“Margin of Safety” by Seth Klarman


Seth Klarman

I recently finished Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor by Seth Klarman.

Seth Klarman is a legend. Since the early ’80s, he has delivered a 16% CAGR for his investors. This is amazing considering the size of his fund (Baupost manages $30 billion) and the fact that he frequently holds a lot of cash during bull markets.

He stayed true to his value investing roots. Among the big billionaire “guru” investors still alive today, Klarman is the true disciple of Benjamin Graham-style value investing. While most value investors eventually “graduate” from cigar butt value investing to Buffett-style long-term investing in companies with moats and high returns on invested capital — Klarman stuck to cigar butts. This is particularly interesting considering that he manages $30 billion at his firm, Baupost Group. Usually, the shift from cigar butt investing occurs because it’s no longer scaleable as investors manage too much money. Klarman has been able to keep the party going.

Klarman finds companies that are at a cyclical nadir and sells them once their fortunes have improved. He also does extremely sophisticated investing in things like distressed debt.

He is a quiet guy that doesn’t grant a lot of his interviews. He focuses on his craft and delivers his returns to investors, largely shunning the limelight. Due to the lack of interviews and his legendary investing returns, value investors have been hungry for information about him and his process. They find it in his 1991 book, “Margin of Safety”. The book only sold 5,000 copies when it was originally published and was never re-issued. Due to the small number of copies and the legend of Klarman, copies of the book now sell for $800-$1,000 on Amazon.

I’ve read the classics of value investing and this was one of the few I didn’t read in its entirety. I was glad I did. I think a better title for this book would be “The Intelligent Investor 2.0″. It’s very much a more modern reiteration of the same principles outlined by Ben Graham in “The Intelligent Investor”.

Other possible titles: The Intelligent Investor 2: Electric Boogaloo. The Intelligent Investor 2: Invest Harder. The Intelligent Investor 2: Attack of the Speculators.

Acquiring & Reading the Book (If you want to learn about Margin of Safety, you can skip this ridiculous story)

Getting my hands on a copy of the book was not easy. I found it in Prague and tried to acquire it with a trusted team of colleagues. Unfortunately, we failed. When the situation went bad, my colleagues were murdered in an awful sequence of events. After failing the first time, I tracked down the book to a train moving along the Chunnel in France. The person who had the book tried to escape from the top of the train to a helicopter via a tether. I tied the tether to the train, forcing the helicopter into the Chunnel itself. I acquired the book and then destroyed the helicopter via a chewing gum explosive.

Fearing that the book’s wisdom could be dangerous, I went to a remote cabin to read it. Once I reached the cabin, I read the book out loud. The text was so powerful that it summoned demons, who assaulted me. The ensuing battle with the army of the undead caused me to lose my arm, which I promptly replaced with a chainsaw. Ultimately, the battle opened up a vortex to the year 1300, but that’s another story.

This is actually the plot of the first “Mission Impossible” movie combined with the “Evil Dead” film series.

I read the book on the beach and it was quite pleasant. Anyway, on to the book review!

Speculation vs. Investing

One of the first points that Klarman stresses is the difference between speculating and investing.

As Klarman sees it, understanding this distinction is the key to long-term success. You should ask yourself before making a decision: is this an investment or is this a speculation? I’ll bet that if you asked Klarman, he would say that if you get anything out of the book, understanding this difference is the most important.

What is the difference between speculating and investing? Seth sums it up with this:

“Investments throw off cash flow for owners. Speculations do not. The returns to speculations depend exclusively on the vagaries of the resale market.”

In other words, investments are something for which you can actually calculate a margin of safety or a yield. Your calculations might be wrong, the investment might not be successful, but at least you have a clue about what to expect. Bonds, stocks, private businesses, real estate (with cash flows in the form of rent) — all of these have a defined rate of return. You can figure out what they are worth and purchase them with a margin of safety.

Speculations, in contrast, are things for which your return is dependent solely on what someone else will pay in the future. Obvious examples are collectibles or art. There is no way to determine based on math and financial statements what they are worth. Whether it is a beanie baby or a Picasso, there is no way to determine a margin of safety.

Other, less obvious examples, are respected investment categories like commodities. Buffett frequently makes this point about gold. Gold sits there and doesn’t throw off any cash flow that you can use. There isn’t a way that you can calculate a margin of safety. It’s the same for oil. The asset itself doesn’t produce anything. There isn’t any way you can purchase gold or oil and have a margin of safety.

Real estate doesn’t have a margin of safety unless you plan on renting it out in which case the asset generates cash flow. If you’re buying a house because real estate is “hot” and you think the price will go up, then you’re a speculator.

Cryptocurrency would be another example of speculation. Bitcoin, Ripple, Ethereum. Say what you will about the future of blockchain, but your return on these assets are solely dependent on what other people will pay and there is no way to generate a margin of safety.

Speculations can work out. You can make a lot of money speculating, but keep in mind that it is speculation. The outcome was never certain. There is a high likelihood that the “winners” in speculative assets were simply lucky. Their tales of easy wealth are nothing but survivorship bias.

Graham makes the same points in The Intelligent Investor, but his definition is vaguer. Klarman gets very specific on what is and isn’t investing. The cash flow definition is a great way to think about it.

Of course, the differences between what is speculation and what is investing could be hotly debated. For me, I think Klarman’s definition makes a lot of sense. Examining financial decisions through the “investing vs. speculation” template would likely help many investors avoid a lot of trouble.

If you take a look at an opportunity and it is more of a speculation than an investment, it’s probably a good idea to move on. Only invest in assets for which you can calculate a margin of safety.

Wall Street is not your friend

“If you depend on Wall Street to help you, investment success will remain elusive.”

Klarman points out clearly that Wall Street is not the friend of investors and you should treat their advice and their products with caution. They exist to generate revenue for themselves: typically via underwritings. They are incentivized to earn fees and commisions which often come in the form of investment fads. They do not exist to generate returns or control risk for individual investors.

Seth suggests avoiding IPO’s entirely. When you think through it, investing in IPO’s is nearly always a dumb idea because: 1) The company is going public at a good time for them and they are incentivized to get the best price possible. They aren’t attempting to create a margin of safety for you. 2) The business is often unproven and the investment in the IPO is a speculation on the future, which is unknowable.

Sure, every now and then, you’ll hit a home run like Google, Facebook, or Microsoft. Those home runs are impossible to predict. Klarman explains:

“Investors even remotely tempted to buy new isssues must ask themsleves how they could possibly fare well when a savvy issuer and a greedy underwriter are on the opposite side of every undewriting. Indeed, how attractive could any security underwriting ever be when the issuer and underwriter have superior information as well as control over the timing, pricing, and stock or bond allocation? The deck is almost always stacked against the buyers.”

The history of Wall Street is a history of fads that end badly for investors and every bull market has a new take on the oldest stories in Finance. Klarman spends a lot of time discussing the investment fads of the 1980s: namely, the junk bond craze and the corresponding bad behavior that went along with it. If you want to read more about the behavior of this time period, I would recommend reading Liar’s Poker by Michael Lewis. The Predator’s Ball and Den of Thieves are also good summaries of the period.

While Klarman focuses on the insanity of the 1980s, it’s important to keep in mind that every bull market exhibits this kind of behavior. What’s important for investors is to identify this behavior and avoid it.

Klarman also warns against Wall Street research. Wall Street research departments have a bullish bias. This exists for a few reasons, but chiefly it is because they have a vested interest in stocks increasing and they want to maintain close relations with companies so they can generate income from new issues of debt and equity.

He points to an example of Marv Rothman, who was fired from his job as an analyst at Janney Montgomery Scott in 1990. Marv wrote a critical analysis of Donald Trump’s casino empire, arguing that Trump was overleveraged and wouldn’t be able to meet his debts. Marv turned out to be correct, but he was fired because his firm wanted to make deals with Trump to generate income.

