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June 19, 2014

INCH WIDE, MILE DEEP

HOW TO RESEARCH A BUSINESS:

I begin my research into an industry with a prominent company 10K.  The Annual Report, or 10K, is filed with the SEC and is signed off by the CEO and CFO as truthful and compete.  In effect, they are signing that the information in the 10K is all you will need to understand this company including its business, marketing, competitors, risks, market position (Moat) and its financials.  If the information is incomplete in some material way ... that is if a missing piece of info might have misled me as to the quality of the company ... or if information is wrong, the CEO can go to jail. 

 

Read the ‘Business’ section of the 10K; its only a page or two and it should give you a good idea about what this business is all about.  Now, before you even get going on digging into the 10K, reflect for a bit on whether this business is right for you to own.  You now know something about it so decide if you think  you’d love owning this business.  Do you love the products or services?  Would you be proud to own the company?  Would your family be proud to have their names associated with this business?  Would you be happy to change the company name to your name?  Does it fit your values?  Do you want these products in the world in twenty years?

 

Those are tough questions for some people when it comes to some industries.  Let’s take the oil industry for example; people who believe burning oil and gas is a detriment to the environment and that oil should be replaced at all costs with renewable, clean energy may not be interested in owning an oil company.  That’s a values question and only they can answer it.  For me, owning an oil company is something I’m proud of.  I love flying in jets, driving my car, hauling my horses, heating and air conditioning the house, turning on the lights, using the internet, watching TV, living in a nation with no real poverty and none of that would be possible without oil.  Yes, I’d love it even more if I could do all those things using electric engines or solar engines or hydro engines or whatever other clean energy source we can evolve into but for now and the foreseeable future, if the world didn’t have oil, not only would my cushy life be a lot less cushy but its highly likely we’d be in a world war so fast we wouldn’t know what hit us and last time I checked, the last world war was worse for the health of about 80 million people than smog.  Those are my values and I’m voting with my money.  You should vote your values with your money and you start figuring out how to do that by reading 10Ks.

 

Start with any prominent company but immediately try to get to the best company in the industry.  Most 10Ks will have a section on Competition.  Use that to figure out who else to read about.  Or just go to ruleoneinveseting.com, put in the symbol of the company you’re starting with, click on the drop down menu and click on Peers.  The Peers page will show you all the companies in that sub-industry and give you a quick look at the Rule #1 Scores for the top companies.  Pick who you think is best and then dig in.

 

Read the 10k’s from most recent back to the oldest.  You start with the last fiscal year’s 10k because you want to learn the business, as it is today, not how it was 10 years ago.   Once you’ve read it and you dug into the numbers and understand them, at least to a degree of competence, then, before you go back to the previous year’s 10K, go over to the company’s website and listen to the last quarter’s analyst report.  Between the two, you’re looking to get an overview of the business and a sense of who the CEO is and how he communicates with you about this company.

 

Here’s the key thing about the 10K and the live quarterly analyst report; they should make it easy to understand the business.  If they make it hard to understand either they don’t understand it or it’s too complicated to invest in or they are intentionally making it hard so they can cover up problems.  All three of those are good reasons to move on.  Don’t mess with ‘complicated’; find a business run by people who understand it and who are honest about explaining what’s going on.  And never feel like not getting it is your problem.  It isn’t.  Investing is never about being a lot smarter than other people.  If that were the case, all those fund managers who can’t beat the market would be killing it and many of my students would still be broke. 

 

Investing (as opposed to speculating) starts with understanding a few things well and sticking to those things.  Warren Buffett calls that notion his ‘circle of competence’.    Part of this process of reading and listening is about figuring out the industries in the market that you’re going to become an expert in.  I tell my students I want them to be an inch wide and a mile deep when they first start out.

 

What you’re looking for is a simple business to understand and one that doesn’t have to change its product much.  Is Apple is going to have the best phone in 10 years?  Who knows if we’ll even be using iPhones?  But is Exxon going to be producing oil in 10 years?  Yes, they will be.  Oil is a good product to research because it’s not going to change in the next decade. 

 

We’re also looking for the Moat.  A Moat is how this business keeps its profit margins with the other similar businesses trying to take over the market; this is critical in the oil patch because oil is a commodity, i.e., nobody cares whose oil it is.  Brand means nothing much to a consumer or refinery.  So what’s the Moat? What makes one company more durable than some other company?

