13 Investing Gems from Anthony Bolton

One of the unexpected benefits of working overseas early in my career was learning about investors I probably wouldn't have come across until much later on. British investors like Nick Train, Neil Woodford, and Terry Smith, for example, have influenced my investment philosophy in some fashion.

The subject of today's post, Anthony Bolton, also fits into this group. Bolton ran the Fidelity Special Situations Fund in the U.K. for 28 years ending December 2007, posting incredible annualized returns near 19.5% while at the helm. 

Source: Excess Returns: A comparative study of the methods of the world's greatest investors 

Suffice it to say, there's a lot we can learn from Bolton.

His tenure coincided with another famous Fidelity fund manager, Peter Lynch, whose foreword to Bolton's book, Investing Against the Tide: Lessons From a Life Running Money was alone worth the price of admission. 

Here are a few lines from Lynch's foreword:

• To succeed in investment you have to work at it. Watch for the importance of hard work as you turn these pages. Note how often going the extra mile on research and analysis is what accounts for sustained success. Keep your eye on that theme and you'll see that what the media call investment "genius" actually springs from a base of sustained, unending research - which, in turn, yields a decisive information edge. That edge, plus steady nerves, flexibility, good judgement and a complete lack of bias or prejudgement is what has enabled Anthony Bolton to deliver record-setting compound returns for decades. (my emphasis)
• I stress hard work, an information edge and flexibility because few cliches have done more damage to investors' wealth than the phrase 'play the market'. 
• What distinguishes investment winners...is the willingness to dig deeper, search more widely and keep an open mind to all ideas - including the idea that you might have made a bad call. He or she who turns over the most rocks, looks over the most investment ideas, and is unsentimental about pas choices is most likely to succeed.

The book's worth a read for intermediate and advanced investors. The organization is messy, unfortunately, but there's rich content inside. Bolton's recollection of company meetings serve up some great lessons. Those managing money will appreciate his thoughts on portfolio management, as well.

Here are 13 gems I double-highlighted while reading the book.

1. Often, I ask myself a very simple question: 'How likely is this business to be around in ten years' time and to be more valuable than today?' It's surprising how many businesses fail this test.
2. Sometimes the names of the institutional shareholders (of a company) will carry information because there are some I rate more highly than others and if one or two I rate are on the list that's a positive. 
3. The ultimate commendation is when a company talks positively about a competitor...In fact, as a general rule, when a company says the opposite of what you expect them to say I put a double weight on it.
4. (Good managers) tend to be fanatical about the business, working long hours and demanding high performance and excellence from their team and they are reasonably self-assured and on top of what they do without being arrogant.
5. Seeing through spin is one of the most important aspects of the job. 
6. I prefer thinking in levels of conviction rather than in price targets.
7. The (stock) price itself influences behaviour - falling prices create uncertainty and concern, rising prices create confidence and conviction. Understanding this is a really important part of investing.
8. A portfolio should, as nearly as possible, reflect a 'start from scratch' portfolio...One of the things I do each month is an exercise that helps me measure my conviction. On a piece of paper I write five headings across the top: "strong buy", "buy", "hold", "reduce" and "?"
9. I don't normally make large adjustments to the size of my holdings in one go, my moves are incremental.
10. When I've analysed the biggest mistakes I've made over the years they have nearly always been in companies with poor balance sheets.
11. Thinking like a short specialist is a good discipline for most portfolio managers...If you are aware of what might go wrong in a company (knowing the counter investment thesis) one may be able to spot before others the fact that it is going wrong. 
12. It's rare that you only get one chance to make a trade at a specific level.
13. I've always thought that the best environment in which a fund manager could perform well was one in which they didn't know how they were doing.

== Earlier this year, I was invited by Harriman House publishers to contribute a chapter to their forthcoming book, Harriman's New Book of Investing Rules: The do's and don'ts of the world's best investors. 
I contributed a chapter on dividend investing and can't wait to read the 50+ sets of rules written by some of my favorite investors including Vanguard founder Jack Bogle, Nick Train, and today's subject, Anthony Bolton.  
Stay patient, stay focused.
Best,
Todd @toddwenning

The opinions expressed here are the author's and not those of his employer. For a full disclaimer, please click here. 