This continues to this day. Consider the bullish ratings on Enron that went on to nearly the very end or the lack of “sell” ratings in all market environments.

As Gordon Gekko put it, if you want a friend, get a dog. Wall Street and much of the financial world is not your friend. There are certainly good people on Wall Street and the financial world, but your instinct should be cautious. As Ronald Reagan put it, “trust but verify”.

“Like dogs chasing their own tails, most institutional investors have become locked in a short-term, relative-performance derby.”

Klarman also points out that Wall Street is entirely focused on short-term performance. They obsess over how much they lag the market benchmarks. This causes them to operate as a herd, buying and touting the same investments like lemmings to avoid falling behind the averages.

You see the herd behavior not only in individual stocks but in entire investment classes. In the late ’80s it was Japan. In the mid-2000s obsession with emerging markets, the late ’90s obsession with dot-coms, or the current obsession with cryptocurrency and disrupters. They use the same buzzwords, they invest in the same things. A good investor ignores this noise.

He also points out that the more money an institutional investor manages, the less likely it is that they can deliver impressive results. They also engage in “performance dressing,” whereby at the end of every quarter and year they try to stuff their portfolios with the best-looking stocks and discard the weakest performers. This is the opposite of what a savvy investor would actually do.

Fortunately, Klarman believes that these activities and these flaws can be exploited by smaller investors. By looking at what Wall Street is getting rid of recklessly (like panic selling in a stock getting thrown out of an index, spin-offs sold without rhyme or reason, etc.) there is often value in these situations.

“Picking through the crumbs left by the investment elephants can be rewarding.”

Margin of Safety = Avoidance of Losses

“Most investment approaches do not focus on loss avoidance or an assessment of the real risks of an investment compared with its return. Only one that I know does: value investing.”

In Klarman’s view, the most critical aspect of value investing as an investment philosophy is the avoidance of losses. In Klarman’s view, the purpose of buying stocks with a margin of safety is the minimization of risk. The margin of safety is thought of as a margin for being wrong.

“The problem with intangible assets, I believe, is that they hold little or no margin of safety.”

Klarman is a classic cigar butt value investor. He is skeptical of the Buffett approach which emphasizes enduring value created by strong franchises and moats. Klarman believes in classic Graham-style investing. He believes you should wait until you have a clearly defined margin of safety and only buy when a sufficient margin exists.

“Sometimes dozens of good pitches are thrown consecutively to a value investor. In panicky markets, for example, the number of undervalued securities increases and the degree of undervaluation also grows. In buoyant markets, by contrast, both the number of undervalued securities and their degree of undervaluation declines.”

Klarman agrees with Buffett’s view that the key to investing is “waiting for the right pitch”. In other words, securities markets constantly offer new securities at different prices. You don’t have to figure out every situation as you don’t have to swing at every pitch. You don’t have to swing at every one. You don’t have to remain fully invested.

Klarman vs. Academics

“Value investing is, in effect, predicated on the proposition that the efficient market hypothesis is wrong.”

“Even among the most highly capitalized issues, however, investors are frequently blinded by groupthink, therebycreating pricing   inefficiencies.”

Klarman thinks that the efficient market hypothesis is bunk. The academics argue that markets are mostly efficient and incorporate all available information at any given time. There are therefore no “mispriced securities”. Klarman dismisses this.

“Technical analysis is indeed a waste of time.”

Additionally, Klarman also dismisses the entire field of chart reading and technical analysis. A chart is a reading of Mr. Market’s sentiment about a stock. He believes that you should try to profit from Mr. Market’s folly and not pretend that there is an wisdom that can be gleamed from a chart. Time is better spent researching the business and attempting to determine your margin of safety.

“I find it preposteorous that a single number reflecting past price fluctuations could be thought to be completely describe the risk in a security. Beta views risk soely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments.”

“If you are buying sound value at a discount, do short-term price fluctuations matter? In the long run they do not matter much; value will ultimately be reflected in the price of the security.”

Klarman is also strongly critical of the academic’s notion of “beta”. Academics view beta as the underlying volatility of a stock and that is their preferred measure of risk. Klarman believes this is bunk and thinks you should focus on risk in the sense of (1) whether or not the business itself can cause a permanent loss of capital or (2) if you are making the purchase with a margin of safety.

What was the beta of mortgage-backed securities before their collapse? They likely showed very little volatility, but this was meaningless as the underlying underwriting standards were collapsing.

I majored in Finance in college and the focus of the curriculum was almost entirely on the different aspects and permutations of the efficient market hypothesis. I didn’t believe it then and I don’t believe it now. Looking at the history of markets, I see absolutely no evidence that they are efficient. We witnessed a bubble in internet stocks, a bubble in real estate and now we’re witnessing a bubble in cryptocurrencies. The markets are insanely volatile and will continue to do so. 50% drawdowns occur once every 20 years. 20-30% reductions occur once every 5 years. The underlying businesses that make up the indexes haven’t experienced this level of volatility. Mr. Market is a far more instructive way to describe markets than the capital asset pricing model.

As Joel Greenblatt likes to point out, look at the 52 week highs and lows of popular stocks. Did the actual business prospects of those firms experience the wild price swings of their stocks? Of course not.

Value Investment Philosophy

“Value investing is a large-scale arbitrage between security prices and underlying business value.”

“Value investing is simple to understand but difficult to implement. Value investors are not supersophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or asses underlying value. The hard part is discipline, patience, and judgment.”

Klarman identifies three key components of a value investment strategy:

  1. Bottom-up investing. Klarman recommends ignoring macroeconomics and focusing on specific businesses. He refers to this as “bottom-up” investing. Starting with the company itself, then worrying about the macroeconomy. This is in contrast to “top-down” investors who focus on the macro picture. As Klarman sees it, this is simply too hard for anyone to successfully implement over time. I believe he’s right. Think of all of the so-called “gurus” of macro who predicted the 2008 crisis. Have any of them been able to successfully forecast the last decade of a bull market? Most of them predicted unrealized bouts of hyperinflation and saw bubbles in everything from commercial real estate to municipal bonds.
  2. Absolute performance orientation. Klarman thinks you should ignore the rest of the market completely and focus on your own returns. Concentrating on what the rest of the market is doing can cause you to make stupid decisions to keep up with other investors. The reason that professionals frequently underperform the averages is, ironically, because of their relative performance orientation. Focusing on relative returns prevents them from doing anything differently than the averages.
  3. Paying careful attention to risk. Risk is defined not as the academic notion of beta, but the probability and amount of loss due to permanent value impairments.

Business Valuation

“Business valuation is a complex process yielding imprecise and uncertain results. Many businesses are so diverse of difficult to understand that they simply cannot be valued. Some investors willingly voyage into the unknown and buy into such businesses, impatient with the discipine required by value investing.”

After discussing the merits of valuing a business separate from the market price, Klarman goes on to provide his opinion about different methods of business valuation. He examines the different forms of business valuation and looks at it as a complex art. Different valuation techniques should be used for different kinds of business. There isn’t any kind of “one size fits all” approach to valuation. Most importantly, Klarman recognizes that some businesses cannot be valued. A fast-growing company with a brand new product, for instance, is impossible to value correctly because there are simply too many unknowns. Valuation is hard enough to figure out with a stable company, let alone brand new companies with a million different rapidly changing variables.

