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.

 

Price versus Value

Price versus Value

The following is an excerpt from one of Bruce Flatt’s letters to the shareholders. Bruce Flatt is the CEO of Brookfield Asset Management. In it he explains how his team at Brookfield handle the investor problem of weighing the price of an asset against its intrinsic value. By the way in stead of reading and being manipulated by the mainstream media, a good idea is to read what the CEO’s of good companies actually have to say about the businesses they run. You will find the reading far more valuable and insightful.

‘Value investing is, in essence, the arbitrage between “Price” and “Value.” The goal of a value investor is to arbitrage price differentials between the Price put on assets, whether that be in the public or private market, and the Value of those assets. Unlike classic arbitrage, however, value investing is not risk free, and profits are not instantaneous or certain. And while simple to understand, it takes years to develop the discipline, patience and judgment required to successfully implement a value investing strategy.

We are great believers that over the longer term, the Price of a security will equal its Value. However, in the short term, for many reasons, Price often does not equal Value. Investors in the stock market, of course, have a daily mechanism to determine the Price of assets which are quoted. For private investments, the Price is not quoted daily, but is influenced heavily by the supply and demand of capital.

Price is more difficult to ascertain in the private markets – particularly during periods of market volatility, and it can be higher or lower than long-term values. This is usually dependent on the supply and demand of capital, which is in turn influenced by investor attitudes. In robust markets, there is generally more capital than there are assets. This forces the Price higher, even to the point where it exceeds Value. In stressed markets, if a sale is necessary, the Price can be much lower than Value. The 20% post-Brexit mark-downs offered to retail investors in UK property funds for liquidity is an example of this.

Inversely, we are often asked how it is that we are able sell assets above our IFRS values. The answer usually lies in the fact that we only try to sell assets in robust capital environments, catching the window where Price is greater than our view of Value.

In summary, Price is merely a function of the supply and demand characteristics for capital that is looking to be invested in a sector of the market, or in a specific asset or stock. Price is often influenced by topical news of the day, market sentiment, availability of capital, and other factors that may or may not have any relevance to the Value of a specific security.

Value, on the other hand, is the net present value of the future cash flows of a business or asset, based on assumptions for future growth and discounted at the appropriate risk rate for that particular investment strategy. The difficulty in ascertaining Value is that there is no absolute value for anything, so there will always be a wide range of views over an asset’s growth profile and the appropriate discount rate. The experience and discipline we have in determining these factors for real assets is one of the key attributes of our franchise’

Resource Conversion

Resource Conversion

          One exercise we go through on all our most interesting ideas is what we call balance-sheet optimization. It’s our term for debt recap. What can management do, fully under its control, with the capital structure to create value? Use Microsoft as an example. It has $60 billion of cash on hand, very little debt and throws off something like $30 billion in free cash flow per year. The equity has been trading at 8 to 10 times earnings and the company can issue debt at less than 3.5%, so there’s a huge difference between the cost of debt and the cost of equity. As an exercise, what would happen if it went to a net $60 billion debt position? Given the free cash flow, that’s still a modest capital structure. They take the $120 billion in cash proceeds and buy back a significant amount of their equity. With a lowered cost of capital and shares outstanding cut in half, if we run that through our cash-flow model – assuming no growth – we come up with a share value in the low to mid $40s, versus around $28 today.

          We look at this as our downside protection and also as a way to distinguish our analysis. It’s difficult to out-predict the Street consistently on Microsoft’s growth over the next five years, but very few analysts focus on value creation through the capital structure, so it can provide us with a different perspective on how to value the stock.

         

          Stephen Goddard, The London Company

Welcome to the world of corporate events. I was introduced to this world by reading Marty Whitman, the founder of Third Avenue Management. He wrote that there are more ways to create shareholder value other than focusing on the operational side of a company. In other words everything you have read so far in this blog pertains to the company as an ongoing concern. According to Whitman a company can create value through corporate restructuring by engaging in mergers, acquisitions, spinoffs, buyouts, recapitalizations, liquidations, changes of control, and other activities that generate wealth by putting a companies resources to other uses.

Now this is all fascinating stuff for sure but unfortunately Whitman can’t write to save his life. Reading him for the first time was a somewhat dirge-like experience but what he writes about is so important you should make the effort to familiarize yourself with him. Luckily for me along came Joel Greenblatt with his ‘You Can Be a Stock Market Genius’, a truly great book on investing in the stock market. What Whitman described as resource conversion Greenblatt referred to as corporate events. If you choose to investigate this area of investing I suggest you start with Greenblatt’s book. It’s a much easier and fun read. After I read Greenblatt’s book I went back and tried to read Whitman again.

