Sticking to the basics

For the last 5 months, markets have been nuts. The price swings have been awful and painful to watch.

During times like this, it’s hard to focus on the fundamentals because watching your portfolio get diced every day is very distracting.

But, getting distracted, especially when great value are to be had, will lead you to poor returns over time.

How am I avoiding distraction? I’m sticking to the basics: looking at businesses I understand, evaluating underlying business economics, evaluating management, and examining valuation versus price.

First off, I can’t get good returns by looking at businesses I really can’t understand. No amount of research will allow me to understand a biotech firm, so I don’t try to. Sometimes, I can educate myself enough to understand a firm, but it doesn’t make sense to. Why figure out how to pick ripe fruit high on a tree when the same fruit can be picked off the low-hanging branches? If I can understand the firm without having to learn particle physics, I have a good candidate for further evaluation.

Second, I evaluate a business’s underlying economics. What kind of returns will it generate over time? What competitive advantages does it have? Are those advantages stable, or does technological innovation and industry shifts make predicting the future almost impossible. Businesses with good economics are great candidates for potential investment.

Third, I evaluate management. Are they honest? Do they speak plainly and describe their business and its dynamics well? Are they compensated rationally? Do they own a chunk of the business themselves with shares purchased on their own (not options or restricted stock grants)? Do they do what they say over the years? Do they measure the business’s performance rationally? A business I understand with good economics and management is an excellent candidate for potential investment.

Last, I examine price versus value. What is the company worth to a rational, long-term investor? What are the discretionary cash flows relative to the price of the business? What kind of growth rate and return on equity can be generated in a normal environment? Does the business carry too much debt making it susceptible to insolvency during difficult times (boy is this important)? If value is significantly above price, then the business is a very good candidate for purchase.

When the economy is in the tank and stock market prices are gyrating wildly, it’s best to focus on the fundamentals. Right now, I’m focusing on businesses I understand with good economics and good management selling at cheap prices. There are a lot out there right now, so I have a lot of work to do. And, that’s a nice “problem” to have.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Comparing apples and oranges

What would you say if I told you the market was over-valued by 30%? Would you think I was full of it?

What if I told you that this over-valuation were based solely on market commentators comparing apples and oranges?

When someone says the market is fairly valued or over-valued, what do they mean by that? What standard are they comparing it to? This may seem like a pie-in-the-sky question, but it’s very important.

Why? Because market commentators are frequently saying the market is fairly valued by comparing apples and oranges! And, the two are off by 30%.

You see, many say the S&P 500 is fairly valued because they are comparing the S&P 500’s forecast, operating earnings to the S&P 500’s actual, reporting earnings. But that’s comparing apples and oranges.

This may seem like technical minutia, but it makes a big difference. In fact, operating earnings of the S&P 500 have been 20% higher than reported earnings over the last 5 years. And, forecast earnings for the S&P 500 have been 10% higher than actual earnings.

In other words, when commentators say that the S&P 500 is trading at its historical average, they are comparing apples (forecast, operating earnings) to oranges (actual, reported earnings). And, those apples are 30% overstated compared to the oranges.

Next time you hear someone say the market is fairly valued, ask them if they are comparing apples to oranges. Are they comparing forecast, operating earnings to the historical average of actual, reported earnings? If so, tell them to adjust their numbers and get back to you when their figures are fairly comparing apples to apples.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Value versus Growth; “Boy…I say, I say, boy…ya do’in it all wrong!”

One of the most pernicious fallacies spread in the investing world is the difference between value and growth investing.

Growth investing is usually described as the opposite of value investing.

Growth investing is supposed to be the practice of picking investments with rapidly growing earnings and/ or sales with no focus on valuation.

Value investing is supposed to be the practice of picking “value” investments with low statistical indications of value, like price to earnings or price to book value.

The problem with this method of categorization is that it sets up a false dichotomy. Growth is a vital input to valuation. Some practitioners may ignore growth, but by no means do all value investors ignore growth. Neither do all growth investors categorically dismiss valuation as irrelevant.

It makes no sense to me why any investor would ignore either value or growth. For starters, like I already said, growth is a key input to valuation. A company is worth its future cash flows, so you need to know what those cash flows are and how they will grow to arrive at value.

A growth “investor” that ignores value is not an investor, but a speculator. If you haven’t assessed where price is going and why based on valuation, then you are speculating (a.k.a. guessing) what will happen instead of assessing what can reasonably happen.

Growth and value investing are not opposites, they are different sides of the same coin. The people trying to draw strict distinctions between the two either don’t understand valuation, or they’re academics trying to over simplify investing so they can use computer models to do testing.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

“I made my fortune by selling too early”

Baron Rothschild once said, “I made my fortune by selling too early.” What did he mean by that?

Some “investors” think they can buy an investment as it bottoms and then sell right before it tops. I call such “investors,” speculators. There is too much speculative movement in price to precisely time tops and bottoms.

But, because so many speculators pursue this ideal, they tend to laugh at those who sell too early. Hence, Rothschild’s quote is in response to them.

Investors like Rothschild spend time figuring out what an investment is worth. Only then do they try to buy low and sell high. With the reference point of worth, or value, they can try to buy things below value and sell them above value. Not surprisingly, speculative stock movements lead them to buy before a stock bottoms and sell before it tops. In buying investments below value and selling them above value, though, they make fortunes over the fullness of time.

In other words, Rothschild has the last laugh. Speculators make fun of him for selling too early. But, his ability to sell too early is the reason why he keeps his gains, while the speculators end up holding investments on the way down. Using the rational reference of value, Rothschild buys low and sells high (and too early in most cases), while speculators frequently buy high and sell low trying to time tops and bottoms.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.