  1. Liquidation value – Liquidation value, net current asset value, or net working capital is the purest measure of a business’s worth. In Klarman’s view, the best time to use this analysis is when the business is unprofitable.
  2. Net present value – He suggests using net present value when looking at a very stable business with predictable cash flows. In other words, a net present value or assessment of discounted cash flows should not be used in all circumstances. It should only be used if the business is predictable and the assumptions are extremely conservative. It is easy to game this kind of analysis, so it is important to use this with caution and conservatism.
  3. Earnings – Klarman cautions against earnings provided by the business as they are frequently subject to manipulation by unscrupulous management. It’s important to dig into the earnings and assess whether or not they are real.
  4. Book value – Klarman cautions against the use of book value as the value on the balance sheet isn’t necessarily accurate. Inflation can rapidly increase the price of real estate holdings, for instance. Technological change can rapidly depreciate the usefulness of plant, property, and equipment. These changes aren’t always captured on the balance sheet. Klarman doesn’t look at book value alone as a particularly useful tool for assessing the worth of a business. Balance sheet analysis should be deeper.
  5. Dividend yield – Klarman cautions against looking solely at dividends in assessing value. He points out that some businesses are simply terrified to cut a dividend even if the business is falling apart, which in effects turns the dividend into a liquidation that ultimately destroys value.

Finding Value Opportunities

“Computer-screening techniques, for example, can be helpful in identifying stocks of the first category: stocks selling at a discount from liquidation value. Because databases can be out of date or inaccurate, however, it is essential that investors verify that the computer output is correct.”

In the hunt for areas that value investors can exploit, Klarman recommends a number of key areas. The first, and most obvious, is looking for cheap stocks with the use of screening. Klarman restricts this to liquidation or net-net scenarios, but I believe that the use of screening among other methods of statistical cheapness is just as valid.

However, Klarman cautions that you should investigate the numbers in the screener for yourself. Find the financial statements (which you can easily do at sec.gov) and confirm that the numbers match the valuation output from the screener.

Klarman believes that you should research an understand your positions, but also cautions against doing too much work. There is only so much that can be known and the research process is subject to diminishing rates of return. This is also a reason that we should buy stocks with a margin of safety. Because all of the facts aren’t knowable, it’s important to have a margin of error built into the analysis.

“Out-of-favor securities may be undervalued; popular securities almost never are. What the herd is buying is, by definition, in favor.”

In the hunt for investments, he mentions many of the same areas covered more in-depth in Greenblatt’s You Can Be a Stock Market GeniusYou can read my review of that book here.

He talks about many of the same things as Greenblatt: spin-offs, share buybacks, recapitalizations, asset sales, bankruptcies, liquidations. He also discusses thrift conversions (an area exploited by Ed Thorp as explained in A Man for all Markets).

Klarman also devotes a chapter to discussing the value in distressed debt. I actually work in operations for a bank and deal extensively with distressed debt. He’s right: the opportunities are enormous. Unfortunately, they are difficult to exploit for small-time investors. Usually, you need to be an accredited investor to buy these assets. They are also subject to minimum transfer requirements, which are normally at least $1 million. For hedge funds and big investors like Klarman, they are an attractive area to exploit. For small investors like myself, not so much.

Klarman can also hire forensic accountants and lawyers to dig into distressed situations and find out if there is any underlying value. This is simply beyond my capabilities or those of most small investors.

With that said, it is still fascinating to read his process and how he categorizes the different types of distressed opportunities.


I highly recommend that you read a copy of Margin of Safety. There is a reason that the book is so feverishly sought after. Klarman clearly communicates the key principles of value investing for small investors.

To summarize some of his key points:

  • Clearly understand the difference between investing and speculation. Avoid speculations at all costs. An investment is something which currently (or will in the future) generate cash flow and a speculation is an asset that generates no cash flow for which you are attempting to re-sell at a higher price in the future.
  • Margin of safety is designed to minimize losses and controls for your investment thesis being wrong. The future is unknowable and a margin of safety is a way of protecting yourself from what could go wrong.
  • Business valuation is complex and can involve many different kinds of analysis. There is no one-size-fits-all approach. It’s important to use the appropriate technique (or overlapping techniques) depending on the situation you are presented with. Avoid situations where value cannot be calculated.
  • When dealing with financial professionals and Wall Street, always remember that they are not on your side. Avoid Wall Street fads. Do your own homework. Remember that investment professionals and Wall Street firms have their own incentives which may not align with yours.
  • The efficient market theory and the concept of beta are nonsense.
  • Avoid top-down macroeconomic analysis. Macro is too hard and there is too much room for error. Bottom-up investing on a case by case basis will lead to better results. I’m definitely guilty of this, but do my best to try to avoid it.
  • Adopt an absolute performance orientation. Constantly comparing your returns relative to a benchmark over short-term time periods can lead to bad decisions in an effort to keep up. The irony here is that focusing on absolute returns ends up crushing the averages over long stretches of time, as Klarman proved throughout his career. I admit this is hard for me after lagging the S&P 500 last year, but I know it’s something I need to constantly keep in check. The biggest challenge in investing is managing your emotions.
  • Klarman thinks technical analysis is a waste of time and I agree with him. A stock chart is a reading of Mr. Market’s sentiment. Value investors are trying to profit from Mr. Market’s folly. Reading the chart is getting get sucked into Mr. Market’s insane game. You are trying to exploit Mr. Market, not get caught up in his capacity for manic euphoria and bouts of depression. In the time you spend trying to find head-and-shoulders patterns, finding Fibonacci sequences, consulting tarot cards, looking at astrology, applying calculus to chart movements, calculating Elliot Waves, comparing a chart to 1987 or the Nikkei, etc. – you could be researching the business and trying to asses value.

Unrelated. This is great:

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.

The Dark Art of Recession Prediction


The Masters: this is a bad idea

I refer to recession prediction as a “dark art” because all of the respected sages of investing say you shouldn’t do it. It’s a taboo subject in finance and economics. I imagine it’s akin to walking into a vegan’s house and eating a rack of ribs.

The Peter Lynch/Warren Buffett/Jack Bogle school of macroeconomic sends off a pretty basic message: don’t bother.

“The only value of stock forecasters is to make fortune-tellers look good.” – Warren Buffett

“After nearly 50 years in this business, I do not know of anybody who has done market timing successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.” – Jack Bogle

Nobody can predict interest rates, the future direction of the economy or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.” – Peter Lynch

Meanwhile, since 2010, we have listened to most macro forecasters provide year after year of gloomy apocalyptic forecasts that never happen. After 2008, people confidently predicted bubble after bubble and thought every year would bring a new recession. The Federal Reserve’s recklessness would trigger hyperinflation, they told us. We were supposed to have a commercial real estate crash. There was supposed to be a crisis in municipal bonds.

Eventually, of course, they will be right. Since World War II, the average expansion has been 57 months, and the ordinary recession has been 18 months. Since 1980, the average expansion has been long and the typical recession has been short. Are we becoming better at managing the economy? Are we lucky? Probably some combination of both.

You’re not supposed to pay attention to macro. I can’t help myself.

The Yield Curve predicts recessions . . . 20 months ahead of time

Lately, there has been a lot of lamenting on FinTwit and in the financial media about the “flattening” of the yield curve. It’s well documented that inversions of the yield curve predict recessions. An inversion in the yield curve is when long duration bonds yield less than short duration bonds. Essentially, it shows you that monetary policy is too tight. The bond market is indicating that short-term rates are too high and the Fed will have to ease in the near future.

As you can see by the below chart comparing the 10-year bond to the 2-year bond, recessions tend to occur shortly after the inversion.

10 vs 2

This is why everyone is freaking out that the yield curve is “flattening”. As you can see, a flattening of the curve isn’t something to worry about. You should worry when the curve inverts.

Once the yield curve inverts, there is a lag of 20 months on average before the recession begins:


20 months is a long time. This suggests to me that we shouldn’t worry about the yield curve “flattening.”  We should worry when it inverts and, even then, we have some time.

Why the yield curve works

While it is commonly known that inversions in the yield curve occur before recessions, there is little thought that goes into why the yield curve predicts recessions.

The reason that the yield curve predicts recessions is because the Federal Reserve is the most critical factor in the American economy. The Fed can’t control how productive our economy is, but they can control the timing of recessions and recoveries. The Fed is both the cure and cause of every recession.

As Ray Dalio told us, economic cycles occur because of debt. Ray calls this the “short-term debt cycle.”

