Friday, November 20, 2015

Avoiding Stupidity

"It’s not brilliance. It’s just avoiding stupidity.”

Warren Buffet's 60-year investing partner, Charlie Munger, has famously said this more than once about the astonishing success of Berkshire Hathaway over 60 years. But what comprises stupidity? Is it one-time foolishness or a pattern of dumb? A reckless mistake, or a poorly devised strategy, or just a bad habit? Can someone of average intelligence achieve truly impressive investment returns? 

In truth, the list of “don’t’s” in stock investing is probably longer than the list of ”do’s”. But they’re both more intuitive and less technical in a lot of ways. Which means they’re more accessible to regular folks who have never studied finance or who have crazy schedules and simply can’t put in the time to nail the details. Which is to say, if you can just avoid touching the third rail, you’ll probably do fine.

Don’t invest in mutual funds.
I go into more depth on this subject in another post, but I’ll nutshell it here: if after reading all my investing how-to you still feel like you aren’t ready to pick your own stocks, get yourself an online brokerage account at E*Trade or TD Ameritrade and pick up a couple of ETFs (exchange traded funds), which hold a basket of companies but trade as a single stock. The easiest are the large-basket ETFs like VOO and SPY, which mimic the movement of the largest market index of 500 different stocks. If instead you insist on paying a professional fund manager to hand-pick stocks for a mutual fund, you’ll pay 1-2% of your assets for that manager’s ‘expertise’—which frequently does not outperform your own common sense—and your money will be much less liquid should you need to access it. The vast majority of mutual funds do no better than the broader market and you pay for the privilege. Don’t believe me? Read this and this, by other people.

Don’t worry about the price of a share.
Lots of people get weirded out by the cost per share. They think that if a share is $500 and they can only afford one share, better to find something for $100 per, or $20 per share and buy more shares. Which is ridiculous: if you’re going to spend the same dollar amount, and the company is going to rise, say, 10% in the next year, then you’re 10% wealthier either way. Go with the company which best fits your investment model and your interests.

The other thing that happens is that people avoid companies analysts describe as “overvalued,” whose shares have risen substantially over recent months. The thinking is that if it’s gone up that much it’s probably close to tapped out, and the price will flatten or even fall. But the truth is, no matter what analysts say, that stock’s price has risen because investors overall have decided it’s worth a lot more than previously thought. Perhaps the company acquired a competitor, or announced some international expansion, justifying the rise. If instead you only buy stocks that you think are undervalued or “on a dip,” you miss out on some amazing opportunities (think Apple, Amazon, Netflix). Companies with rising valuations tend to keep rising until something changes—a new competitor, a corporate scandal, an economic shock. If you stop worrying about how high the price looks today, and measure it instead against the potential for that business tomorrow, you’ll have a much clearer understanding of the future value, which is why you want to own it in the first place.

Don’t buy blind.
When you hear from a friend or a trusted broker about a great value stock or a sudden opportunity that "won’t last long," your inclination is to believe they know something you don’t and therefore you should jump. But it ought to be a red flag: if you’re hearing about it from someone else, the likelihood is you’re not already following that business, or you would already know this information. (Plus, if word has already gotten around, then any amazing momentary price is likely already over.) Don’t succumb to the temptation to get in with your friend just because. Do a little research. Understand what the business does, who their competition is, what kind of leadership they have, how their growth trajectory looks. Get a feel for things. If you don’t understand how the company makes money today and how big the opportunity is the future, how can you possibly assess it as an investment? You’re buying an ownership stake in an ongoing business: you’re much more interested in where they’re going than where they are or where they’ve been.

Don’t be in a hurry.
Unlike in the movies, investing is not shorting orange juice futures one time and finding yourself on a yacht in the Bahamas for the rest of your life. Investing is a lifelong process. It requires an understanding that the value of your assets will rise and fall in in the near term but, with patience, will likely increase substantially over time. 