3 Challenging Scenarios for Quality-Value Investors

One night a few weeks ago, I sketched out my investment philosophy in a “one pager” format. 

I found the process to be useful, so I shared it on Twitter before heading to bed, thinking others might give it a try themselves.

Tried my hand at a one-pager of my investment philosophy. Nothing revolutionary, but an enjoyable exercise. pic.twitter.com/gEklvqr96a

— Todd Wenning (@ToddWenning) September 1, 2017

In the morning, I discovered the post was going viral - at least FinTwit's version of viral. 

The feedback on the post was overwhelmingly positive, which, while appreciated, also made me a little nervous. A cheery consensus around a company or a strategy doesn’t lend itself well to outperformance.

That said, there’s a difference between prescription and practice. Advocating regular exercise is sound and non-controversial, yet the temptation to be remain sedentary can be hard to overcome.

Indeed, part of the motivation for doing the one-pager was to hold myself accountable and stay focused during a bull market when there's pressure to relax standards.

The one-pager isn't meant to be a magic formula of any sort. No company will check off all the boxes. Instead, it serves as a personal framework for evaluating businesses and investment opportunities.

Peeling back a layer

Most of the questions I received about the one-pager regarded the three highlighted sections below.

To be a “strong buy,” I want the company to have an economic moat, be managed by excellent stewards of shareholder capital, and trade at an attractive valuation. 

These opportunities are rare, to be sure, but it's good to know when you might have a "fat pitch" heading your way. 

The highlighted sections address three challenging - and comparatively more common - scenarios that quality-value investors encounter.

In each case, two of the three requirements are present, but one is missing. Here, I’ll address the problem, pitfall, potential, and process for analyzing companies within the three scenarios.

“Quality at any price” (Moat and Management only)

• Problem: Great companies don’t always make great investments.
• Pitfall:  Even if the underlying business performs well, if the company doesn’t live up to high market expectations, you’re in for a bumpy ride. Consider an investor who bought shares of Wal-Mart in September 1999 when the stock traded with a price-earnings ratio over 30 times. Though Wal-Mart as a business grew earnings and dividends per share at an impressive rate over the next decade, the stock price didn't fully follow suit because the business performance wasn’t enough to match lofty initial expectations. Formidable competitors like Costco, Target, and Amazon were also chipping away at Wal-Mart's competitive position. Ultimately, Wal-Mart's price-earnings multiple contracted and the 10-year total return was about 2.4%.
• Potential: Investors can underestimate optionality in a well-run business. Those that considered Amazon, Facebook, or Google wildly overvalued early in their public market histories, for instance, didn’t foresee the new opportunities these businesses would create or discover in the subsequent years. Similarly, firms with existing moats may look expensive now, but if management can further widen the moat, today's price may look cheap in hindsight. 
• Process: Don’t rely solely on relative valuation and market multiples. Instead, make explicit forecasts to determine what the market price might imply. Then, consider whether or not you think management is capable of beating those expectations by introducing new products, entering new markets, becoming more efficient operators, or adding new lines of business.

“Beware quality traps” (Moat and Price only)

• Problem: The market knows something you don’t.
• Pitfall:  Though the stock's premium may have diminished, there could be good reason. The company’s legacy moat could be under assault by new and motivated competition or a disruptive technology. If management is incentivized to protect the old cash-flow-rich operations or if the corporate culture is bureaucratic and stagnant, there could be further to fall. Kodak is a classic example – a former blue-chip darling that had a dominant market position, saw the coming of digital photography in plenty of time, but its culture refused to embrace the change.
• Potential: A management transition could lead to cultural change, which could reinvigorate the business and make it more competitive. To illustrate, a positive cultural change happened at Sealed Air after the board brought in a new executive team following the controversial $4.3 billion acquisition of Diversey in 2011. In the twelve months following the deal's announcement, Sealed Air's stock price dropped about 60%. Despite the poor M&A decision by prior management, Sealed Air (makers of Bubble Wrap) and Diversey still had some durable competitive advantages. The new management team overhauled the corporate culture and got the company back on solid footing.
• Process: Ask yourself if the company has a culture of innovation and change. Could a new management team realistically step in or is the board too close to the CEO and CFO? Review management’s incentives and the board structure and determine whether or not they have enough skin in the game to want to improve operations.

