Domino’s: Mean Reversion in Action

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I love this story. Not simply because I love pizza (my philosophy is that even bad pizza is good pizza), but because it’s a great example of mean reversion in action. One should never write off a company that is struggling. Companies with a poor return on equity can take steps that can turn their situation around and often do.

By 2010, Domino’s stock was devastated. The stock was down 57% from 2005 to 2010. It was struggling with a battered and beaten brand in a boring industry. They successfully turned the situation around with some creative thinking and hard work. Since the strategy change, Domino’s is now up 1,453%. That beats the storied Amazon, which is up 557% over the same period. It all happened in a boring, conventional industry with a company that Wall Street wrote off.

Domino’s isn’t currently the kind of stock I would buy. It is currently trading at 42 times earnings. It’s a great company but I’m not getting any margin of safety from the investment. With that said, there were numerous opportunities in the 2010-2012 period when it had a solid margin of safety.

It is a story like this to keep in mind the next time a growth investor asks you “why are you investing in this crap?” Crap can turn to gold. It happens more often than is typically appreciated.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Chasing Perfection

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“Many shall be restored that now are fallen, and many shall fall that are now in honor.”

– Horace.  This is the opening quote in Benjamin Graham and David Dodd’s “Security Analysis”

Buffett & Munger

Warren Buffett started his career buying cheap stocks. These weren’t good companies, they were mediocre and bad companies that were ridiculously cheap. After the 1960s, his style evolved from buying cheap “cigar butt” stocks to finding quality companies at decent prices. “Quality” in the sense that the companies are capable of compounding wealth over long periods of time.

Buffett moved on to the new style of investing primarily as a matter of size. His wealth had advanced to a point where it was difficult to move in and out of companies when they were at 2/3 of their value and then sell when fully valued. He had to be able to park money and let it compound over long stretches of time. Another reason for the style change was via the influence of Charlie Munger. The quality companies that he purchased are now famous investments: The Washington Post, See’s Candies, Coca-Cola, Gillette, etc.

These were companies that had high returns on capital.  They were also businesses with competitive moats. No one will ever be able to make a beverage that can effectively compete with Coca-Cola.  Men will always shave with razors and Gillette is the most well-known brand.  People will always buy candy and See’s candy is a great brand. You’re not necessarily going to play it cheap on Valentine’s Day. No other paper will displace the Washington Post as the premiere newspaper of the Washington, D.C. metroplex.

Many value investors that were small in scale were able to achieve high compounded rates of return dealing with cigar butt stocks. They normally become too wealthy to nimbly move into and out of cheap stocks at the opportune times. A notable exception is Seth Klarman. Very few been able to duplicate Buffett’s returns at his size, or even fractions of his size. Buffett admits that size matters. In fact, he says that if he were running $1 million, he could achieve a 50% rate of return.

It’s Not As Easy As It Looks

Everyone saw what Buffett did and now wants to duplicate it. In retrospect, it seems obvious that the businesses Buffett bought would go on and continue earning their high returns on capital. But was it as obvious as it seems now with the benefit of hindsight? If it is so obvious, why have so few been capable of duplicating Buffett’s results?

The answer is competition. The forces of competition in a capitalist economy are relentless. Consider this: since 1955, 88% of Fortune 500 companies have moved on in one way or another. There were countless companies that had high returns on capital in Buffett’s time that looked invincible. I’m sure most former Fortune 500 companies looked invincible in their heyday, but 88% of them weren’t. Buffett was capable of identifying the companies that would survive and acquiring them at a good price. He made it look easy but it wasn’t.

Competition

Competition is relentless. Any business that achieves high rates of return is going to attract competition. Human nature makes us extrapolate whatever is happening in the present into the future, but this is typically folly.

Let’s say I invent a widget that costs 50 cents to make and generates $1 of revenue, a 100% rate of return. Naturally, other companies are going to try to make widgets.  They will undercut me in price.  The supply of widgets will also continuously increase until it meets the demand. Over time, the introduction of competition will reduce the rates of return. Think of what happened to any major industry and you see the forces of competition in action. This isn’t a flaw of capitalism, it’s a feature. It’s one that benefits the consumer.