A lot of people succumb to action bias, which is just the need to do something with your investment portfolio beyond just watching it grow. Because most folks don’t have an endless supply of incoming cash with which to buy more or different stocks, they instead move the money they have from one investment to another, looking for higher or faster returns. This eliminates any one business’s ability to earn them a substantial return over time, it kills the stunning advantage brought by compounding interestit generates capital gains taxes and transaction fees, it takes time and energy and increases frustration. Instead, buy smart and sit tight: investing, not trading. Your returns will demonstrate the difference.

Don’t let your emotions take over.
Investing well, and I’ve said this before here, and here, requires a steady hand on the helm and your eyes on the horizon. There’s just no way around it. Stocks rise over time, but in the shorter term they gyrate all over the place and some of it is just plain sickening. This is especially true of young companies, technology companies, and of so-called “fad” companies, whose products or services might turn out to be just a momentary cultural obsession (think Sodastream, GoPro, Crocs, Tesla) which analysts and investors worry will fade in time. If you act on your emotions, you might save yourself a headache or a sleepless night but over time you will have terrible returns. Never buy on a whim of fancy, and never sell in a panic. (There are exceptions, but you’ll know them when you see them—like Volkswagen.) Buy it with some thought and analysis and some vision, then then sit on your stocks for years. That’s it. Containing yourself is certainly hard, but it’s not complicated.

Don’t sell on movement.
Everyone sets out to buy low and sell high. But the reality is often very different: we buy high (see “Don’t worry about the price,” above) and sell when it drops because we fear it will keep dropping. Clearly, this will prove a poor strategy over time.

Once you own shares, don’t sell unless you must. I go into much greater detail in When to Sell, but the basic idea is that, if you did at least a little due diligence prior to purchase, and you still like the company and believe in their capacity to grow, then you shouldn’t sell just because it has moved up or down. Stocks swing, sometimes a lot, and sometimes very quickly. Selling because it’s dropped substantially following a missed quarterly earnings report (a Wall Street analyst’s problem, not the company’s or the shareholder’s problem)— or worse, because it popped upwards, is exactly the kind of behavior you want to avoid. You bought it to hold it, expecting it would slowly move up— so let it. Sell only when something really bad has happened at the company (again: Volkswagen) or when you need the money for something else. Trust your purchase, trust your judgment. Patience is rewarded.

Don’t wait.
You’ve been hearing it since you landed your first job, if not earlier: the longer you put off the start of your investing career, the less time you’ll have to earn enough to stop working.

Take a look at this chart of Warren Buffett’s personal wealth. Can you see the huge hockey-stick shape to the right? His net worth grows steadily enough over time but really accelerates in the last decade or so? That’s compounding interest. I keep saying it: the longer you do it, the faster you’ll earn and the more you’ll have. Investing is the slow boat, so get on now. For more on the subject of waiting to get started, have a look at this.

Friday, November 6, 2015

My 6 Critical Investing Criteria

Nothing more worries individual investors than not knowing what to look for, and choosing the wrong companies to buy. How do I know when a stock is cheap? How do I tell if it will go up (or down) over time? 

But that doesn't work for me. I'm much more interested in what a stock will do tomorrow than in what it did yesterday-- and I don't believe I can learn much about tomorrow based on yesterday. Which means I have to find other ways to value the companies I buy. I need to look at non-financial criteria. I've written about this before. But because it gets so much investor attention and because it seems so difficult to people starting out, I'm going to revisit it here.

Most money managers try to steer an investment portfolio by looking in the rear-view mirror

1. First up, I want a great brand. By that I mean I want a company people have heard of, and one which dominates or nearly dominates an industry. Examples include Netflix and Apple. Sure some people gotta hate because these companies steamroll the competition (respectively: Cable TV/Blockbuster/neighborhood video rentals, and Microsoft/Dell/Gateway/Sony/Nokia/Blackberry...) but that's what makes them such compelling investments. These companies are so strong they redefine their category: it is no longer possible to have a realistic discussion about retail without mentioning Amazon, or about home video without Netflix. They change everything and as consumers we can either get on board or get out of the way. 