“Avoid turnaround traps” (Management and Price only)

• Problem: Even excellent capital allocators can struggle to fix a broken business.
• Pitfall: Turnarounds have low odds of success. Ultimately, management facing such a situation needs to identify a potential moat source and attack it full force. Then, hope for a lucky break or two. When there are massive secular headwinds in place, this becomes a near-impossible task, even for great management teams. Eddie Lampert at Sears Holdings is a good example. Lampert has done a remarkable job playing a tough hand, but the long-rumored turnaround has struggled as department stores face immense competitive pressures from changing consumer tastes and from online retail.
• Potential: When turnarounds happen, the rewards can be enormous. Steve Jobs' second stint at Apple is one of the best – if not the best – turnaround story of our generation. Though the full story is more complex than this, what Jobs did was make Apple (traditionally a beloved niche personal computer maker) into a premium global consumer brand, starting with the iPod and later the iPhone and iPad. Jobs' efforts, along with the rest of Apple's staff, spawned a brand (intangible asset) advantage that, when paired with the switching costs created by the iTunes platform, led to a solid economic moat.
• Process: Is management facing secular headwinds in their core operations? Are industry dynamics stable and asset growth slow or is capital flooding the industry? Does management attempting a turnaround have to reckon with a debt-laden balance sheet or an under-funded pension plan? 

Bottom line

Rarely will the stars align so that management, moat, and price are all clear and a strong buy is evident. Much more frequently, quality-value investors must wrestle with one of these three scenarios where one factor is missing - or at least isn't obvious. 

As such, it's helpful to approach the scenarios with both the pitfalls and potential in mind. Weigh the pros and cons, make a decision, and then be patient!

Stay patient, stay focused.

Best,

Todd

The opinions expressed here are the author's and not those of his employer. Todd's family owns shares of Amazon and Costco. For a full disclaimer, please click here. 

Should Long-Term Investors Mind the Macro?

One of my key takeaways from the Berkshire Hathaway conference last weekend was that Buffett and Munger don't spend a lot of time, if any, thinking about the direction of the broader economy when they make investment decisions.

At one point, Buffett and Munger joked (half-joked?) that they thought any company that employs an economist has one employee too many. Munger said it was best to declare yourself ignorant about macro forecasts and, when it comes to investing amid uncertain economic times, said that he and Buffett "keep swimming and let the tide take care of itself."

Other investors I admire had similar feelings about incorporating macroeconomic forecasts into their investment process.

As Philip Fisher wrote in Common Stocks and Uncommon Profits:

The amount of mental effort the financial community puts into this constant attempt to guess the economic future from a random and probably incomplete series of facts make one wonder what might have been accomplished if only a fraction of such mental effort had been applied to something with a better chance of proving useful.  

Here's Peter Lynch on the subject:

It's lovely to know when there's recession. I don't remember anybody predicting (that in) 1982 we're going to have 14 percent inflation, 12 percent unemployment, a 20 percent prime rate, you know, the worst recession since the Depression. I don't remember any of that being predicted. It just happened. It was there. It was ugly. And I don't remember anybody telling me about it. So I don't worry about any of that stuff. I've always said if you spend 13 minutes a year on economics, you've wasted 10 minutes. 

I recall during the financial crisis spending a disproportionate amount of time thinking about macroeconomic matters - worrying about hyper-inflation, interest rates, etc. - that would have been much better spent searching for great businesses that had been beaten down.

In February 2009, for example, I started a small position in a Treasury Inflation-Protected Securities (TIPS) ETF in an effort to "play" inflation. The 7% or so gain I made on that investment pales in comparison to the money I would have made simply putting that sum into a S&P 500 ETF or into one of the other stocks I bought during the market downturn. (I mourn such errors of omission more than those in which I invested but ended up losing money.)

Still, it's important to keep tabs on the macroeconomy, even if we're not actively forecasting it.

As Howard Marks put it:

In my opinion, the key to dealing with the future lies in knowing where you are, even if you can't know precisely where you're going. Knowing where you are in a cycle and what that implies for the future is very different from predicting the timing, extent and shape of the next cyclical move. (his emphasis)

I would think that Buffett, Munger, Fisher, and Lynch would agree with this statement. Then again, maybe not, but I'm not sure how you invest in any company - especially a commodity-linked business - without having an opinion on where that business might be in its cycle.