The Market

The impact on the stock prices of companies of these competitive forces is even more extreme. The widget company earning 100% returns on capital is going to attract a lot of attention on Wall Street and will likely earn insane valuations. Therefore, not only do these companies have real-world economic pressures that will bring them down, their stocks typically become overvalued as well. The introduction of competition to a company with an overheated price is an explosive combination.

You can see this in the backtesting for mechanically buying “quality” stocks with high growth and returns . The returns aren’t linear like you would expect. The “best” decile doesn’t perform the best. Unlike the backtesting for value metrics — which typically show a linear relationship where the cheapest decile has the highest stock gains and then they decline from there — quality metrics typically show lumpy returns. Typically the best returns are somewhere in the middle. The companies in the highest decile “quality” metrics don’t deliver the higher rates of return. You can see this in backtesting for return on equity, return on invested capital, return on assets, growth in earnings per share, etc. The notable exception to this is gross profits to assets, as discovered by Robert Novy-Marx. Although now that it has been discovered, it is possible that this advantage may be arbitraged away in the upcoming years.

In an attempt to duplicate Buffett and try to elevate value investing above the dirty business of buying cigar butts, value investors are constantly trying to marry “quality” with “cheap”. They’re looking for companies with amazing managers, a competitive moat, high returns on capital . . . that also sell for a good price.

This might sound easy but it’s not. As I mentioned, 88% of the Fortune 500 from 1955 is now gone. I’ll bet they all thought they had a “moat”.

General Motors used to have a moat in the 1950s and 1960s (well, it was an entrenched oligopoly, but a form of moat nonetheless). Other companies that appeared at one time or another to have a moat were Bethlehem Steel, Kodak, Standard Oil, Western Union, The American Tobacco Company, Fairchild Semiconductor, RCA.  All of these companies eventually succumbed to the relentless forces of competition and were taken off their perch.

Buffett and Munger have an underappreciated genius in identifying these rare firms with strong moats and high returns on capital and then buying them at discounted prices. I don’t think this is something that can be replicated in any quantitative fashion. Joel Greenblatt attempted to do this in The Little Book That Beats the Market, with outstanding results. However, Tobias Carlisle discovered that the quality component of Greenblatt’s formula (return on invested capital) actually reduces the returns. You can read about this in Deep Value.  Simply using the “cheap” component of the magic formula actually achieves better results.

My thinking is that attempts to duplicate Warren Buffett and Charlie Munger actually leads to the under performance of value managers. It’s the reason that most value managers outperform the S&P 500, but can’t beat the lowest deciles of price-to-book and price-to-earnings.

The Good News

The obsession with quality creates many of the value investing bargains that I seek. The flip side of the relentless impact of competition on high return business is that low return businesses attract little attention. Low return, bad businesses aren’t necessarily dead. They may be at the end of a waning period in their industry in which many of their competitors are dying. The decline of competition will ultimately drive returns higher. A struggling business with a low ROE is trying to turn things around, likely by reducing their costs. If their strategy doesn’t drive returns higher, at the very least there will be very little competition and the existing competition may leave the market behind.

A good example of something like this is a stock like Archer Daniels Midland. It operates in a mediocre return business (ADM has a ROE of 7.77%, compared to a Buffett stock like Coke with an ROE of 15.92%), but attracts little competition due to the mediocre returns of the business and large investments necessary to penetrate the market. No one is going to make the massive investments in scale to duplicate ADM’s results for a relatively low ROE. Simultaneously, low ROE stocks will typically be ridiculously cheap at the end of a competitive cycle because they generate an “ick” reaction in most investors. “Ick” creates bargains.

The “Ick” Factor

I’m not opposed to quality investing. I just think it is far more difficult to implement than is typically appreciated.

