items were financial metrics (revenue, free cash flow, return on invested capital and operating margin) while the other three were about placing those numbers in the specific context of the companies business model, the industry structure the company operates in as well as the capital allocation ability of its management. All of this information is available in the companies annual report. The Morningstar website is a good source of this information as well, especially for the financial numbers of a company.

Let's break down the financial metrics one at a time. One thing I should mention. You should always look at the numbers over a period of years. This is referred to as trend analysis. You want the numbers to steadily increase over time and if they don't you want to read about the companies operating history to find out why? You may even have to refer to previous annual reports...sorry.

Revenue represents the cash and promises to pay from customers for either services provided or goods delivered over the past year or quarter. It indicates how much business the company is actually doing. You want to see revenues grow over time as this is the engine for the company to grow and prosper as an ongoing business.

Free cash flow is what is left over after the company has paid all it's bill and expenses. They can raise the dividend, pay down debt, make acquisitions, buy back shares, invest in research and development and/or hire new and skilled employees. It is the ability of a company to self-fund making them less reliant on debt and raising additional equity. It makes them more self reliant. If the corporation's ongoing operations are consuming more cash  than they produce it makes them more vulnerable to their creditors and places them at a competitive disadvantage to other companies in their industry.

Return on invested capital is the return a corporation makes on every dollar of capital invested in the business (both equity and debt). Good companies will have ROICs in the mid teens. It is the ability of a company to create value. Value is created when a company's  return on capital is greater than the cost of that capital. Over time the additional return on capital can be re-invested in the business to help accelerate it's growth as an ongoing concern. It ties in closely with management's ability to allocate capital efficiently.

Operating Margin reflects how well a company can control its costs. the higher the margins, the better the cost containment and the higher the profits will be. It indicates how well a company is running its entire business from an operational standpoint.

Taken together theses metrics will indicate which companies are operating more efficiently for the benefit of their shareholders. The CFOs of these corporations will have the financial flexibility to build the company over time by increasing dividends, investing in R&D (constant innovation helps keep them ahead of their rivals) and make strategic mergers and acquisitions (helping the company to grow its market share and pricing power).

As everybody has access to these numbers you will often find the stocks of these companies priced to perfection. Sometimes its worth investing in them anyway but it often makes more sense to wait for a decline in the entire market. The forced selling that occurs during that time can put these stocks temporarily on sale for the value investor to take advantage of. Another investing opportunity can occur  when a good company misses it quarterly numbers causing its stock price to be punished and driven down. A small cap company can sometimes have these good metrics and be overlooked just because of it's size offering the investor another chance to buy an under valued asset.

In my next post I will finish up with the three remaining items that place the financial metrics of a company within the context of a companies business model etc.....whew.

There is no future in making Predictions

There is no future in making Predictions

Or following the predictions of others, I may add. Like the kid in the candy store who just wants to grab, the average investor wants to know what is going to happen in the unknowable future and the financial media knows it. So in their own self-interest of increasing their audience (advertising dollars) they feed this demand with a never ending supply of predictions. Short term, medium term and long term, it doesn’t matter as long as it’s a forecast.

The predictions are never followed up on, because there are too many future forecasts waiting in the wings. Of course they are almost always wrong but it doesn’t matter. So insatiable is the public’s appetite for these prognostications they don’t care about the result, they only want more of them. It’s really a fascinating  social phenomenon. Sure some forecasts turn out to be accurate but its just randomness. Like the economist who predicted 7 out of the last 3 recessions.

Then there are the predictions an individual makes for himself. Welcome to the land of 'confirmation bias'. The investor will only read or agree with opinions that are in unison with his own ignoring anything that counters his point of view. This is largely because of the investor's ego which wants to be proven right so it can thumb its nose to the rest of the world. Beware the ego, the market will  feed on its foibles and will eventually crush it. Be humble and dispassionate if you can and make no predictions about anything because part of your ego will always be attached to it.

Well wait a minute I hear you say. What about investing in a growth stock? Don't some investors run a 'Discounted cash flow' analysis to get a handle on the future cash flows of a company? I've never done this but from what I've read there are so many variables that go into the process that it ends up being like the Hubble telescope, you turn it a fraction of an inch and you're in a different galaxy.

Many investors are numbers orientated and approach investing from a left brain point of view (deductive). They are prone to believe in the precision of their numbers and make forecasts thereof. I approach investing more from the right side of my brain (inductive). I'm not a numbers guy but you can't invest without using them. I'm just saying I look at numbers to put me in the ballpark, not into my seat.

