The Making Of A Value Investor: The 2015 Edition

Summary Looking back at the last 18 months this is what I learned, in the order I wish I learned it. I discuss my thoughts on: framework, where to search for stocks, how to analyze them, portfolio sizing, etc. I share some of my favorite books and Seeking Alpha authors. I started my quest to becoming an investor during the Summer of 2014. Since then, I have read countless books, chosen financial markets as my major, met multiple hedge fund managers, became a contributor for Seeking Alpha, and most importantly started investing. Along the way I have learned much. Looking back at the last 18 months, I asked myself, if I had to do it all again, where would I start? This is my best answer, my try at a roadmap, and a few lessons I learned along the way. If I learn as much in the next year, I will be satisfied. I hope this will be helpful to readers just starting out. I also hope it will help readers get to know me as a Contributor. I. A Value Investor’s Framework. Warren Buffett’s notoriety helped me get started. As I was facing the mountain of information available in books and online, it was extremely overwhelming to figure out where to start. So I picked Buffett. My rationale was straightforward: This guy obviously figured it out, so what are his tricks? What are his secrets? Quickly enough I was led to Graham’s book: The intelligent investor. You’ll meet very few people with an interest in the stock market who will admit to not having read the book. Everyone has an opinion on it too: some say it is the cornerstone of value investing. Others say it’s outdated, and that there is no such thing as net-net anymore. I read it. The real lessons were in between the lines. The magical secret that I thought would make me a zillionaire by the end of the month didn’t exist. My key takeaway is that being a successful investor is function of your state of mind more than the tools at your disposal. Source: If you don’t understand value investing in 5 minutes, you never will. – Ben Graham Simple, but it is a concept which is at the core of value investing and my beliefs as an investor: Buy something for less than it’s worth. The difficulty resides, of course, in determining how much something is worth. For that you will need several tools, and you will need to think in a way most people don’t. As such, being a value investor doesn’t apply only to stocks, but to buying groceries, shopping for clothes, and how you choose to spend your time. The eternal question is: Am I getting more than I’m giving? You can’t do the same things others do and expect to outperform. Unconventionality shouldn’t be a goal in itself, but rather a way of thinking. – Howard Marks. This is an oversimplification of the framework within which I have chosen to analyze the markets and securities. Here are my favorite books for anyone who wants to embrace this mentality and view of the world. Howard Marks: The Most Important Thing Seth Klarman: Margin of Safety George Clason: The Richest Man In Babylon George Soros: The Soros Lectures II. Where To Look For Securities? Source: Featurepicks Understanding the framework is one thing, operating within it is when the fun starts. If we group together all securities listed on the NYSE, Nasdaq and TMX Group, there were a total of 9012 as of January 2015. It is unlikely that any of us will ever have time to sift through all of them to find a mispriced gem. As such, we must find places where there might be a structural or emotional reason which justifies a discrepancy between price and value. In a market there must be a buyer for every seller, and a seller for every buyer, and understanding what motivates your counterparty is key. Try to imagine what the person on the other side of the trade was thinking. – Leon Levy It is Seeking Alpha’s contributor Chris Demuth Jr. who first got me to think this way. He takes pride in ” looking for non-economic counterparties “. There are many places one can search to reduce the amount of securities you need to look at to find an opportunity: worst performing stocks on any given daily session, spinoffs, mergers, upcoming inclusions or recent exclusion of major indices, articles in Wall Street Journal or Barrons (If you are going to subscribe make sure you get a discount, and once the discount is up call them to cancel, they will give you another), people you talk to, and authors on Seeking Alpha. You want to be looking in places where any of these apply: Your counterparty is panicking, and you can provide the liquidity they need at the price you want. Your counterparty isn’t looking, maybe there is no or little Wall Street/Bay Street coverage? Your counterparty doesn’t have a choice, like an S&P 500 ETF (NYSEARCA: SPY ) having to sell all of their position in the 500th stock when it becomes the 501st largest stock. Or like dividend funds having to sell their position