If one is going to go down the “quality” road, I think it’s important that the stock have some level of an “ick” factor to the investing public. If a consistently high ROE stock with a competitive moat has what appears to be an attractive price, it’s important to ask why everyone else doesn’t see the value (particularly if your insight into the attractive price is achieved with DCF analysis).

A great quality investment needs to generate an “ick” to ensure you’re getting a good price. Some of the best Buffett buys had a massive temporary “ick” factor — like the salad oil scandal, New Coke, or GEICO’s massive losses in the mid-1970s. If the stock isn’t reaching out to you with an “ick” factor, it’s probably not really a bargain. If you find one of these stocks, my suggestion would be to only go after it if there is an “ick” factor and you’ve done sufficient research to know that the “ick” is temporary.

I’ll Stick With Cigar Butts

I’m not Warren Buffett. I’m not Charlie Munger. I’m not going to achieve their rates of return over long stretches of time.  The good news is that I don’t need to identify Buffett stocks to do well in the market, mainly because I’m operating with small sums of money and can behaviorally deal with temporary losses in the realm of cigar butts.

15% rates of return in the lowest value deciles of the market may not sound as sexy as the Buffett’s 19.2% returns on billions and billions of dollars in capital, but it is an excellent return to strive for and it’s one that can be obtained by operating in the lower valuation deciles with small sums of capital.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.  Full disclosure: my current holdings.

Long Term Capital Management and the Dangers of Debt

This is a good documentary about the ’90s hedge fund Long Term Capital Management (LTCM). If you want to learn more you should read Roger Lowenstein’s excellent bookWhen Genius Failed.

The story is a cautionary tale about leverage (leverage: what rich people call debt). LTCM was leveraged 25-1, meaning a 4% reduction in assets would kill the firm. That’s precisely what happened.

LTCM would make ‘safe’ bets and leverage up on those safe bets to amplify returns.  It worked great for years, until 1998 when the world defied the model with Russia’s default.

Leverage boosts returns but it blows up in your face when you are wrong, no matter how brilliant you are. Everyone gets things wrong.  That’s a part of life.  That’s a part of investing.  In the face of an error, the proper course of action is to pick up the pieces and move on.  Excessive leverage destroys the ability to do that, because one mistake will wipe you out.  LTCM had two Nobel Prize winners and one of the greatest bond traders of all time, John Meriwether.  If they can get things wrong, then anyone can.

Whenever I hear of the returns of Renaissance Technologies, I think of LTCM. Genius minds, complex mathematical models, massive returns and leverage. They may not be leveraged 25-1, but they are reportedly leveraged 17-1.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures. Full disclosure: my current holdings.

How to Overvalue a Company: Use Discounted Cash Flow Analysis

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Discounted Cash Flow Rationale

Discounted cash flow (DCF) analysis is the most popular method of business valuation.  It is taught extensively in most finance classes.  The goal is to find a reasonable price for a future stream of cash flows and compare it to a risk-free rate of return, usually US treasuries.

It’s also fraught with peril because it usually results in overvaluing businesses.  It is the preferred method of valuation in investment banking.  I suspect this is because investment bankers can easily game the numbers and make companies appear more valuable than they actually are.  Allow me to explain.

Apple Valuation (AAPL)

To show the power of assumptions, let’s try a real world valuation example.  Let go with Apple (AAPL) using this method.

Free Cash Flow

Let’s start with a fact: in the 2016 fiscal year, Apple’s free cash flow was: $65.844 billion in operating cash flow – $13.548 billion in capital expenditures = $52.296 billion in free cash flow

At the end of the 2016 fiscal year, there were 5.336 billion shares of Apple common stock.

$52.296/5.336 = $9.80 of free cash flow per share of Apple stock.

So what’s the value of $9.80 in discounted cash flow?  Let’s use DCF analysis to figure it out.

Zero Growth Example

For example 1, let’s take an extreme approach.  Let’s say Apple won’t grow at all (unlikely).  For the interest rate, we’ll use US treasuries.  The 10-year US treasury currently pays 2.38%.  Here is a link with a detailed explanation of the math.

