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.