Truly great businesses run by able management teams should be able to adapt to various economic scenarios and deliver solid results across a full business cycle and beyond. However, it's much more difficult to predict when the cycle will turn, how much it will turn, and for how long it will turn. As such, our research time is much better spent analyzing things like competitive dynamics, strength of the management team, and the company's financial health. We have greater odds of being right on this than we do on forecasting macro trends.

How do you use economic forecasts, if at all, in your research process? Please let me know in the comments below or on Twitter @toddwenning.

Related posts:

• Philip Fisher's 15 Points to Look for in a Common Stock
• A Closer Look at Peter Lynch's "Principles"
• When Should You Sell a Good Stock?

Stay patient, stay focused.

Best,

Todd

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Paying Up For Quality Stocks

Price is what you pay, value is what you get. - Warren Buffett

A few years back, my wife and I were shopping around for a leather couch to put in our new home. As we walked around the showroom of a furniture store and had a look at some of the price tags for the couches, however, I realized our bank account would end up being a little lighter than I expected. Real leather couches don't come cheap.

Never eager to spend large amounts of money, my attention quickly turned to the faux leather options. Much to my delight, these were much cheaper. For a fraction of the price of a real leather couch, we could get the same size and design.

And besides, I reasoned, visitors wouldn't be able to tell the difference anyway. Why spend the extra money?

It seemed like a sweet deal at the time, but things have changed.

Today, my "deep value" couch is falling apart -- literally -- and I find myself back in the market for a new couch. Had I originally paid up for a high-quality leather couch, I probably wouldn't be in my current predicament. The poor man pays twice, indeed.

My mistake was this -- I only considered the price of the faux leather couch relative to the real leather couch without considering the prices relative to their respective quality.

As investors looking to buy stocks on the cheap, we often fall into the same trap -- we erroneously think a company with a lower multiple presents a better deal than one with a high multiple. While that may hold true when we're comparing two identical assets, the rule breaks down when we're comparing assets of different quality.

While the market isn't perfectly efficient, it is generally efficient, so more times than not tomorrow's great companies won't be found using a low price/earnings screen. If you want a chance to own a few of tomorrow's great companies, then, you'll need to eliminate your aversion to paying premium multiples.

As you might deduce from my story about couch shopping, this is something I've struggled with in my own portfolio. On a number of occasions, I've had a case of sticker shock and balked at investing in promising companies only to watch those stocks push higher as their competitive advantages, pricing power, and earnings growth more than justified their premium prices.

The risk with buying premium-multiple stocks is that today's premium-multiple will be tomorrow's average-multiple and your returns will be decimated by a re-rating. Reversion to the mean is a powerful force, of course.

As with any investment, it's critical to get a feel for the market's current expectations for the company and weigh them against your own. Equally important is the ability to tell the difference between a great company from an average company. If you're confident in your evaluation of both factors, you shouldn't shrink from paying up for quality stocks.

Related posts: 

• A Closer Look at Peter Lynch's Principles
• Investing is an Expectations Game
• The Difference Between a Good Company and a Great Company

What I've been reading/watching this week:

• 16 investing rules to live by -- Morgan Housel
• Having a high tolerance for repetition is a key to portfolio management - A Wealth of Common Sense
• Hedge funds are having a hard time being different - Monevator
• Value and glamour investing - Millennial Invest
• Unbroken - Laura Hillenbrand (If you haven't read this already, I highly recommend it)
• The Warren Buffett Portfolio - Robert Hagstrom 
• Does money make you mean? (video) - TED Talks/Paul Piff

Stay patient, stay focused.

Best,

Todd

Follow @ToddWenning

The Difference Between a Good Company and a Great Company

Consider the largest stock holding in your portfolio. If I were to ask you to list ten reasons why you own the stock, what would you say?

You might talk about the company's strong competitive position, its attractive profit margins, its solid balance sheet, and provide additional commentary about its growth opportunities. And well you should, as these are important points to consider before making an investment.

Now, what if I asked you to list three to five reasons you're investing behind the company's management team? 

Perhaps that's not so simple to answer. I know I would struggle answering that question for some of my current portfolio holdings. 

The longer I invest, however, the more I've come to believe that what separates a good company from a great company is the people behind the business. A good horse with a mediocre jockey will win its fair share of races on talent alone, but a good horse with an elite jockey is even tougher to beat. 