If you want to do this quickly, Gurufocus has a calculator tool that you can use here.  Another nice shortcut is a formula that can be used in Microsoft Excel or in Google sheets.  Simply input the following formula into a cell:

=NPV(discount rate, cash flow 1, cash flow 2, etc.)

Now, let’s try to find the present value of a $9.80 stream of cash flows.  Based on no growth and 10 years of cash flows and using the 2.38% rate, we get a value for Apple of $86.30.

Growth and Different Discount Rates

2% Growth, 2.38% rate, 10 years = $96.02

What if instead of using the 10 year treasury as our base, we used the 10 year average AAA corporate bond yield, 2.96%

2% Growth, 2.96% rate, 10 years = $93.11

Terminal value

Most likely, Apple isn’t going to go out of business in 10 years.  For this reason, most DCF analysis adds a terminal value to the value after the 10 years of cash flows.  Let’s proceed with our assumption that there will be 2% growth for 10 years, then let’s say after 10 years the growth rate drops to 1%.

Present value of 10 years of cash flows + Terminal Value = $173.52

Now, what if we increased our assumptions?  Let’s say Apple grows by 5% a year, and then the terminal value grows earnings at 3% into the future?  Now the value goes up to $228.54!

With DCF analysis, you can make the data say whatever you want.  That’s great for investment bankers but it’s not very good for investors.

Conclusion

By messing around with different assumptions, I produced valuations for Apple that ranged from $86.30 to $228.54.  All of these assumptions are debatable.  You can’t say with any degree of certainty where interest rates are going, what Apple’s cost of capital will be, what their growth rate will be, how long the business will be viable, etc.  All of these are assumptions.  Also keep in mind that I produced this wide range of values with one of the the largest and most recognizable company in the United States.  If we can’t safely value Apple, how can we safely value a micro-cap stock?

For this reason, I avoid discounted cash flow analysis.  It is simply too easy to twist around the data with your assumptions and get the result you want.  If you want to find a margin of safety with DCF analysis, you’re going to find one.  I suspect that this is what the investment banking community does when they want to convince corporate managers to make acquisitions that may not be in the best interests of the acquirer.

A simple ratio (i.e., the stock trades at 10 times earnings) is a far more simplistic . . . and far more telling . . . statistic than DCF analysis.  The cheapness of something should hit you over the head and should be abundantly obvious.  If it’s not, move onto something else.  There are plenty of publicly traded companies.  Torturing the data to get the result you want is not a prudent path.

I prefer the Graham approach and focus on what’s actually known in the here and now without making so many assumptions about the future.  This is why the Grahamian balance sheet approach (because what’s more clear cut than the value of a balance sheet?) of net-net’s is a nearly foolproof method of investment.

For the goal of finding the present value of cash flows in analysis of stocks, I think a more useful metric is one that is more simple: price to free cash flow or enterprise value to free cash flow. If you can find a decent company like Apple trading at a price to free cash flow of 10 or less, then DCF analysis would likely yield a number close to the current price even with very conservative assumptions. It is probably then a good candidate worthy further research.

In the world of finance, there is a tendency to make things more complicated than they really are.  I like to keep things simple.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.  Full disclosure: my current holdings.

Seth Klarman Interview

This is a great interview between Charlie Rose and Seth Klarman.

Seth Klarman is a value investing legend.  What fascinates me about Seth Klarman is that he never moved beyond the “cigar butt” deep value style of investing, while many value investors eventually adopt the Buffett-Munger style of finding quality companies at attractive prices.  His out of print book, Margin of Safety, sells used on Amazon for $765.  Since the early 1980s, his fund (Baupost Group) has been able to achieve a 19% rate of return.  There are many great insights in this interview and it is well worth your time.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.  Full disclosure: my current holdings.