The short-term (5-10 year) debt cycle behaves like the below. The Fed is at the center of it all, and the yield curve gives a good indication of where they are in the cycle.

Recession (year 0): Incomes and asset values decline. People are losing a lot of money, and the attitude is grim. Unemployment is high, and fear is high. The Federal Reserve responds by increasing the supply of money: they cut interest rates and engage in quantitative easing.

Early recovery (year 1-3): As the Fed cuts rates, the yield curve steepens, and the economy begins to turn around. Asset prices start going up. The unemployment rate starts going down. Fresh from the wounds of a recession, people and institutions take on loans but do so reluctantly and with caution.

Middle Recovery (year 2-6): Interest rates are low, and lending picks up. The economy recovery gathers steam. People and institutions are cautiously optimistic. As a result, they are more likely to take on debt.

Late Recovery (year 3-9): The economy has been doing well, and debts have accrued. Worried about inflation and an overheating economy, the Fed begins to raise interest rates. The yield curve inverts.  The debts accumulated during the rest of the recovery start to rise in costs. People and institutions start to suffer “sticker shock” when looking at their bills. They begin to scale back their borrowing and spending to deal with the rise in debt payments.

Recession: The scaling back of borrowing and spending is what causes the slowdown. The Fed created the recession by raising interest rates too much. At this point, the only cure for the recession is to cut rates.

And on and on the cycle goes . . .

Can you time the market?

We understand that yield curve inversions occur before recessions and we know why the yield curve works (it shows how tight monetary policy is and where we are in the cycle).

With that knowledge, could you use the yield curve to time the market?  In other words, stay out during the years of inversion and get back in when the curve turns positive. Below is a rough test of this idea and the ending result:


As you can see, merely staying invested all of the time yields better results than trying to time the market with the yield curve. The yield curve accurately predicts recessions, but even armed with that knowledge, attempting to bob in and out of the market winds up costing investors over the long run.

Remaining fully invested from 1978-2017 turned $10,000 into $873,590.25. Timing the market using the yield curve turned $10,000 into $510,034.21. You avoided the bear markets, but you also missed out on some of the best years in the bull markets. Additionally, you would have bought back in prematurely in 2002. The yield curve was positive, but the bear market raged on.

While the information is useful to determine where we are in the cycle, the yield curve is unfortunately not an effective way to time the market.

Peter Lynch, Warren Buffett, and Jack Bogle are right. You shouldn’t try to time the market.

The dark arts in fiction are usually something seductive that comes at a terrible price. Like eternal life . . . by splitting your soul up into horcruxes. Timing the market isn’t quite as dramatic. The seduction of avoiding bear markets simply leads to poor returns over the long run.

As I’ve said before . . . Macro is fun, but it’s probably a waste of time.

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.


A lesson I learned last year from Cato Corp, IDT, and Manning & Napier: sell out of stocks that post an operating loss and either lock in gains or cut the bleeding.

I lost 51.56% on Manning & Napier, 51.05% on Cato, and 21.44% on IDT. If I sold when their core business posted an operating loss, I could have left the positions with minimal losses. I’m fine with an EPS miss or even a loss at the bottom of the income statement that is related to a one-time expense or an accounting issue, but I think it is a clear sign that I’m in a value trap when the core business posts a loss at the top of the income statement.

I’m sold out of my 405 shares of BGFV @ $8.1293. I made money on the position, 8.27%. BGFV might continue to do well, but I’m going to stick to this sell rule. I think the rule should prevent nasty losses even if it doesn’t work 100% of the time.


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.

Q1 2018 Performance

Q1 Performance

q1 2018

For the first quarter of 2018, my portfolio declined by 3.46%, and the S&P 500 dropped by 1.22%. My strategy still isn’t delivering any outperformance from when I started. I’ve discussed the reasons on this blog. I think a bulk of it is due to value investing’s underperformance as a strategy and specific errors that I’ve made with stock selection.

I believe the outperformance will come, but there is no way to tell when it will happen. It’s not something that you can time. I just have to stick to it and be patient.

Sentiment Shift

With that said, it feels like the sentiment is starting to shift in a way that might benefit value stocks.

For years now, the market has been rewarding cool, growth-oriented companies with higher and higher valuations. You know their names: Facebook, Apple (although Apple is odd in that it sometimes trades at a dirt cheap valuation), Amazon, Google, Netflix, Tesla, Nvidia. I would even lump cryptocurrency’s run into this bucket as an example of the sentiment.

Cool things rarely reward investors. Nearly all growth companies eventually run into problems that investors can’t anticipate or imagine. The higher their valuations (i.e., the higher the expectations), the harder they do fall once they run into the problem, which is inevitable. It appears that the stars of this bull market are simultaneously hitting those problems.

Tesla, for example, has been a star of this bull market. Its rise is due to a cool product and a popular CEO. The rapid rise in Tesla stock to absurd valuations gave Elon the currency to issue new shares and debt to keep the company afloat. Meanwhile, the company has never been profitable or generated significant cash flow. That sentiment appears to be shifting.

A friend of mine owned a Tesla and took me out for a ride in it once. It’s an impressive vehicle. The iPad instead of a console, the quick and silent acceleration. All of it is super cool. With that said, auto innovation is quickly commoditized. Think about it: your bottom of the line economy car (think about a Nissan Versa or a Toyota Yaris) has all of the features that a luxury car had in the ’90s. I’ve never been a “car guy.” For me, every car does 80 mph (which is all you can get away with on a highway) and has all the features I need. Why spend any more money than I need to? Tesla’s innovations are fresh and exciting, but in 10-20 years it’s just going to be standard. The big automakers are going to copy and compete away Tesla’s innovations. In the long run, it’s probably road kill. In the short run, the stock is at absurd valuations.

Facebook Is Bad For You

Facebook is running into problems as well. The problem which has been brewing for years is privacy concerns. Facebook presents its business model as a benevolent force aimed at “connecting humanity.” The reality is that it is an addictive product whose goal is to get people to turn over information about their lives, which Facebook then sells to advertisers. The perils of that business model came to a turning point in the recent scandal with Cambridge Analytica. I don’t know if the scandal will disrupt Facebook’s business model. As long as people continue to upload their life’s details to the site voluntarily, Facebook will have something that they can monetize. With that said, recent events do appear to be having an impact:


I dropped my Facebook account a couple of years ago. Privacy was a part of it, but for the most part, I felt like Facebook was bad for me.

For me, I felt like Facebook was rotting my brain. That was the cost I was paying. The benefit was the connection with friends and family, but even that was entirely superficial. I also found myself wasting a lot of time on the app.

Regarding “brain rot,” a lot of it had to do with politics. The odd political opinions of my relatives and friends were making me dislike them. I thought to myself: did I become friends with these people because I agreed with their politics? Should a family member’s weird political opinions make me love them any less? The answer was, naturally, no.

Moreover, the bizarre beliefs I read on Facebook were hyperbole. The hyperbole on Facebook pollutes people’s outlook on the world. I also had to admit; the same thing was happening to me. I was confining myself to a shrinking bubble of information, and the increasing intensity of it all was polluting my mind. I found myself emotionally reacting to political posts instead of thinking critically about them.

The other odd thing I noticed was increased envy and jealousy. It’s unconscious, but it happens. No one posts their real life on Facebook. No one goes on Facebook and says “I had a huge fight with my husband today and I think he’s a jerk.” No one goes on Facebook and says “My children have so poorly behaved today that it makes me feel like I’m a bad parent.” No one goes on Facebook and says “My career feels like it hit a dead end and it makes me question my life choices.” However, these examples are all natural feelings that most people go through.

When you only see people post mostly “good” things about their lives, you start to think that your own life is inadequate, even though their life is probably as challenging and screwed up as your own. Think about it. Is life the happy pictures – the wedding albums, the graduation pictures, smiling families at events (the stuff that people put on Facebook) – or is it more nuanced than that? Every life has pain and disappointment. That’s not a bad thing – it’s just life.