Warren Buffett, for example, has stressed the importance of having a "knight" in the castle who is trying to widen the company's economic moat, the majority of Philip Fisher's "15 points" to look for in a stock are management- and employee-focused, and Ben Graham said in The Intelligent Investor that "It is fair to assume that an outstandingly successful company has unusually good management."

William Thorndike's modern classic, The Outsiders, also opened my eyes to the potential for material outperformance when you've invested in a good business run by top-notch capital allocators.

Admittedly, analyzing a company's management and corporate culture can be tricky and is far more qualitative than quantitative in nature, but therein lies an opportunity to separate yourself from other market participants.

As such, our research time would be well-spent learning more about the company's leaders and what it's like to be an employee of the company.

To illustrate, here are two companies in my portfolio and some reasons why I like the people behind each business.

WD-40 (WDFC)

1. The company generates about $1 million in revenue per employee. This is a sign of a highly-motivated, very efficient business.
2. WD-40 has a vibrant corporate culture. Employees are part of the "tribe," which may sound a little silly at first, but as Philip Fisher wrote in Developing an Investment Philosophy, "More successful firms usually have some unique personality traits...This is a positive not a negative sign." Companies with almost cult-like corporate cultures tend to have an uncommon ability to overcome challenges -- an intangible asset that should be considered when evaluating a company. 
3. The company has a near-perfect score on Glassdoor, with every employee review approving of the CEO and willing to recommend the company to a friend. 
4. Management has smartly focused on leveraging its WD-40 brand into other uses (bikes, specialist, etc.) and into new regions rather than trying to build up lesser-known brands in which it lacks a competitive advantage.

Sun Hydraulics (SNHY)

1. Sun has a decentralized business structure, which puts decision-making power in the hands of all employees. If a customer needs something done right away, for instance, it doesn't need to go up five channels of bureaucracy to be approved.
2. There are no formal job descriptions and employees are encouraged to learn other areas of the business. This greatly reduces "key employee risk" and if one person is out of the office for a week, the problem can still be solved.
3. The board is only paid in stock in order to better align their interests with those of the shareholders. Very few boards do this, unfortunately, instead preferring considerable annual cash payments with some common stock as a kicker.
4. The company has a low dividend payout ratio, but usually pays out a special dividend in particularly good years. This is an appropriate strategy given the cyclical nature of its products and is indicative of a leadership team interested in sharing rewards with shareholders.

How do you evaluate the people behind the businesses you own? Let me know in the comments section below or on Twitter @toddwenning.

Related posts:

• How to Find a Good Dividend Growth Stock 
• Exploit Your Advantages as an Individual Investor
• Philip Fisher's 15 Points to Look For in a Common Stock

What I've been reading/watching this week: 

• A long look at short-termism - Michael Mauboussin
• Beware of ultra-high dividend yields - Total Return Investor
• Howard Marks speech -- an hour long, but well worth your time (video)
• Management financial incentives usually miss the mark -- IRRC Institute
• Portfolio management and decision fatigue - A Wealth of Common Sense
• Not everyone sucks at investing -- Jesse Livermore
• The profitability factor in your portfolio -- Monevator

Stay patient, stay focused.

Best,

Todd

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Playing the Loser's Game

In a 1975 article in the Financial Analysts Journal entitled “The Loser’s Game”, Charles D. Ellis wrote:

Gifted, determined, ambitious professionals have come into investment management in such large numbers during the past 30 years that it may no longer be feasible for any of them to profit from the errors of all the others sufficiently often and by sufficient magnitude to beat the market averages.

Ellis concluded that the influx of smart and motivated people into the industry led to money management becoming a “loser’s game” -- a game in which you'd be crazy to compete and one that you should perhaps consider surrendering to (i.e. buy an index fund). Ellis recently reiterated this opinion in a recent article for the Financial Analysts Journal. 

Time to throw in the towel?

It's natural to read these comments and get discouraged about buying individual stocks, but Ellis's 1975 article offers a few excellent tips on how to not play the loser's game. 

1. Be sure you are playing your own game.

The individual investor’s advantage is not in trading. The hedge funds, mutual funds, and professional traders of the world simply have better data, more advanced trading platforms, and more financial incentive to focus on the short-term. The weekend investor doesn’t stand a chance versus this type of firepower, so trading is a game where the odds are stacked against the individual investor.