when a company cuts the dividend, or spins off a division. What gets us into trouble is not what we don’t know. It’s what we know for sure that just ain’t so. – Mark Twain Flip the question, what does your counterparty know, that just ain’t so? There are three books I would recommend you read to help you find the best people to buy and sell from. Joel Greenblatt: You Can Be A Stock Market Genius Leon Levy: The Mind Of Wall Street Ken Fisher: The Only Three Questions That Still Matter Immature poets imitate; mature poets steal. – T.S. Eliot Here on Seeking Alpha, we are lucky enough to have among us some great minds. Sift through different authors, find authors who have a style you like. Think for yourself, but feel free to steal ideas, trust me the stocks don’t care whether your hard work found the opportunity or someone else’s did. These are my 3 favorite authors, but based on your style, there are many others which can offer you what you need. In no particular order: Also, look up value funds in your town. Send them an email, have a chat, ask questions, build relationships. Motivate your friends into learning more about investing, you’ll be doing them a favor. Everyone you know with a common interest in investing might have a great idea for you. III. How To Analyze The Stocks You Find? Source: Crossfitinvasion Once you have found a security with a reason to justify its mispricing, you will want to figure out what is the company worth. As an investor you will come to look at stocks as companies, not as lottery tickets. In doing so you will have to analyze companies’ business models and industries. It might seem like a daunting task and you might not have access to professional industry reports (I don’t), but a few quick searches on Google will help you gain the insights you need. Warren Buffett says he looks for companies which have large moats around them, companies whose returns on invested capital remains above their cost of capital for a long period of time. You will also want to analyze the management and strategy of the companies. To help you understand great business models and great management, there are two books which I recommend: Michael Porter: Competitive Advantage Mckinsey: Value, The Four Cornerstones of Corporate Finance. You will gain many insights from reading biography type books of successful investors. Time Horizon is a framework for patience. The two are almost the same thing but the first helps with the second. Knowledge and time horizon team up so you can more easily be patient. – Frederick Kobrick I enjoyed these: Peter Lynch: Beating the Street Mark Stevens: King Icahn Frederick Kobrick: The Big Money Peter Cundill: There’s Always Something To Do Obviously you will need to have a working knowledge of corporate finance, accounting principles, and valuation models. I use comparable ratio analysis as a guide to how a company fares against the competition. I will question any discrepancies in multiples within an industry to understand why some companies command higher relative prices than others. There usually is a good reason. I will also perform a DCF valuation of stocks I analyze. My thoughts on such models are mixed, since the output is only function of the inputs. Bullsh*t in, Bullsh*t out. When I talked to Natcan’s previous CEO Pascal Duquette, he told me of a time when he had to value an oil rig which was privately owned by a fund he worked for during his career. He had all the information, from the number of workers, to the amount of planned production. After just two years, his previsions of earnings were off 25% because one input hadn’t been correctly modeled. On the other hand a business’s value is equal to the present value of the future cashflows the business will generate, so you can’t ignore the model. The way I proceed is by reverse engineering the DCF. Assuming constant margins, what revenue growth is required to justify today’s price? Is such growth attainable? If not, what kind of margin improvement will be necessary at a lower growth rate to justify today’s price? Once again, is it achievable? From there I’ll use my judgment, are the assumptions priced into the security underestimating its potential, or overestimating it? By how much? Are they being underestimated enough that even if my conservative estimate is off, the security is still mispriced? Thinking as an investor, means creating a distribution of potential outcomes in your mind. If X, Y or Z happens, what does it mean for the price of the security? How likely are X Y or Z? What is the weighted value of the security for these given outcomes? It is an approximate exercise, but it’s the best we have. It’s what Howard Marks would call “second level thinking”. IV. How Many Securities Should You Buy? Source: icollector Now we come to portfolio allocation. I have to say, I’m unimpressed by Markowitz’s portfolio theory, and most of modern finance’s