People aren’t sharing their problems publicly on Facebook, but problems are still happening. We’re all human, and we all have issues. Social media makes us forget that and makes us feel inadequate.

I think more people are going to realize what I realized a couple of years ago. Facebook rots your brain and kills your self-esteem.

One of the most significant challenges in life is preventing your emotions from fooling you. Social media can make that an even more difficult task than it already is.

I digress. For growth stocks, the sentiment does appear to be shifting. We’ll see if it lasts.



The average investor allocation to equities

At the end of last year, the average investor allocation to equities in the United States was 43.787%. We are now beyond previous sentiment peaks, and current valuations had only been higher in 1998-2000. The 43.787% metric implies that in the next ten years we can expect returns of roughly 2.5%. The 10-year treasury yields 2.74%, so stocks no longer offer a premium over bonds.

The road to those returns is unknowable, but I think most investors are going to be disappointed in their returns over the next decade.


The spread between the 10 year and 2-year treasury. When the 2 year has a higher yield than the 10 year (an inversion), it implies that monetary policy is too tight and will probably trigger a recession.

Concerning recession risk, the yield curve has not yet inverted, but it is in the process of flattening as the Fed raises rates. The lack of inversion means that a recession is unlikely over the next year. Eventually, however, the Fed’s tightening will cause a recession as it always does. The Fed is the cause and cure of every recession.

What this means for the short-term direction of equities is anyone’s guess. It does reduce the risk that equities will go down in a 2008-2009 style 50% drawdown. If the market does decline, it will probably be more like the 2000 decline. The economy was healthy, but valuations were absurd.

Of course, this bull run might just be getting started, and valuations may get even more insane. Over the short run, it is unpredictable, but we can infer from valuations that long-term returns will not meet investor’s expectations.

The Return of Volatility

After remaining dormant for a long time, volatility returned in force back in February. Volatility spiked, the market went down a little bit (10%), and everyone lost their minds. For people who were crazy enough to “short” volatility, they suffered a permanent loss of capital.

What’s funny about the whole ordeal was that the market decline was pretty tame and the rise in volatility was actually pretty normal in a historical context:


The return of volatility: angels and ministers of grace defend us

It was also really funny to me that so many tried to develop an explanation for the February decline. The reality is that there still isn’t agreement on what caused the crash of 1987! If we can’t fully understand what caused the crash of 1987, how can anyone say with authority what caused a 10% hiccup in February?

Everyone overreacted and lost their minds over a pretty normal event.

Volatility is your friend. Volatility is Mr. Market overreacting to events and losing his mind. You want to take advantage of Mr. Market, not be ruled by his mood swings. Too many investors fail to understand that the volatile nature of stocks is the reason that they offer opportunities to purchase mispriced assets.

If you can’t handle volatility – if you can’t handle very normal events like the one in February – then you don’t belong in the stock market. Bottom line, if you can’t afford to lose half of the money invested, it shouldn’t be in stocks.

Stocks are going to suffer a massive decline at some point. You can’t predict when that will happen, but I guarantee that in the next 10 years there will be multiple episodes when stocks suffer gut-wrenching declines. If you can’t handle them, then stay the hell away from the market.

It’s a good thing that most people can’t handle volatility and have no stomach for the gut punch that stocks frequently deliver. As long as most people are like this, Mr. Market will continue to offer attractive opportunities to people with the right emotional temperament.

My Portfolio

Below is a list of all of my open positions and the percentage change since I bought them:


Random musings:

  1. Retail: My retail stocks continue to weigh on my portfolio with the notable exceptions of Dick’s Sporting Goods and Foot Locker. Both companies delivered somewhat decent news, which was enough to deliver some solid gains. The two cheapest stocks in my portfolio (Francesca’s and Gamestop) continue to disappoint. Big Five isn’t doing quite as bad as those two, but it is still making me wince. Amusingly, Francesca and Gamestop are the two stocks that I am the most excited about. They are both priced for roadkill and any whiff of good news is going to send the stocks soaring (I hope).
  2. The international index ETFs I purchased for countries with low CAPE ratios are all doing very well and delivering solid performance. Russia and Singapore are doing the best, while Poland is the only one that is down.
  3. I didn’t do much this quarter. I did one trade, a small purchase in Argan. I had $1,000 in cash left from a distribution from Pendrell (odd lots were paid out when the company de-listed) along with some dividend payments. I decided to deploy it in Argan, which is an absurdly cheap stock with an enterprise value that is less than 1x its operating income. The timing was lucky, as the stock surged almost immediately after I bought it.
  4. Aflac was fairly volatile this quarter due to some lawsuits from former employees. The stock had a brief decline and then bounced back. It doesn’t seem to be a big deal and the stock continues to be one of the cheapest in the S&P 500.

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.

Financial Statement Basics


Before you invest your hard earned money, put the company under the microscope.

I received a request from a reader on how to read financial statements and do some basic company research. I thought it was an excellent idea for a post!

Below is a very brief summary of places and methods to find information on companies along with a description of how to read financial statements.

Accounting statements aren’t something that generates “clicks,” which is why some of these basics are hard to come by on a basic google search. I wish I had a little summary like this when I started out.

Types of Financial Statements

I throw around terms on this blog like “enterprise value,” “net current asset value” like everyone knows what they are. Of course, not everyone does, so I hope this helps.

If you want to go more in-depth than the summary I’m giving here, there are some books you can check out to learn about financial statements. The Interpretation of Financial Statements by Ben Graham is probably your best bet. It’s a concise, quick read. Stig Broderson and Preston Pysch (who host my favorite podcast) also wrote an excellent book on financial statements: Warren Buffett Accounting.

As a brief recap of Accounting 101, here are the three financial statements and their purpose:

Balance sheet – The balance sheet is a statement of a company’s assets and liabilities at a fixed point in time.

Income statement – This is a snapshot of how much money a company made over a period of time.

Cash flow statement – This is a breakdown of how a company’s cash position changed over a period of time. The statement of cash flows wasn’t required for a company to post until the 1970s.

Where to obtain financial statements

Google Finance was my go-to source for financial statements. It had a very nice summary of financial statements, with accompanying charts. For some reason, they decided to dump it. Their “financials” section is currently a few critical ratios on the company.

These days, there are a few places you can obtain free financial statements. Morningstar is an excellent source and offers free financial statements and valuation ratios. They also show relative valuations, which is nice when you want to compare a company to others in the same industry. Just go to the website, type in the ticker, and go to financials.

Yahoo Finance is also an excellent alternative to Google Finance. In their “statistics” section they even break down EBITDA and Enterprise Value, which is something that Google never did. On the downside, the website isn’t as clean and fast as Google used to be.

Why, Google, why?

K’s and Q’s

The gold source for financial statements is company filings with the SEC. When I am interested in a company, I usually start my search with free services like Yahoo. If I like the numbers, I will then go to the SEC website and delve deeper.

Because it’s possible that the free service (Yahoo, Google, Morningstar, etc.) may have input the wrong #’s into their online financial statements, I always double check their work by going straight to the 10-K and make sure that the numbers match up.

You can find 10-K’s for free at the SEC website. Scroll down on the homepage and search any ticker:


The output of this search looks exceptionally intimidating.


Don’t be intimidated. The documents you want to focus on are the K’s and Q’s. 10-Q’s are quarterly statements. 10-K’s are annual reports.

When you click on a K or Q, you’ll receive another batch of documents. The only doc you need is the first one. That will contain the financial statements and management commentary.


The 10-Q will start off with the consolidated financial statements. This is the financial statement for the entire company. If you scroll down in the 10-Q, it will break out separate financial statements for each division along with commentary. For our purposes, you only need to concentrate on the first financial statements that you see, the consolidated financial statements.