2. Second, I like to see a wide moat. Simply put, this is the distance between the business in question and the nearest competitor, which usually indicates the difficulty of the competitor catching up in the next few years. A good example is Starbucks. On the surface Starbucks sells a commodity-- coffee. But what makes them so valuable is they do it with panache: across a massive swath of the globe, at tremendous profit (remember when we thought $3 for a cup of coffee was crazy?) and they do it in their ubiquitous neighborhoody, comfortable, jazz-infused stores. Sure another business can mimic what they do-- and thousands have-- but Starbucks has such a massive head start and with worldwide brand recognition and a well-established level of quality product and service that no one can realistically catch them for years to come. 

Another great example of a wide moat is Visa. Almost regardless of where you travel, time of day, language spoken, or currency used, they take Visa. Even MasterCard can't catch up. And newer methods of payment-- ApplePay, PayPal-- are just alternative ways for most people of using their Visa card (both systems tie into an existing card account), and in any case are many years away from the level of saturation Visa has worldwide. 

3. Next, I'm looking for a business which is in strong growth mode. This one is obvious: a company whose sales are expanding rapidly year over year as they add new stores, or put out new products or services, or buy up their competitors (or kill them). It is nearly impossible to value these businesses financially based upon their past performance because in a lot of cases they're growing too fast for last year's numbers to mean much. For example, a division of Amazon called Amazon Web Services, or AWS, offers cloud computing services to other businesses (Netflix among them). AWS is only a few years old but it's currently growing at something like 80% per year. In time it could be worth more than the company's "traditional" ecommerce business. A number of other, more established technology companies have even abandoned the cloud services industry in the face of Amazon's juggernaut (Hewlett-Packard did that just that last week). Partially as a result, Amazon's stock valuation has increased over 100% in 2015 alone. That's a ride I want to be on. 

4. After that, I want a business with low debt. Typically, manufacturers have higher fixed costs for heavy equipment and materials, so they must borrow more for those items and maintain higher debt levels on their corporate books. By contrast, software companies and online services generally have much less need for serious capital (their highest costs are often their people) so they tend to carry less debt. (An exception to this is Apple, which contracts most of its manufacturing to offshore companies.) Generally speaking, a company with relatively little debt has a lower bar to clear to make a profit, and therefore has a much wider operating margin to work with. As a side benefit, businesses carrying little debt can usually better weather difficult economic climates or other sales downturns. 

Long Term Debt is a line item on any public company's Balance Sheet. This can easily be found on Yahoo! Finance by entering the company's name in the Quote Lookup field. Ideally (but not exclusively), Long Term Debt should total 25% or less of the company's annual revenues, which is available in the same location on Yahoo!, but on the company's Income Statement. 

5. The next has to do with the company's executive leadership. We want smart, transparent, confident leaders who are less interested in Wall Street analysts' quarterly expectations and more interested in long-term growth, product quality and customer service. You can read interviews, listen to conference calls with press, watch them on YouTube: are the executives of your business providing clear direct answers to questions posed? Are they worried about share prices or customer satisfaction? What do they say about competitors, about new technology, about growth plans? Do they come across as a little phony, a little slimy or more genuine and trustworthy? Do you believe them? Like them? 

Financial research and the news are added to my existing customer experience. Together they serve to enrich and deepen my knowledge

The most famous example of straight-talking, trustworthy leadership is Berkshire Hathaway's billionaire leader Warren Buffett. In his annual letters to shareholders, Mr. Buffett comes across as down-to-earth, honest, folksy and even funny. Whatever the business he's describing he tells is like it is, explaining how it works and why it's important as he goes along. Reading his letters is some of the best business education you can find, not to mention a model for others and entertaining to boot. 