theory of investing. They teach us how markets should be, not how they really are. The single reason ultimate diversification doesn’t work, is that in times of crisis, correlations go to one, and you lose as much money as everyone else. As for eliminating firm specific risk, the consequence is also eliminating firm specific return. Risk doesn’t lie in the volatility of returns, but comes from the operations of the companies in which you invest in, and the price you paid for those companies. So how many stocks should you buy? It depends. It depends on your goals, on your aversion to losing money. I have met with the money managers from different firms, here are a few who have different outlooks: Brian Pinchuk from Lorne Steinberg Wealth Management , this value firm believes in investing no more than 3% of the portfolio in an individual security. Patrick Theniere, from Barrage Capital who believes in concentrated portfolios with stocks taking up as much as 10-15% of the portfolio. Paul Beattie from BT Global Growth , who has a couple dozen positions long and short. All three are successful money managers and have good track records, so there is no one size fits all answer. On one hand, if you have a stock go up 50% when it is only 1% of your portfolio, it will only represent a .5% gain for your portfolio, on the other hand a 50% loss on a 10% position is a 5% loss for your portfolio. I believe Ken Fisher summed it up when he said: Don’t aim to beat your benchmark by more than you are comfortable lagging it. No matter how many stocks you choose to buy, give yourself the chance to initially be wrong on the price you pay to double down several times to reduce your price. I adhere to Chris Demuth’s outlook on portfolio sizing which you can read more about here . V. Measuring Your Performance. Source: Rowealth You will also choose how to measure your performance. Are you aiming for absolute performance, or to beat a benchmark? Even if your goal is absolute performance, you will be confronted to comparing yourself to the benchmark. Why? Because if after several years you are unable to do better than an appropriate benchmark, why not spare all the effort and just invest in an ETF? You have to admit, over a long period of time it seems like a decent idea. SPY data by YCharts On the other hand I smirk every time I read a fund manager says he is happy because this year he delivered a performance of -10% whereas the S&P 500 did -20%. Yes it seems tough to deliver absolute returns during bad years for the markets, and I don’t claim to be able to do so, time will tell. Ultimately I’m seeking to perform on an absolute basis, as should all individual investors who are investing with the goal of spending that money someday. The problem with trying to beat the market is that many money managers have become closet indexers during the years. The question for these people is no longer: Do I want to own Apple (NASDAQ: AAPL ) or not at these prices? The question becomes: Should I overweight or underweight Apple relative to its weighting in the index? For me, this just isn’t intelligent investing. VI. Don’t Be Afraid To Share Your Ideas. Source: Wordpress Once you start to analyze stocks and find ones you would like to own, why not share your ideas on Seeking Alpha? One thing we all have in common here, from contributors, to readers, is we want to find great stocks for our portfolio. Writing articles here will help you put your ideas on pen and paper, the editorial team will help you go further on parts of your analysis you might have overlooked, and confronting comments will help you think of your thesis in a different way. Like everyone you are going to have some dogs in your portfolio, and it will be easy for you to blame it on the market or on bad management or whatever, but having your bad picks publicly available on Seeking Alpha will force you to question where you went wrong. I for example, recommended buying Volkswagen earlier this year. Not so great looking back, and rather than just shrug it off, I’ve learned that I should be weary of companies with obscure corporate structures since it creates opportunities for management to employ devious practices. VII. Final Words. I look forward to everyone’s comments, please feel free to confront me on anything you disagree with, constructive criticism is always welcome. If you liked this article, please consider following me on Seeking Alpha. Also in this article I gave a list of my favorite books. The price of these books quickly adds up. My tip to saving money on books was buying a kindle reader. You can get their latest tablet for $50. Kindle books are usually a bit cheaper, but subscribing to Scribd was my favorite way of reading all these books cheaply. I have no business with them but the subscription costs $10 a month, and if you use this link you’ll get two months free (No I’m not getting compensated for this.)