Your Politics and Your Portfolio Do Not Mix

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Your Political Opinions are Emotional

Political opinions are powerful forces. Usually, they are more influenced by emotions and passion than they are by facts. The enemy of good investing is human emotion. Human emotion fueled the internet bubble. Human emotion drove people to buy homes they couldn’t afford (it’s the American dream!). Human emotion took the Nasdaq to 5,000 in 2000 and took the stock market to a 15 year low in the spring on 2009. Most investors underperform because of their emotions.  They pile into stocks when they are overvalued and exit when they are at their most appealing level. Winning at investing isn’t about smarts, it’s about mastery of your emotions. If the market were made up of people like Spock, then Mr. Market wouldn’t be able to act so crazy. Fortunately the market is made up of people who are the opposite.

Making the Wrong Call

The emotional impact of politics is one of the key reasons it should be excluded from investment decisions. Case in point: I am sympathetic to a small government perspective. After the election of Barack Obama and a completely Democratic congress in 2008 during a financial crisis while the Federal Reserve was increasing the money supply like Weimar Germany, it was tempting for people of my orientation to think that the country was about to turn into a hyperinflationary socialist state. At this time it was more tempting than ever to shout “sell” from the rooftops.

Selling in late 2008 would have been a terrible mistake. It is a mistake made by many right wingers who loaded up on gold as they prepared for financial Armageddon. Since 2009, the S&P 500 is up 155%.  Gold is only up about 15%.  In 2009, the immediate year after the collapse, the S&P rose 28%.

Let’s examine another scenario. Let’s say you were someone of a more liberal orientation when Ronald Reagan was elected is in 1980. Many of the leading (liberal) economists of the time predicted that Reagan’s policies would be a complete failure.  They predicted that his fiscal policies would stoke instead of quell inflation. The Reagan years saw a 144% increase in the S&P 500.

The bottom line is that while you may try to convince yourself that your politics are hard grounded in facts and are as immutable as the laws of nature, you simply can’t use your political beliefs as a useful metric to predict future market returns. Your politics are grounded in emotion and for that reason they shouldn’t guide your investment thinking.

Does it Even Matter Who the President Is?

Nor do I think politics even matter that much to the economy. The popular news creates the impression that politics is the only thing that influences the economy, but the truth is that it doesn’t really matter all that much. American businesses are going to try to sell more products and be more productive no matter who is President.

My guess is that if Al Gore won the 2000 election, Alan Greenspan would have still cut interest rates in the wake of the internet bubble, homeowners would have still levered up, and the housing collapse was inevitable. Similarly, was Bill Clinton responsible for the surpluses and prosperity of the late 1990s, or was it simply a surge of computer-driven productivity gains that would have happened anyway?  The President and their party receive the credit for booms and the punishment for busts in the public’s mind, but their actual real world influence is limited.

Also, the United States political system is set up to resist radical change.  That may be frustrating when the President can’t implement their desired mix of policies, but it is a good thing for the health of the economy.  The Constitution is designed to derail radical change and it works most of the time.

Productivity

The Federal Reserve plays a more important role than the President in the direction of the economy. The Fed’s influence is still limited, though.  The Fed can only influence the short-term gyrations of the economy and the inflation rate. They can’t impact the long-run trend of the economy because the long-run trend is driven by productivity. Despite the attempts of policy makers to influence productivity, I doubt that public policy can have any impact at all on productivity rates.

Productivity seems to be driven more by the forces of capitalism and the abilities of managers than it is by policy.  I doubt that laws can make a country more productive any more than a law can change the weight on my bathroom scale.  Productivity is the true driver of economic performance and it appears to be out of the hands of policy makers.  That’s probably a good thing.

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Source: United States Department of Labor.  Productivity does not seem to care who the President is.

Right now we’re in a productivity slump and everyone is losing their minds over it. I think this productivity slump is much like the slump that occurred in the 1970s: it’s temporary. Much like the boom in productivity from 1995 to 2005 was also temporary. Productivity appears to be stubbornly mean reverting. It has a tendency to revert to its 2% long term trend and there is little we can do to change it.