 

The right Moat for a commodity business is Secrets and/or Price.  Do they know how to find oil better than anyone?  Can they get it to market cheaper than anyone?  You’re reading to determine that.  Here’s a clue what to look for: Higher profit margins than their competitors.  Look at CF Industries, for example.  They produce nitrogen fertilizer, a commodity, but they are number one in their world because they produce it far cheaper than anyone else.  Look at Whole Foods; they sell groceries, a commodity.  But they sell twice as many dollars per square foot of store than their competitors and their profit margins reflect that sales power.

 

Now that you’ve decided you like the business, its something you can understand, it matches your values, has a moat and you like the CEO, you start reading the previous year’s 10k and work your way back as far as the 10Ks go.  Read’m all.  I put Melissa to sleep at night reading the 10Ks out loud.  I should record myself and sell the CD as a sleep-aid.

 

From the 10Ks I go to Seeking Alpha, put in the symbol and start reading all of the analysis; good, bad, mediocre.  I read the quarterly report transcripts; again reading for Moat support as well as ideas about what can go wrong. 

 

Through all this reading I’m out to figure out a good Story that says ‘this is why this is a wonderful business’ and I keep reminding myself that a wonderful business is one that I can understand and matches my values (Meaning), has a durable competitive advantage (Moat) and a CEO I trust (Management). 

 

An important part of my Story will be an inversion of the data.  Once I get it all together I’m going to try to prove that this investment is a bad idea.  Only if I can’t prove that, only after I’ve inverted the Story to no avail, am I going to be really excited that this might be a great company to own.

 

From the Seeking Alpha I go to the library (Amazon.com) and try to find books on companies in the industry.   Then to Fool.com for more commentary.  And of course I just google the company and read everything that looks interesting. 

 

Once through that, its time to do something similar for the major competitors.  Read it all.  You won’t be sorry and you only have to do it once.  After reading all this you’re going to know more about this industry than most analysts.  You’ll be an inch wide and a mile deep.  That’s where you want to be.

 

May 05, 2014

6 PRINCIPLES FROM 80 YRS OF MARKET-CRUSHING INVESTING

I'm going to post up the 6 vital principles that come to us from great Rule #1 investors starting with Ben Graham then Warren Buffett then on to today's greats like David Einhorn and Mohnish Pabrai.  These principles are timeless but have been stated in one form or another publicly for at least 80 years and yet still to this day few investors follow them.  Its hard to understand why that is; these are not fair-weather or bull-market principles.  These principles have worked to generate serious alpha returns through the Great Depression, WWII, Korean War, Vietnam and the Great Society inflation, the end of the gold standard, the great bull from 1980 to 2000 and through two huge bubbles that crashed the market in the last decade.  These are principles to invest by.  Learn them well and violate them at your own risk.  Here is the first one:

1.  RATIONAL: Stay Rational

Easier said than done when you are investing real money.  Money you can't afford to lose tends to be 'hot' or emotional.  Pro gamblers try to avoid sitting down with more than they can afford to lose but anyone investing all of their own hard-earned money is always sitting down with more than they can afford to lose.  Fear of losing more than you can afford to lose tends to make the mind go irrational.  You start guessing.  You can't tell the difference between a good idea and a bad idea.

Investing decisions are not life and death decisions (unless you've embezzled $100 million or so) but still, remaining rational in the face of intense emotions is an art that is learned in the trenches.  They don't teach this at business school because they can't generate real emotions in a classroom setting.  

Staying rational is an art that the best investors in the world have learned.  They have the ability to separate their emotions, block them off and operate on pure reason.  If A, then B.  If B, then C.  Therefore, if A, then C.  Using our rational mind is a huge advantage in a marketplace that dominated from time to time by irrationality covered over with Modern Portfolio Theory.  MPT says that the market is a roulette wheel which never remembers the last spin, all professional investors are solidly rational and, therefore, price is value.

I'll write more about irrationality in the future but for now suffice it to say that were it not for the occasional irrationality of otherwise brilliant fund managers sheltered and comforted by MPT, we'd all of us be out of luck trying to beat the market.  Fortunately, its in the nature of the beast for a fund manager to do irrational things; principally to sell something at a significant discount to its actual value.

A corallary of 'Rationality' is that price is not value.  Price is only what you pay.  Value is what you get no matter what you paid for it.  Pay too much and you'll never have excess alpha returns.  But buying value on sale requires an intelligent human to do the irrational thing and sell it when its on sale.  The good news for us is that fund managers rarely hold stocks for longer than 3 months.  If a company is having an issue that may take longer than a few months to solve, an issue that calls their near-term future earnings into question, fund managers will begin to sell.  Uncertainty is anathema to the Big Guys.  Hampered as they are by size to react to unforeseen events and by their Ivy League MPT education, we can forgive them their hair-trigger launch for the exits, particularly since their loss is our gain if we stay rational.