My recommendation is that you check out the consolidated statements on the free sites. If you like what you see, double check Yahoo and Morningstar’s work by going to sec.gov and double checking the numbers for yourself.

Typically, my focus on the 10-Q is the financial statements.

Once I’ve checked the numbers, and I like what I see, the next step is reading the 10-K. I recommend reading the recent 10-K for every stock that you buy. The 10-K will provide financial information, but it will also summarize all of the company’s activities more robustly than you’ll find on the quarterly statements.

In my opinion, the most critical section of a 10-K is called “risk factors,” and it is generally near the beginning of the report. This is the section where management is legally required to disclose anything that they deem to be a risk to the business. In other words: while much of the 10-K is management’s opportunity to gloss over and obscure problems facing the company (it’s like a job interview – they are going to give you 110% and their only weakness is that they work too damn hard), the risk factor section is one where they are legally required to cut through the B.S. and tell you what they’re worried about.

The SEC: A watchdog and fountain of information

The SEC is one of the main reasons that I only buy individual stocks in the United States. The SEC isn’t the perfect watchdog, but it’s the best in the world. With the SEC website, you have every public company’s financial statements at your fingertips. Moreover, you have an enforcement agency to keep these companies honest. I’m fine with buying a massive basket of 50 companies in one country, but I simply don’t trust other enforcement agencies enough to buy individual foreign stocks. I also can’t easily find financial statements the way that I can in the U.S. As a guy with a full-time job for whom investing is a hobby, I also don’t have the time to dig around to find foreign financial statements. Reading everything available for a US companies takes up enough time!

The Balance Sheet

As stated earlier, the balance sheet is a statement of a company’s financial position at a given point in time. The focus here is on assets and liabilities.

The balance sheet is broken up into three sections: assets, liabilities, equity. Equity is a confusing term in finance because it is used to describe different things. Equity can mean an ownership interest in a company. On a balance sheet, equity is merely the difference between assets and liabilities.

The balance sheet equation is simple: Assets – Liabilities = Equity

When we talk about book value, we’re talking about equity. That’s the accounting asset value of the entire company.



Assets are broken out into current assets and long-term assets. The order of items begins with the most liquid and liquidity decreases as you go down the list of assets. Current assets are assets that can be liquidated in a time period less than a year, so they are listed at the top. The most obvious asset is at the top: cash and cash equivalents.

The second section is longer-term assets. Property, plant, and equipment is pretty basic. That’s the big stuff that the company owns. Buildings, smokestacks, etc.

Goodwill is a kind of accounting fiction. When a company acquires another company, they usually pay more than the true accounting value of the new company’s assets. They’re buying the company for its long-term cash generating ability, not merely the value of the stuff that it owns. This excess amount is treated as an “asset” and is on the books as goodwill.

Goodwill also comes into play on the income statement. Goodwill is expensed over time, an event that is called “amortization of goodwill”. This is why income estimates like free cash flow or “Earnings Before Interest, Taxes, Depreciation, and Amortization” are designed to exclude items like this. It’s not a direct cash expense.

Intangible assets are things like patents and copyrights. Basically, they’re real assets that aren’t easily liquidated into cash.

Deferred taxes are assets that the company expects to recoup at a later date in the form of a tax refund. This is not liquid because the company can’t just sell this or obtain it immediately. They have to wait until the appropriate time to include this expense.

When we calculate tangible book value we are stripping away goodwill and intangible assets. In contrast, book value treats all assets equally. Tangible book value focuses on assets that you can actually turn into cash. Tangible book value = Tangible Assets – Total liabilities.

Ben Graham’s Balance Sheet Approach

Ben Graham’s focus was on net current asset value, which is even more conservative than tangible book value. Ben didn’t even give value to property, plant, and equipment or longer term assets. His goal was to focus on what the company could sell for as scrap. He thought that asset value should focus entirely on current assets. Net current asset value = Current Assets – Total Liabilities.

When Ben took the metric to an even more conservative extent, he focused on working capital, which was the current asset value which only assigned 75% of value to receivables and 50% of value to inventory. The idea was to get a rough approximation of a conservative liquidation valuation. In a liquidation, inventory would be unloaded at fire-sale prices and not all of our customers would pay the company back due to impending doom. This is the most conservative estimate of a company’s value. Company’s that sell below this value are essentially worth more dead than alive.

It was net current asset value and net working capital stocks that Ben Graham used to generate 20% returns for his investors in the 1930s through the 1950s. Warren Buffett used this method in the 1950s, but abandoned it because he became too large to employ it effectively.

Today, these opportunities mostly exist abroad. They are available infrequently in extreme situations (one stock I own is a net-net – Pendrell) during normal times. They are only available in large numbers in the United States during times of economic stress. Even then, they are in a micro-cap universe that most investors can’t take advantage of (this is a good thing!) They were available in large quantities during the dot-com crash in the early 2000s and after the 2008 crash. Like cicadas, they only emerge once every decade or so.

I’m patiently awaiting the next opportunity to buy a lot of them.



Most value investing ratios treat all liabilities equally to ensure maximum conservatism when assessing value.

Like the assets section, the liabilities section is listed in order of the time in which the payments are due. Current liabilities are debts that the company needs to pay in a year. Accounts payable are short-term bills due. Further down the liabilities section is long-term debt, which are long-term items like bank loans and mortgages on properties.

Deferred income taxes, in contrast to deferred taxes in the assets section, are income taxes that the company will owe in the future.

When we talk about the debt to equity ratio, we are talking about long-term debt divided by equity. This is an excellent rough metric to measure how leveraged the company is. Current liabilities aren’t included in this metric because current liabilities may be a simple part of the business’s operation and aren’t a long-term risk. Graham recommended a debt/equity ratio below 100%. In my backtesting, I’ve found that debt/equity ratios below 50% tend to work best.


Enterprise Value

Enterprise Value is a term that value investors throw around a lot. Traditionally, investors focused on the total market value of a company’s stock (per share price times the number of shares) – also known as “market capitalization.”

Enterprise value goes beyond simple market cap and tries to calculate the total cost of the entire business to an acquirer. If we were to buy the whole company, we wouldn’t merely have to pay the market price. We would also become responsible for all of the company’s debts. We would also have to pay out holders of preferred equity. Additionally, we would have full access to the company’s cash on hand for whatever we want. The enterprise value is the sum of all of these components to arrive at the true cost of buying the company.

This is important because a company can have a low market capitalization, but a massive amount of other liabilities. Valuation ratios using the enterprise value try to take the entirety of a company’s size into the valuation equation.

You can calculate enterprise value by using the relevant balance sheet items and then adding it to the market capitalization.

Enterprise Value = Market capitalization + Debt + Minority Interest + Preferred Equity – Cash

Income Statements

The statement of income attempts to sum up how much money the company made over a set period of time.

As a general rule, the items at the top of the income statement are more reliable than the items at the bottom. It’s hard to fake sales, for instance. It’s easy to play games with taxes and depreciation. A typical income statement looks like the below:


The income statement is reasonably self-explanatory. You start with sales and you take away the cost of sales (also called “cost of goods sold”, or expenses directly tied into what you’re selling) and you arrive at gross profit. After gross profit, you take away “selling expenses” (all of your expenses that aren’t directly tied to what you’re selling).

If we were running a lemonade stand, sales are the total amount of money that we received from patrons for lemonade. Cost of sales would be cups, lemons, water, and sugar. Selling and administrative expenses are what we’re paying our lemonade stand employees.

You then take out depreciation and amortization. The full cost of an asset (i.e., our pitchers for the lemonade and wood to make the lemonade stand) isn’t expensed up front, it’s spread out over a period of time. For each period, this is the cost in the form of depreciation. Amortization usually refers to the “amortization of goodwill,” which is expensing how much we paid up for the business over its accounting value.