There was a belief in the late 1990s that information technology had permanently increased the productivity rate.  That’s what the “New Economy” talk and hyper optimistic federal government budget projections were driven by.  It wasn’t permanent and productivity is reverting to the mean.  Similarly, the worry now is that the productivity slump is a sign of permanent stagnation in the US economy.  That’s probably just as wrong as the 1990s optimism was.  At some point in the next 10 years when productivity starts surging due to mean reversion, we’ll hear that we are in a new economic era of higher productivity driven by artificial intelligence, social media, cloud computing, 3-D printers, etc.  Then it will revert to the mean and everyone will start wondering if we are in a permanent slump again.

There is very little that politicians do to change desire of individuals and businesses to earn more money, which is really the driving force behind productivity.

Ignore It

The lesson of history seems to be that the safest long term bet is to leave your politics at home when making investment decisions.  There is a human tendency to believe that if there are people you disagree with in power, then the world must be headed to hell in a handbasket.  If there are people that you agree with in power, then there is a tendency to believe that manna will begin to come down from the heavens.  It’s your emotions talking and emotions are the enemy of capital gains.

Besides, your political beliefs should be deeply held as a result of moral conviction.  They shouldn’t be formulated based on the impact that a policy will have on the S&P 500.  They’re for the voting booth, not your portfolio.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.  Full disclosure: my current holdings.

What is the Best Stock Valuation Ratio?

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Value investors use a number of ratios to assess whether a stock is cheap.  Everyone has their favorite.  Everyone debates the merits of one versus the other.  I backtested some of the popular ratios to see how they would perform if you simply split the market up into deciles and compared the cheapest to the most expensive deciles.  The population I used for this analysis was the S&P 1500.  In this case, we are comparing the most expensive 150 stocks to the cheapest 150 stocks.  These are the total returns since 1999, with the 150 stocks re-balanced annually, because re-balancing monthly is impractical.

Below is a list of the ratios that I tested:

EBIT/Enterprise Value – This is the ratio identified by Joel Greenblatt in The Little Book that Beats the Market.  EBIT is “earnings before interest and taxes”.  Tobias Carlisle refers to this as the “Acquirer’s Multiple” in Deep Value

The Enterprise Value is the total cost of the firm to an acquirer.  Enterprise values are the total cost of the firm to an acquirer at the current market price.  In other words, if you were to buy this company in its entirety, you wouldn’t simply pay the market price.  You would also assume all of its debt obligations and would inherit all of its cash on hand.  It is the cost to acquire the entire company.  EV gives you a good idea of the true size of the business.  The calculation for Enteprise Value is:

EV = market value of common stock + market value of preferred equity + market value of debt + minority interest – cash and investments.

Price/Cash Flow – The price per share divided by the total trailing twelve month cash flow for the last calendar year.  In other words, how much total cash is the stock generating for what you are paying?

Price/Sales – The price per share divided by the total revenue per share.  This ratio was popularized by Kenneth Fisher in his 1984 book Super Stocks.

Price/Free Cash Flow – Free cash flow is the company’s operating income minus its capital expenditures.  Free cash flow strips away the company’s other financial performance variables and looks simply at how the core business is doing.  This ratio looks at how much free cash flow is being generated per share relative to the price of the stock.

Free Cash Flow/Enterprise Value – This is the same thing as price/free cash flow, but instead compares free cash flow to the total size of the business.

Price/Book Value – Book value is the total balance sheet value of the company.  It’s the simple equation Assets – Liabilities = Shareholder Equity.  The goal of many asset-based value investors is to buy company’s that are trading at or below book value.

Price/Earnings – This is the most basic and common valuation metric.  It takes the per share price of the stock and divides it by the earnings per share.

Price/Tangible Book Value – The same thing as price/book value, with a twist.  When calculating shareholder equity, intangible assets are taken out of total assets.  The goal here is to look at what assets can actually be sold and turned into cash.