Under this approach the quality and quantity of a companies assets, become an important factor both in valuing the company along with considering its growth prospects. This is especially important when dealing with larger more established companies.

To gain insight into valuing this type of company an investor must look beyond the company as an ongoing concern (operational earnings) and consider the potential of a company redeploying its assets in mergers, acquisitions, spinoffs and liquidations. A company can also act as financiers when they decide to go private, incur debt and distribute cash to their shareholders.

Consider Brookfield Asset Management as an example how a company can manage its assets to enhance shareholder return…

They obtain equity from clients looking to invest in real assets, then use the company’s global reach to acquire distressed but high quality assets. They do this when capital is scarce and the assets they seek are generally on the market below their replacement value. They then finance those assets on a long-term and low-risk basis. They further enhance the cash flows and values of those assets through their leading operating platforms.

Needless to say I own several of Brookfield’s subsiduaries.

The Gods and Goddesses of Investing and Trading

The Gods and Goddesses of Investing and Trading

I’ve been at this now for almost a month and my time is almost up. I hope I haven’t over stepped myself. I mean who am I to advise, or lecture other people about investing in the stock market. Nobody died and left me the book of knowledge. I hope the Gods and Goddesses of Investing and trading don’t feel compelled to strike me down with a thunderbolt of randomness.

The object of starting this blog was to put down in writing my investment philosophy, to make it tangible, to put it down in writing where it will exist outside of my own head. If other people can find some benefit in what I have written, I think that is a good thing. I’m still learning as I go along. I don’t think you ever stop learning. What I have written in these blogs about investing is what I have learned so far in this journey.

So to recap allow me to go over the main tenants of my approach as I’ve developed them so far. Below is my basic strategic framework for dealing with investing in the stock market. These topics can be found in my first five posts.

1)     Psychology  (what’s going on inside your own head)

2)     Current Market Environment  (what's going on inside the market's head)

3)     Stock Selection

4)     Portfolio Management

The personal Balance Sheet (see post on April 17) involves the tactics used to meet your investment goals which are listed below.

Liabilities…Psychology

Assets…….Margin of Safety

                    Risk Management

                    Wager Value

I don’t want to beat a dead horse but your biggest enemy in investing is yourself (the media is a close second). So it pays to know your self, or to at least make an attempt to know yourself. Try to examine your basic or hidden motivations for wanting to make money in the stock market. And remember the Gods and Goddesses of Investing and trading have to be soothed and appeased so when things are going well stay within yourself. Be humble and be thankful.

Tomorrow I will post a bookmark for everything I have posted this month to make for easier reference both for myself and whomever would like to read what I have written in this blog. I've enjoyed the experience of writing this blog but the urge to write is flagging. I might post further entries in the future. I guess it depends on whether I feel I have anything notable to say. Thanks for listening.

T

Thoughts on Creating an Investment Portfolio

Thoughts on Creating an Investment Portfolio

Sometimes I look with wonder on my investment portfolio. I created it. It came out of me and is an extension of myself. It represents my opinion as opposed to the opinion of others. It is a part of me. I look at it bobbing and weaving up and down everyday like a cork floating on a great ocean. I shouldn’t look at it everyday but I do. Every weekend I record how my portfolio did for the week. I love the markets and have integrated them into my lifestyle. But that’s me. Everybody will be different. Many people will recommend that you should for the most part ignore it. That’s probably good advice but in the end you will have to hone your own investment style from everything you have read and experienced in the market.

I hold three limited partnerships from Brookfield over here and over there a have several smaller growth companies. I’ve got some solid mid cap growth firms and some pharma stocks. In all I hold 22 positions but not equally weighted. I plan on reducing that number in the future. I usually hold little cash in my portfolio. It would have been nice to have it on hand during this last market correction but you learn as you go along. The thing I really like about my portfolio is that I know I have my money invested in productive assets based on my own judgement and experience. I think that sets me apart from most other people and I like that idea.

There are many roads to Rome when it comes to investing. Everything I have talked about so far represents my basic investment philosophy, my investment policy. But it doesn’t have to be yours. If you are interested in investing for yourself, I encourage you to read about it first and when you feel you are ready to test the waters, start small and get use to the idea of having some of your money at risk in the market.