6. Finally, I prefer businesses with which I have first hand customer experience. I've found it invaluable: how better to judge a business's performance than by being a consumer of their products and services over time? 

This one is a slightly higher hurdle because most of do business with only a handful of public companies  relative to the thousands worldwide in which we could invest. But in truth there is no shortage of investment opportunities just among those: manufacturers of toothpaste and paper towels, clothing and shoes, electronics and furniture, housing and automobiles, sporting goods and appliances. Makers of entertainment products like books, magazines, music, movies, television, video games. Service companies like utilities and cellular, cable and internet, shopping clubs and online retailers, banks and even brokerages. 

For example, I prefer Under Armour's athletic clothing to Nike's both for fit and durability, and have since I stumbled onto it about 10 years ago. I'm a huge fan of Amazon's Prime service, which is preferable for me rather than shopping around for vacuum filters that fit, or having the right gas grill shipped to my door. Despite living in Seattle my coffee snobbery has never advanced past Starbucks' fresh roasted espresso beans. I generally enjoy Disney's Marvel superhero movies. I've mentioned Netflix and Visa. Also there's LinkedIn and Twitter, IMAX and Zillow, all of which have come up with a great new business concept or revolutionized an everyday process like career networking or house shopping or movie-going.

By being a customer/user (even an unpaying one), I better understand the value proposition these businesses offer and I've already got a finger on their pulse. I notice when quality slides or new services are added, and this information informs my investment decisions. Financial research and the news I read are additional to my existing, ongoing customer experience. Together they work to enrich and deepen my knowledge.

This list of criteria has provided me close to 80% of what I need to know prior to investment-- but you likely will not find all 6 in one company very often. It happens, but those are rare. Look to get several in one stock. I've listed several of them here, but there are probably a couple of hundred if you look hard enough. This method is largely unscientific and non-financial, and therefore is an unconventional way of assessing a stock-- but then being somewhat contrarian is my nature. Some pro stock-pickers and market timers might poke fun at you; they certainly have at me. Generally speaking, however, my returns crush theirs... though I don't think they believe my numbers. A high-class problem if there ever was one. 


I've posted previously about Volkswagen's ginormous diesel engine deception and what it means for automakers, car owners, VW employees and much of Germany. But sadly this story is still going, just spiraling downward for the company, its customers, its government, and the pollution levels our planet is already struggling to absorb. 

Not only did VW install an emissions-test cheat device on 11 million 4-cylinder diesel engines sold in almost every country on earth, then lie about it for years to the testing authorities in each nation, unlawfully and irresponsibly permitting discharge of poisonous nitrous oxide (NO2) gasses at up to 40 times legal limits all over the globe. Heck, we knew all of that in September, but that's just the headline. Early this week we learned that the company likely substantially overestimated the mileage numbers and the carbon dioxide (CO2) emissions of many of its gasoline-engined cars as well. And yesterday we learned that most of VW's 6-cylinder diesels (including a Porsche and a number of Audi models), which were previously exempted from the cheat device findings, probably run the same tricky and illegal software. So now it's beginning to look as though every consumer vehicle engine made by Volkswagen in recent years either gets lousy mileage, or spews huge quantities of poisonous NO2, or dumps huge quantities of climate-warming CO2. Or two of the three. 

Oh, and there's this nugget: a new study in Environmental Research Letters shows that the additional pollution resulting from 500,000 U.S. cars which are worse contributors of poisonous NO2 than we thought will prematurely kill about 60 people, even if all the vehicles are fixed by the end of 2016. Which they won't be. And that's just in the U.S: there are another 11 million NO2-spouting VW diesels around the world.

This mess makes Enron look like a pack of unimaginative amateurs. 

And today it came out that our family car, which I had earlier thought escaped the cheat-device indictment, is among those affected. So we're joining our local jurisdiction's class-action lawsuit against Volkswagen. I am bitter and unforgiving. 

Thought you'd want to know.