The results are below:

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I think it is best to look at the effectiveness of the ratio based on the difference in return between the cheapest and most expensive decile, rather than looking at its total return for the cheapest decile.  A ratio that is effective in identifying cheap stocks should be equally effective in identifying expensive stocks.  Based on the backtesting, the acquirer’s multiple popularized by Tobias Carlisle is the most effective.  Tobias maintains a nice screener here.

Here is a visualization of the value premium in chart form:

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The important takeaway is that no matter which ratio you prefer, they all work to some extent and buying expensive stocks is a risky bet.  Value investors can debate about which ratio works best, but they all work!  No matter how you slice it, cheap beats expensive.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Bruce Greenwald on Globalization

This is a fascinating and thought provoking video with Bruce Greenwald on globalization and the future of the economy.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.

 

Greenbrier (GBX)

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Greenbrier, one of my holdings, is poised to benefit from a recovery in oil prices.  Greenbrier manufactures, leases and repairs rail cars.

Greenbrier was a beneficiary of the fracking boom and was negatively impacted by the bust in the last two years.  Much of the oil that is being drilled throughout the US must to be transported via rail.  Greenbrier’s stock peaked at $75 a share in mid 2014 around the same time that oil prices peaked above $100 and then began its decline to $50.

GBX’s Performance

Meanwhile, amid the decline in oil prices, Greenbrier has been humming along and generating profits while the stock has been disconnected from the actual performance of the company and slid to the current $41.85 price level.  Take a look at the operating income for the last few fiscal years:

2016: $408 million

2015: $386 million

2014: $239 million

They have also been paying down debt.  Long term debt has been reduced from $445 million to $303 million.

Saudi Arabia & Oil Prices

With that said, it appears that oil prices are bottoming.  Saudi Arabia engineered the decline in oil prices to kill their competition.  Their mission is now accomplished and they want to see oil prices go back up.  They are now organizing OPEC to cut production and raise oil prices again.

I suspect Saudi engineered higher oil prices will simply mean that US production will increase in response, which will benefit the train industry and companies like Greenbrier.  The only way that it wouldn’t benefit would be if the US invests in oil pipelines.  It appears unlikely that any pipelines will be built.  In addition to the environmentalists, there is a strong resistance from NIMBY citizens.  Any struggle to get these pipelines built will probably be akin to the Bush administration’s efforts to drill in ANWR, efforts that were abandoned because they were deemed to be too much of a political pain.

Personally, I don’t see how transporting all of this oil via train and truck is any better for the environment than putting it in a pipeline, but I don’t think it is good investing to think in terms of what should happen.  Even if the new administration fights the political pressure and gets a pipeline built, it will be years before it actually happens.  In the meantime, we will need a way to transport all of this oil and rail will benefit.

Margin of Safety

Greenbrier presents an excellent margin of safety at the current price.  Even without higher oil prices, Greenbrier has been performing well while the stock price has fallen amid speculation that ignores the fundamentals of the business.  My guess is that betting against rail while oil goes down has been fashionable on Wall Street, thereby creating attractive prices.  It is a great value even if my prediction about oil prices doesn’t come true.  I feel the same way about Valero, another stock I own as a play for an oil resurgence.

That’s the idea behind the margin of safety — even if I am wrong, the stock was purchased at a wide enough margin of safety that I should still do ok.  I can bet on higher oil prices in a safe way, as opposed to buying a leveraged ETF or oil futures.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.

Don’t Try This At Home! DIY investing is not for everyone.

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I post a disclaimer on every post that this site is not financial advice and I don’t recommend people simply copy my strategy. Buying individual stocks carries significant risk that most people aren’t cognizant off. 90% of investors have no business buying individual stocks. I often tell people that if they can’t withstand a 50% loss of the amount invested, then they have no business investing in stocks. 50% losses (or worse) are going to occur roughly once a decade and most people behaviorally can’t handle them. With that said, many people wonder if they should try buying individual stocks for themselves.  My advice would be: for most people, absolutely not.

But . . . if you are insistent on buying individual stocks, I recommend that you first get your financial house in order and make sure that you have sound investing knowledge.  There are some great personal financial blogs out there chronicling how to pull this off.  Mr. Money Mustache is one of my favorites.  Dave Ramsey gives great advice as well.