Making sense of Market Cap and the Value/Growth Dichotomy

Making sense of Market Cap and the Value/Growth Dichotomy

The market capitalization is the total value of the company based on the current stock price and number of shares outstanding:

Market cap = shares outstanding times Price

The financial industry usually divides them up as below…

Micro cap.................under 150 million

Small cap……....…..under $1 billion

Mid cap…………...$1 billion to $5 billion

Large cap………....$5 billion to $100 billion

Mega Large cap…..over $100 billion

This is a convenient way to get the lay of the land  but always remember to check the revenue line (the amount of business a company actually does). Micro caps are of course very speculative and can very easily fail but if you can catch one, the rewards can be lucrative. A more conservative investor might exclude them from consideration and focus instead on the small cap sector of the market. Even then he wouldn't want to take on positions too big as they can be risky as well. Some of that risk can be mitigated by insisting on conservative balance sheets and positive operational cash flow.

My favorite sector of the market to invest in is the mid cap sector where you can get the growth potential of the small caps along with the stability of the large caps. Larger caps usually have slower growth and are the domain of resource conversion activities.

In addition companies are further categorized as growth and/or value, so you might have one stock considered as small cap value while another might be called mid cap  growth. Blame it all on the box-checking consultants who are spawned out by the banks and insurance companies. This polarization of stocks into growth and value is nonsense. The true value investor aims not to buy stocks which are cheap on some accounting measure (p/e, price to book…etc) but to avoid investing in those stocks which are expensive using those same metrics. He is ultimately looking for investments trading at low prices relative to the estimate of their intrinsic value (the future value of cash flows discounted to the present). Buffet himself has said that growth and value are joined at the hip.

It’s Difficult to create value without growing, unless there is some chance of  resource conversion  going on, but that usually is the realm of the large caps and you have to dig to find it. A lot depends on the perception of the investor; one person’s growth stock could be another person’s value stock.

Investment style labeling is just dumb. Just concentrate on whether the market is efficiently valuing the future cash flows of the company you’re investigating.

Marginal Utility of Information

Marginal Utility of Information

Informational Utility is the benefit an investor derives from uncovering information about a stock. This information largely comes from reading the annual report of a company. The information can be broken down in two ways, numerical (financial metrics) and narrative (the story of the stock).

Marginal utility is a lessening of the value of additional information. I would go further and suggest that too much information can be counter productive and actually harmful to your investment results, but it largely depends on your mindset and the way you approach a stock as an investment.

Peter Lynch once opined, “Never invest in any idea you can’t illustrate with a crayon.”, While Warren Buffet and Charley Munger have said that the riskiest thing you can do in the stock market is invest in something you don’t know a lot about. If you hold very few stocks in your portfolio (less than say eight) you might want to follow the Buffet/Munger model. If you hold more than say 10 stocks I would go with Peter Lynch’s advice.

I have about 17 stocks in my portfolio, over time I would like to reduce that number but my point is if you have a lot of stocks in your investment portfolio, you will probably suffer from the marginal utility of information and not be able to see the forest for the trees.

Bearing that in mind lets say you only want to focus in on the absolute essential investing information. Considering that mindset I propose the following parameters on how to approach the available information about a company’s stock. This approach will lend itself to investing in the mid to large cap area of the market.

Financial Metrics…
Revenue Growth…Free Cash Flow…Return on Invested Capital…Operating Margin.

The Story of the Stock…
Business Model…Industry Structure…Capital Allocation ability of Management.

I will expand on these pieces of information in future posts. Hey, maybe I should have written all this out with a crayon.

Dear Investment Portfolio

Dear Investment Portfolio

Dear Investment Portfolio, we’ve been together awhile now, almost 10 years. A lot of stocks have come and gone during that time leaving their inevitable impressions. Some I should have never sold while others should not have been bought in the first place. But that is how you and the market have taught me. I had to go through those hard lessons in order to grow and develop into the investor I am today. That’s not say I have reached the summit of market knowledge. I’m sure there they will be further lessons to absorb in the future. The investing experience is really a work in progress.

I have seen you bob up and down on the surface of the market as I recorded your weekly values over time. And with those ups and downs I have learned how to compose myself during the storms that can come and go in the marketplace.

You have taught me that you are really just an extension of myself…no its more than that, you are a projection of what is going on inside of me and a way of keeping score so that I can keep track of what I have learned so far.

You are unique because there is no one else quite like you out there. Maybe more than anything else you have taught me the value of extending my time frames and spreading my risk.

You are something I have created, and over time I have seen you develop a faith in myself and the universe that in the long run everything will be okay.

Hedging

Hedging

Hedging is an attempt to protect your investment positions by making a counterbalancing investment within your portfolio. Why do I mention that at this time?