This then takes us down to “operating income”. When we’re talking about “earnings before interest and taxes“, this is what we’re talking about. The reason that many value investors focus on this metric of income is simple: (1) The further you move up the income statement, the less likely the numbers are to be manipulated, so it’s better to focus on an item closer to the top of the income statement. (2) If we’re using enterprise value in the denominator of the valuation ratio, we are already assuming that we’re paying off all of the company’s debts. This allows us to take away the interest expenses. In other words, it provides us with a rough-and-dirty way to compare the relative valuation of companies that have entirely different capital structures.

We then take out taxes, include money made from interest, and take out money spent on interest — this then brings us to net income.

From net income, to arrive at earnings per share, we subtract dividends paid to investors and other distributions. We then have “earnings per share”. This is the E in P/E. When looking at P/E ratios, it is important to examine the earnings and make sure that they are all “real”. If the trailing twelve-month earnings are boosted by some goofy accounting trick in tax expenses or amortization/depreciation, then the P/E can be artificially low.

Usually, when you see quoted values for operating income and earnings per share, it is referred to as “TTM” or “trailing twelve months.” This simply means that they are adding up the numbers over the last four quarters to show you a trailing year of earnings and income.

Most investors use “forward” P/E ratios, or a P/E based on estimated future earnings. Forward earnings estimates are relatively worthless. The backtesting proves this. There is no value ratio that tests as bad as forward P/E’s.

Cash Flows

The statement of cash flows summarizes the change in a company’s cash position from one period to another. The total change in cash on the statement should tie into the change in “cash and equivalents” from one quarter to another on the balance sheet.

The statement of cash flows wasn’t required until the 1970s, after many company blow-ups that weren’t detected on the income statement. If a company is generating tons of sales and income, but they’re burning cash, it’s going to be difficult for them to stay in business over the long-run.

Warren Buffett contends that the real value of a company is the cash flow it can generate for the owner over time.

cash flows

The statement of cash flows is broken down into three sections:

Cash flows from operating activities – This is the section that focuses on the cash that is actually being generated from the business. This is the section that most value investors hone in on. It begins with net income and subtracts all non-cash expenses like depreciation and amortization (because they aren’t real cash expenses). Ideally, the number should be positive, demonstrating that the company is actually generating cash for its owners.

Cash flows from investing activities – This shows you how much cash the company generated from its investing activities. If you were to go out and buy a stock or a bond, it would be a negative number on the statement. If you sold stock, it would be a positive number on the statement. It doesn’t show if the asset was sold for a profit. It simply shows how much cash your investing activities generated. A negative number here isn’t necessarily a bad thing. It simply means that the company bought financial assets more than it sold them. A positive number isn’t necessarily a good thing because it doesn’t tell you if the company sold the asset for a profit.

Cash flow from financing activities – This is cash flow related to the activities of the company outside of normal operations and investing activities.

Cash that the company paid out in dividends to the owners or used to purchase back stock would be a negative number for this. Money borrowed from a bank would be a positive number because that’s cash coming into the company.

The net effect of all three sections will show you the net change in a company’s cash position in a quarter or a year. This change should tie into the “cash and equivalents” section that is on the balance sheet.

High positive cash flows are not necessarily a good thing. If the company is bringing in cash through debt issuance or issuing new shares (diluting your ownership stake), it is not good for investors.

A term that value investors use frequently is free cash flow. This is what you want to focus on when examining the statement of cash flows. Warren Buffet refers to this as “owner’s earnings.” Free cash flow is simply: Cash Flows From Operating Activities – Capital Expenditures. You can find the capital expenditures as a line item in “cash flows from investing activities”. For the above example, they list it as “purchases of property, plant and equipment”. In other words, free cash flow excludes all of the other investing and financing activities conducting by the company.

Free cash flow focuses solely on cash generated by the operating business minus the money spent to keep the business operating.

If you were to buy the business in its entirety, free cash flow is the money that you would have as the owner to (1) pay yourself in the form of dividends or share buybacks, (2) invest to generate more cash flow in the long-run.  Free cash flow is the cash available to you, the owner of the business.

free cash flow


I hope you find this brief summary useful. I know I could have definitely used this breakdown years ago when I got started investing in individual companies. It’s not as hard or intimidating as it appears on the surface.

Investors frequently lose sight of what a share of stock is. A stock isn’t a ticker symbol and a number. It’s not a line on a chart that bounces around that you can find hidden meaning in. A share of stock is an ownership interest in a company. You are a part owner of a company. Before you lay down a dime, you should find out what that company does and understand its financial position.

If this homework sounds too hard, then you shouldn’t go out and buy stocks in individual companies. If you are willing to put in the work, then give it a shot.

There is obviously much more to learn about financial statements and company research, but I hope this is an excellent basic summary that you can use as a springboard to learn more.

Accounting is boring, but it is the language of business, and it’s essential that you know it before you go out and buy an individual company’s stock.

This has nothing to do with investing. I just love it. 🙂

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.

“You Can Be a Stock Market Genius” by Joel Greenblatt


The Book

“You Can be a Stock Market Genius” is Joel Greenblatt’s classic 1997 book. Don’t be dissuaded by the ridiculous title. This is a money making handbook for the small investor who is willing to get their hands dirty and do a lot of homework.

Joel Greenblatt is one of the best investors of all time.  I reviewed another book of his: The Big Secret for the Small Investor in this blog post.

The two books have the same philosophical value investing orientation but are polar opposites in terms of difficulty. The Big Secret is for passive buy-and-hold investors who don’t want to deal with all of the homework of actively picking stocks. You Can Be a Stock Market Genius is a homework-intensive strategy that Joel employed when he was running his hedge fund from 1985-1995 and achieved 50% annual returns.

No passive strategy will get you 50% returns. No systematic quantitative approach will get you 50% returns. Achieving that kind of stellar performance requires a hell of a lot of work and luck. The book is Joel’s outline of the various hunting grounds that he used to generate those amazing returns.

The Small Investor’s Advantages

The book opens with an inspiring message. The small investor has advantages over prominent professionals. Big professionals managing billions of dollars in capital can’t: (1) concentrate in a handful of small positions, (2) take the career risk of dramatically underperforming the benchmark (they’ll get fired), (3) won’t invest the time and resources necessary to investigate weird and tiny situations that they can’t allocate a significant portion of their capital to.

A small investor can do all of those things.

In a world where ETFs with 50 positions are considered “concentrated”, Joel’s definition of “concentrated” is wildly different than the mainstream view. The mainstream view is that “risk” is volatility of returns and “risk” can be reduced by holding more positions. Joel suggests that as few as 8 stocks in different industries is sufficient to properly diversify a portfolio.

8 stocks would result in so much volatility that it would be career suicide for any professional investor. Most people can’t handle volatility. A small investor with the right temperament can. Unfortunately, most small investors squander this advantage. We’re never going to beat Wall Street at their own game: namely, smoothing out returns and reducing volatility (i.e., pain) with fancy financial engineering.

What we should do is focus on the advantages that we have: (1) Temperament – If we have the proper temperament to endure volatility, we can achieve better results. (2) Size – If we’re willing to focus on areas that are hated and ignored, roll up our sleeves and do the work, we can concentrate in situations that Wall Street pros can’t.

I did some backtesting of my own a few months ago to test the limits of concentration. I looked in a Russell 3000 universe with a straightforward strategy of buying the cheapest stocks on an EV/EBIT basis. I constructed portfolios rebalanced annually beginning with 1 stock (the cheapest in the universe) and then just adding the next cheapest. I then plotted the monthly standard deviation of returns (Wall Street’s definition of risk – which is a flawed concept, but whatever).


It looks like Joel Greenblatt is correct. Most of the volatility is meaningfully reduced with a handful of positions. He offers a caveat, however, and suggests that if you are going to run a concentrated portfolio, it is best to diversify among a group of different industries. In today’s market, for instance, it may be tempting for a value-driven bottom feeder like myself to own 10 retail stocks. This would be a bad idea.