So, before you open a brokerage account and start buying individual stocks, I would say that the below items should be taken care of first:

  1. Get out of debt.  Seriously, if you have debt, especially high interest rate credit card debt, your #1 priority in life right now should be getting out of it.  You should treat it as if you are on fire and need to stop, drop and roll.  Compound interest is a mesmerizing thing when it works in your favor as it does for stock investors.  For credit card debtors, compound interest can ruin your life.  As someone who made a number of stupid financial decisions in my 20’s, I speak from experience.  The same goes for other kinds of debt: student loans, car payments, etc.  Get that stuff paid off before you start even thinking of messing around with buying individual stocks.  Start coupon clipping.  Start cutting your expenses.  Get a side hustle.  Whatever you need to do, do it!  Get out of debt as soon as possible!  Life isn’t meant to be lived in chains.
  2. Set up an emergency fund.  Stock market investing only works over long stretches of time.  In other words, you have to lock the money up for years before you even think of using it.  If you’re constantly withdrawing money from your brokerage account, then compound interest will never have a chance to work its magic.  To be prepared for life’s hiccups and keep you from dipping into your brokerage account, you need to have a savings account covering at least 6 months worth of expenses set aside.  Be prepared for life’s unexpected emergencies, otherwise you’re going to dip into your investments and no strategy will work.
  3. Buy a house.  Rent is throwing your money away.  For what you’re throwing away in rent, you could have a mortgage.  With a mortgage, you build equity in a home and get tax deductions for the interest you pay.  Homes really are a great investment over long stretches of time.  Don’t buy dumb, ridiculously expensive homes that you can’t afford and don’t need.  Don’t try to keep up with the Joneses.  Do find a house with a mortgage payment that you can easily afford and is beneath your means.
  4. Invest in mutual/index funds.  You should have money already invested in the stock market via your company 401(k) or set up in mutual funds.  Vanguard has some great options. The IRA account I am tracking on this blog does not constitute my full net worth or investments. I invest in index funds and any stock investor should devote some of their equity investments to this approach.
  5. Read and learn about investing.  An entire section of this website is devoted to books about value investing.  You should read them all before you decide to buy an individual stock.  If you refuse my advice and only read one book about investing, then my choice would be The Intelligent Investor in its entirety before you even think about opening a brokerage account.
  6. Develop your own philosophy about investing.  Value investing isn’t for you?  That’s fine!  However, pick a philosophy.  You must have  an intellectual foundation.  One of the worst mistake that investors make is shifting between philosophies of investing and chasing recent returns with no real commitment to one philosophy over another.  This is a mistake because all styles go in and out of vogue at different times.  After one style has a nice run, that’s probably the worst time to pile in.  The key to winning in the market is finding a style that makes sense to you and sticking with it.  Consistency is key.  You’re not going to be able to stick with it unless you believe in it and it makes logical sense to you.  There will be times when you are losing money and you will want to throw in the towel.  You’ll be less likely to throw in the towel if you can look at your portfolio and remember why you made your decisions.  If you believe in your philosophy, you can weather the storm.  The mind is the true source of investment gains and folly.  Figure out a philosophy that you can believe in and stay committed to it when times get tough.

A good example of consistency being critical is Peter Lynch’s Magellan Fund.  Peter Lynch is one of the greatest money managers of all time.  From 1977 to 1990, he achieved an astounding 29% rate of return for his investors.  However, most investors lost money because they piled into the fund when it was hot and sold when it was cold.  They had no patience and the lack of patience made them lose money even though they were in one of the greatest performing mutual funds of all time.

With that said, once your financial house is in order and you have a sound knowledge and philosophy about investing, then you can feel free to roll up your sleeves and attempt do-it-yourself investing in individual stocks.

Should you do what I’m doing?  No.  

Do your own homework and choose a style that you are comfortable with. Don’t just buy something because someone else is buying it. Think independently.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.