Staying patient, keeping a long-term mindset, and exploiting your advantages as an individual investor alters the playing field and improves your odds of success.

2. Keep it simple.

The less complicated your investment strategy, the better. As Ellis recommends, "Try to do a few things well." By focusing your efforts on one strategy -- whether it is based on dividends, small caps, deep value, etc -- and consistently sticking with it, you can more effectively tune out distractions and make better decisions. As a result, you'll keep trading costs down and give yourself the best opportunity to realize your return objectives. 

3. Concentrate on your defenses.

Ellis advocates improving your selling strategy because the market’s focus on buying makes it difficult to gain an edge on that side of the equation. It’s a fair point. 

To figure out how we might improve our selling strategy, let's consider the market's selling strategy.

While each investment firm has its own selling strategy, we know that the average mutual fund turnover ratio in recent years implies that, on average, stocks owned by funds have been held for just over one year.

Our key strength as individual investors lies in our ability to be patient, so our selling strategy should start with the idea of holding for at least three years and ideally five years or longer. Obviously if one of your stocks shoots well above your fair value estimate, it might be time to sell or trim the position, but on average we should look to hold for longer periods of time.

4. Don’t take it personally.

According to Ellis, the market turned into a loser's game precisely because investors’ "efforts to beat the market are no longer the most important part of the solution; they are the most important part of the problem." Resist the temptation to try harder for better returns. In fact, do just the opposite. This doesn’t mean you should pick stocks at random and buy and hold forever. Do your homework, of course, but be deliberate and patient, too. Let the market go through its phases of euphoria and despair and stay your course. Don't try to force returns.

Bottom line

Trying to beat the market in the short-run is a loser’s game if you make it your primary investment objective, so don’t play it. Instead, redefine the game. Establish your own objectives, stick to your strengths, and stay patient and when you look back at your returns five years from now, I think you'll like what you see. If you happen to beat the market, all the better.

For more on the "loser's game", a new multi-part video series by Sensible Investing addresses the topic and has a lined up a number of good interviewees. Here's the trailer.

What do you think? Let me know on Twitter @toddwenning. 

I've updated my Dividend Compass spreadsheet to fix a few bugs. You can download the updated version here. 

What I've been reading this week:

• Profile of hedge fund manager Joel Greenblatt - Barron's
• How The City is overcharging investors - Monevator
• Buying insurance after a disaster strikes - A Wealth of Common Sense
• Time, not timing, is the key to investing success - Washington Post
• Don't let a single event change your investment strategy - NY Times

Stay patient, stay focused. 

Best,

Todd

A version of this post was published on April 14, 2012. It has been updated.

Book Review of The Outsiders

I finally got around to reading William Thorndike's The Outsiders -- a sure classic that I've added to the "must read" section of my recommended books on investing.

Looking through my Kindle copy of the book, I have 70 highlights and bookmarks, so going through all of them here would be a bit onerous to both read and write.

Instead, I want to focus on the core principles of eight CEOs that Thorndike lays out in the introduction.

With a nod to Buffett's Graham and Doddsville, which analyzes a group of investors who consistently beat the market by following the principles of Benjamin Graham and David Dodd, Thorndike calls his group of CEOs "Singletonville" after former former Teledyne CEO Henry Singleton.

While each CEO was dealt different sets of cards, they all played their hands incredibly well by understanding the following principles and putting them into action:

• Capital allocation is a CEO's most important job.
• What counts in the long run is the increase in per share value, not overall growth or size.
• Cash flow, not reported earnings, is what determines long-term value.
• Decentralized organizations release entrepreneurial energy and keep both costs and "rancor" down.
• Independent thinking is essential to long-term success, and interactions with outside advisers (Wall Street, the press, etc.) can be distracting and time-consuming.
• Sometimes the best investment opportunity is your own stock.
• With acquisitions, patience is a virtue...as is occasional boldness.

Right away, you'll notice that most CEOs don't embody these principles. In fact, if you invert each principle, you're closer to how most CEOs approach their jobs (with perhaps the exception of the sixth principle).

Even though Buffett's been writing about the importance of management's capital allocation decisions for decades, it's a topic that's been undercovered for much too long.