One of the jobs of an investor is to evaluate the current state of the market environment. Most of the time there is nothing to be concerned about. But every once in awhile the risk of a market sell-off becomes elevated and an investor would be wise to hedge his positions if for no other reason but to protect himself from himself psychologically. A violent market selloff can be a scary thing and will tempt the individual investor to run with the herd and head for the exits. Hedging your investments ahead of time is a way to protect yourself against this before it happens.

I keep track of the momentum of the breadth of the NYSE market (advancing  - declining volume) on a daily basis and smooth this data with various moving averages. I then subtract the longer moving average from the shorter one and this produces a trend deviation indicator (a form of market momentum). I use this to help me gauge the internal trend of the market. Both the direction and level of this indicator are of equal importance.

At this moment in time (April 9 2017) the underlying market is seriously deteriorating (money is flowing out of the market). It’s been going on for awhile. I feel a sell-off is eminent. Two weeks ago I bought an ETF that shorts the Russel 2000 index (it trades on the NYSE). It is a non-levered ETF that re-balances once a year so it is safe to use. Its symbol is RWM. I bought it a couple of weeks ago and have added to it since.

This is a way of managing my risk when I feel that the risk in the marketplace has become too elevated. It has nothing to do with predicting the future and is not a forecast.

Shareholder Base

Shareholder Base

We are often looking for broken growth stories, when a once-great company is no longer considered to be great. The market tends to overreact in these cases, as growth and momentum investors move on to the next thing and the shareholder base turns. Since I wasn’t in the stock before, I’m not disappointed if something is no longer a high-flier. All I care about is the future potential relative to what I have to pay for it

Alan Schram, WellCap Partners

Most of the time we’re picking up the pieces after a high-growth company hits the wall at 80 miles per hour, having made at least one too many investments to try to sustain an unsustainable growth rate. Public markets can actually conspire to screw companies up. When you’re growing fast, you get this big p/e and pretty soon you have all the wrong investors with ridiculous expectations and do things contrary to shareholder value.

Jeffrey Ubben, ValueAct Capital

Shareholder base…now there is a subject not too many investors think about. It’s probably more important to the holders of smaller growth orientated firms but its something every investor should be more aware of.

Over the last 35 years or so, the marketplace has become largely institutionalized. The retail investor is in the small minority (a minority I’m proud to be a member of). Institutions (pensions and mutual funds) have an established law or belief system that makes them a power onto them selves. They often say one thing (we are here to serve you) but have hidden agendas (we are here to serve ourselves). Behavior which would be looked down upon in an individual is accepted practice in the world of institutions. These same institutions have brainwashed the investing public into believing the myth that handling their own financial affairs is too complicated and risky. So over time they have come to dominate the investing landscape.

These institutions are in the business of growing assets under management. In order to achieve this they continually try to attract new money by trying to out perform the market on a quarterly basis. This puts an emphasis on short term performance. If the quarterly numbers are not met fund managers could lose their jobs. They have bills to pay and kids to put through university just like everybody else so there is a tendency to do the safe thing. To buy stocks when the market is going up and sell them when the market is going down. “We can all go down together, but I can’t let them go up without me”. Needless to say this does not help their long term performance as it guarantees mediocrity. Another problem is if their funds under management get too big they basically become the market (shadow indexers). Another problem with expanding size is the growth of investment committees where everything needs to be vetted out resulting in further mediocrity. Good long term investing is a solitary game.

The implications of all of this, is that it spills over to the equities they hold in their funds. If a CEO’s company fails to meet his quarterly numbers these institutions dump the stock and move on to the next hot thing. The price of the stock becomes the thing, not the intrinsic value of it.  The result of all of this is a market dominated by short term performance with many CEO’s striving to meet their quarterly numbers at the expense of long term value creation (cutting R&D and advertising budgets). The strong CEO’s who put an emphasis on the long term fundamentals of their companies often see their stock punished and driven down by the lemming like behaviour of these institutions. The media has bought into this game as well as they too put an emphasis on the short term results of the marketplace.

Keep all of this in mind the next time you see a stock you hold beaten down for missing their numbers. 

Now that I have that off my chest lets talk about the minority, the long term value investors. The funds they run have low portfolio turnover as they hold their positions for a long time (years instead of months). They perform due diligence of a company by studying the business Model, the industry structure the company is in and the capital allocation ability of the management. They are concerned with the intrinsic value of a company (the present value of all the cash it will generate in the future). If you are looking for investment ideas these are the people to keep track of and they are the type of shareholders you want holding the same stocks you hold yourself.

Don't let the financial industry or the press take your power away from you. Investing for yourself can be an empowering experience.