This is the key to Rule #1 type investing.  In a nutshell, we buy fear and we can't unless someone is afraid.  That someone is a fund manager who in the face of any uncertainty begins to sway like a too-tall tree in a too-big wind.  We little guys just have to remember that  "A is A".  Its obvious.  Well-educated fund managers all studied this tautology in their survey philosophy courses.  But fund managers forget that "A is A" if they aren't in the classroom and the tautology is structured as "value is value".  If the future earnings are reasonably intact despite the problem, value is still value and it most certainly isn't the same thing as price, no matter what the siren call of Modern Portfolio Theory is whispering in the fund manager's ear.

Next time principle #2.

Now go play.

March 28, 2014

KLARMAN'S 2013 LETTER HAS A DIRE WARNING

Seth Klarman wrote the book, Margin of Safety.  I’d link you to it but I’m worried I’ll get sued.  You can use Google to find it online or you can pay over $1000 on ebay for a copy.  Its a good book.  Read it.  Seth is a very good hedge fund manager.  He has $27 billion under management after giving back $4 billion last year.  The Baupost Group is his fund.  Seth says he’s about 60% in cash right now.

 

Seth’s end of year letters don’t usually leak out but the 2013 letter just did.  Its on Zero Hedge (link below) and well worth reading.  Here are my notes:

 

Reasons to be bullish if congentitally inclined:

  1. PE’s aren’t horribly high
  2. Deficits shrinking
  3. Consumers are lowering their personal debt
  4. Housing is recovering
  5. US energy independence is under way
  6. Bond yields are still so low that equities are the only place to go
  7. It doesn’t matter that the S&P has tripled since 2009, interest rates spiked or the Fed is tapering
  8. QE worked.
  9. The Fed will come to the rescue again if necessary
  10. The Bernanke/Yellen Put is intact
  11. No bubbles are in sight

 

But if you have the worry gene, are more focused on downside than upside and more interested in return OF capital than return ON capital ... in other words, if you are a Ruler there are serious questions to be answered:

  1. Near zero interest rates distort reality so what are the consequences going to be?
  2. Can the Fed end QE without a crash?
  3. Deficit spending propped the economy and inflated earnings and it can't keep going, can it?
  4. Schiller PE is over 25.  The three prior times were 1929, 2000 and 2007.  Isn't that scary?
  5. Junk bonds are now in a bubble so when does the bond bubble pop?
  6. Credit quality going down and so are more and more small banks.  Scary?
  7. Margin debt to GDP near all-time high so isn't that a problem?
  8. IPO’s are near a record number, Twitter is at a 500 PE, Netflix PE is at a 181, Tesla PE is 279.  Signs of a top?
  9. Lowest proportion of Bears since 1987 - another sign of a top?
  10. Europe isn’t fixed.  Greece’s debt to GDP is higher now, Germany’s is, too.  So will they just inflate the Euro?
  11. Europe has 7% of population, 25% output and 50% of its social spending so will it finally crash?
  12. Bitcoin prices went through the roof while gold fell 28%.  Isn't that weird?
  13. We live in The Truman Show in a plexiglass bubble built by the Fed.  When will we discover it?
  14. The Fed purchased 90% of all eligible mortgage bonds in November.  What happens to interest rates when they stop?
  15. What is fake cannot be made real, can it?
  16. Fed can change how things look but not how they are, right?
  17. Hasn't the Fed has become enabler of what it was created to prevent, ie, massive volatility in the economy?
  18. When the show ends, who will be broke?
  19. Won't financial markets have to decline someday? 

Here are Seth's conclusions:

  1. Rising stock markets stop being government policy
  2. QE will end and money won’t be free
  3. Corporate failure will be permitted
  4. The economy will turn down
  5. Investors will lose money
  6. Capital preservation will be favored over speculation
  7. Interest rates will be higher
  8. Bond prices will be lower
  9. The Return from bonds will be commensurate with risk
  10. Fear will return and spread like wildfire
  11. Few will be prepared.

My thoughts on Seth’s thoughts:

Your values are not what you say.  Your values are what you do.  Talk is cheap.  I’m half in cash for a reason.  What I can do while waiting for 'the end' is try to find businesses I’d want to own even if there was no stock market.  And hope to be nimble enough to dance out when the time comes.

Fear is our friend.  Greed, jealousy, lack of patience and the need to do something are our enemies.  Try to be ready for the fear by fighting off the greed gene, exercising patience and go play.

LINK TO KLARMAN’S LETTER ON ZERO HEDGE:

http://www.zerohedge.com/news/2014-03-08/seth-klarman-born-bulls-bitcoin-truman-show-marke

 

Now go play.

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