Wall Street pros and most investors have no stomach for volatility. We saw a vivid example of this in February. The market fell 10%. This is a remarkably normal event in the grand scheme of things. I was on vacation at the time that this happened and couldn’t help but laugh at the insane overreaction to this little event. It generated headlines like this: “Stocks Plunge and Traders Panic” – The Wall Street Journal, “Dow falls more than 1,000 in biggest daily point-drop ever” – thehill.com

If you want to achieve better than average results, you need a better than average temperament to ignore this nonsense.

How to think about the market

Joel tells two stories in the book that represent excellent ways to think about the stock market.

The first is a story about his in-laws. His in-laws were amateur art collectors. They weren’t looking for the next Rembrandt or Picasso, they were looking for small-scale mispriced works of art. They went to yard sales and flea markets looking for paintings that were cheaper than their value. They would find paintings that were at the yard sale for $100 that they knew were worth $1,000, for instance.

This is a useful way for small investors to think about the stock market. The professionals need to find the next Rembrandt and Picasso. We should let them fall over themselves trying to figure out what company is going to be the next Facebook or Microsoft. Most of them will fail and a handful will be lauded as geniuses (they were probably just lucky). For us, we can achieve satisfactory results by merely finding things off the beaten path that is a decent discount against their intrinsic value.

Joel tells another great story where he went to the best restaurant in New York, Lutèce. Joel asked one of the chefs if an appetizer on the menu was good. The chef replied with: “it stinks.” The message was clear: it didn’t matter what you ordered off the menu. Everything was excellent because Joel was at the best restaurant in New York. The best way to invest in the stock market is to identify those places that are the best places to invest, where no matter what you pick, the chances are that it will be good.

The book outlines some key hunting grounds where Joel had success finding these opportunities.


The goal of investing is to find mispriced assets. You want to seek out areas of the market where stocks are prone to mispricing.

One area that Joel finds to be replete with mispricings is spin-offs. Spin-offs are divisions or subsidiaries of a larger company. The larger company decides to “spin off” that piece into a separate company.

Why do companies do this?  They may think that if they isolate the entity in the market, it will be able to command a higher valuation.  For instance, let’s say (in an extreme example) that an insurance company owned a financial software division. Software companies have higher P/E ratios than insurance companies. However, the market might not appreciate the software company because it is buried in an insurance company. If they spun it off – the software company would probably command a higher valuation if it were isolated.

The larger firm might also want to separate itself from a “bad” business that is weighing it down. They might just want to use the spin-off to unload debt on a smaller firm. There could be tax or regulatory reasons. They might have difficulty selling the business, so they decide to dump it in the form of a spin-off.

Whatever the reason, spin-offs are prone to mispricing. This is because institutions and people often sell them for reasons other than the intrinsic value of the company. Some institutions might not even be allowed to own it due to small market capitalization, or it doesn’t fit into their “strategy.” Individual investors probably wanted to hold the larger business and have no interest in owning something completely different. In any case, spin-offs are prone to indiscriminate selling, which creates mispricings and opportunities for smaller investors like us.

In the book, Joel takes you through several real-world examples of spin-offs. He explains why the spin-off was pursued and why he thought it was an attractive opportunity to invest in.

Currently, I own one spin-off in my portfolio: Madison Square Garden Networks (MSGN). My rationale for holding it is described here. I became aware of the opportunity when looking at a list of recent spin-offs back in 2016.


Joel then moves onto mergers as an opportunity for mispricings.

He first addresses the obvious: merger arbitrage. Merger arbitrage is buying a stock after a deal is announced and trying to earn a spread between the buyout price and the market price. For example, let’s say a company is trading at $30 and another company buys it out for $40. As soon as the deal is announced, the stock will rally to $39. A merger arbitrage strategy would buy the stock at $39 and wait for the deal to be consummated.

Joel thinks this is a dumb strategy and I agree with him. The reason is that you are taking on the risk of the deal not going through, in which case the stock will plummet. Mergers fall apart all the time, usually for regulatory reasons. Why take on that risk to make a measly 2.5% gain in the example I provided (in the real world, those spreads are even smaller and keep getting smaller as more people become involved in merger arbitrage).

It’s a strategy that might make sense for a big institution that can hire lawyers and analysts to know for sure whether a deal will indeed go through, but that’s not something small investors like myself can take advantage of.

Where Joel does believe there are opportunities for investors is in the world of merger securities. Often, a buyout can’t be financed entirely with cash and debt. Sometimes, strange derivative securities are sold (usually warrants) to fund a piece of the transaction. Investors will often indiscriminately unload these merger securities, and this will create mispricings.

The difference between a warrant and an option is that a warrant is issued by the company. That’s it. Both of them are merely a contract to buy or sell a stock at a pre-determined price on a future date.

Joel thinks this is a good area of opportunity. I don’t disagree, but I think that pricing merger securities are beyond the abilities of most small investors like myself. I’ve never owned an option or warrant in my life and place it in my “too hard” pile. You might want to tackle it and more power to you.

Like the spin-off section, Joel takes you through a few real-world examples of times that he purchased merger securities and did very well. I think the strategy is too hard to implement for the small investor, but you might disagree.


Emotions create mispricings. Greed and comfort with consensus create insane valuations for amazing companies. Revulsion, hatred, and fear create mispricings among “bad” companies. Nothing generates an “ick” feeling more than bankruptcy.

Joel does not recommend buying stock in bankrupt companies (that’s in the “too hard” pile”). The reason is apparent: equity holders can get wiped out in a bankruptcy. He does believe that the debt of bankrupt companies is often mispriced and offers incredible mispricings. Unfortunately, distressed debt investing is not only challenging to research for small investors but frequently impossible for anyone but an institution to invest in.

He believes that small investors can invest in companies emerging from bankruptcy or going through a restructuring. Often, a company went bankrupt only because it was loaded up with too much debt. They might have a viable business model that was merely being weighed down by too much debt. After emerging from bankruptcy or going through a healthy restructure, it may give the company an opportunity to shine. Meanwhile, the stigma of the bankruptcy creates a nice discount from intrinsic value.


Most classic value investors (me included) think that options are an area that is best for most people to avoid. I agree with this sentiment. Options (and warrants, which are the same thing) are a zero-sum game. Only one side of the trade wins: either the person who wrote the contract will win, or the person who bought the contract will win. They can’t both make money. Zero-sum games are usually areas of the market that are difficult for small investors to make money.

Joel takes a bit more of a liberal attitude towards options. While he doesn’t recommend actively trading options, he does suggest using long-term options (LEAPs – options contracts that mature in over a year) as a way to leverage up the return on a value stock. A LEAP will experience much more significant price swings than the overall stock. If a reasonably priced value stock experiences a 20% gain, for instance, the underlying LEAPs contract will experience a much more significant increase. It’s a way of leveraging up the bet, with the caveat that if the stock falls below the strike price, it will expire worthless. More risk, more reward.

Joel does not recommend that these bets comprise a significant portion of a portfolio, but argues that they can serve a place to amplify returns.

For me, I put all of this in my “too hard” pile. When I contemplate buying options or warrants, it sounds to me like someone saying “Let’s try crack. What could go wrong?”


You should read this book! My brief summary doesn’t do the book justice. While I gave you the broad strokes in this blog post, there is nothing like reading the book and going through the case studies which Joel provides. He provides you with his entire process: how he found out about a specific opportunity, what he liked about, where he researched it and how the idea worked out.

The first and last chapters are useful for developing a template for thinking about markets. As I stated earlier, the goal is to find mispricings. That often means going off the beaten path and finding forgotten and hated corners of the market. Joel provides a roadmap to a few areas that served him well, but they are by no means the only ways to do it.

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.

I am a value investor. My outlook is inspired by the ideas of Benjamin Graham. This site is a real time chronicle of my portfolio and an outlet to share my ideas. I hope you enjoy.