The reason it has flown under the radar, I believe, is that analyzing management is largely qualitative in nature and doesn't lend itself well to screening tools and Excel spreadsheets.

Measuring management

Indeed, it's generally only after the fact that a CEO's impact can be measured and appreciated. Thorndike writes, for instance, that "You really only need to know three things to evaluate a CEO's greatness: the compound annual return to shareholders during his or her tenure and the return over the same period for peer companies and for the broader market (usually measured by the S&P 500)."

The key for investors, of course, is to identify these CEOs before they dramatically outperform the market and their peers.

And here is where understanding the capital allocation processes practiced by the CEOs in Thorndike's book come in handy. If you come across a CEO or management team with an approach that includes some of the principles mentioned above, you might be onto something.

The next step is to read the company's annual reports, understand how executives are incentivized, and reverse engineer management's capital allocation decisions to determine why and how management arrived at its decision to acquire a certain company, divest an asset, or repurchase its stock.

Just because a company may not be led by a member of Singletonville doesn't mean the company isn't worth owning. Elite capital allocators are few and far between; decent-to-good capital allocators, while still rare, are more common. Provided those decent-to-good capital allocators are running a company with durable competitive advantages, that can still be an attractive business to own at the right price.

Finally, the princples outlined by Thorndike in Outsiders can also help you avoid investing behind CEOs that are decidedly poor capital allocators, and ultimately that might be just as important as finding the elite CEOs.

What I've been reading this week

• Capital allocation paper by Michael Mauboussin and Dan Callahan, CFA
• Bonds have taught us a lesson in 2014 -- Monevator
• Investing lessons from a 108-year-old investor -- Telegraph
• A good investing checklist by Richard Beddard
• All-time highs in the market are perfectly normal -- A Wealth of Common Sense

Stay patient, stay focused.

Best,

Todd

@toddwenning on Twitter

This is the Opposite of Real Investing

Innovation in finance is designed largely to benefit those who create the complex new products, rather than those who own them. - Jack Bogle 

Earlier this week, I came across an article about "math nerds taking over Wall Street" and thought it must have been republished from 2006 when quantitative strategies were in their heyday. 

Nope. A few years after the financial crisis broke their old can't-miss algorithims, the quants have returned with a new set of proprietary trading formulas that will work until they don't anymore. 

No one ever said Wall Street had a long memory. 

The article highlights a quantitative software program that "uses historical data and analysis to predict price movements in various assets." 

This line made me think of Buffett's commentary in the 2008 Berkshire letter:

Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas. (my emphasis)

I don't mean to come down too hard on the quants -- they're clearly bright people and there's apparently demand for what they're doing, but their approach is the complete opposite of what we should be trying to do as investors.

Seeking patterns where none exist. (Pi)

Any time you would spend seeking patterns in the newspaper quotes page or developing automatic trading formulas would be much better spent pursuing another type of formula, like the one Buffett outlined in the 1994 Berkshire letter:

We believe that our formula - the purchase at sensible prices of businesses that have good underlying economics and are run by honest and able people - is certain to produce reasonable success. 

This simple formula isn't easy to implement, of course, but it beats using a complex formula that is easy to implement.

What do you think? Let me know on Twitter @toddwenning.

What I've been reading this week:

• The 12 rules of successful investing according to John Lee -- Monevator
• How earnings reports reshape narratives -- Aswath Damodaran
• Masters in Business: Michael Mauboussin (podcast) -- Barry Ritholz
• The best time to invest (video) -- Loring Ward
• Peter Lynch on stock market losses -- A Wealth of Common Sense
• Buy a high yield portfolio and hold forever -- Total Return Investor

Cartoon of the week:

Stay patient, stay focused.

Best,

Todd
@toddwenning

6 Signs of a Good Investment Process

In my baseball-playing days, I was on the mound in a big playoff game, and at a key moment in the game I threw what seemed to be a good pitch, only to watch as the ball sailed over the fence for a home run. It might still be traveling somewhere over North Jersey, it was hit so hard.

Walking back to the dugout after the inning was over, I was furious with myself for throwing the pitch. What was I thinking? What did I forget to do? What could I have done better? All natural questions to ask when you've experienced a bad outcome. 

In the dugout, I asked our catcher what he thought went wrong. He said, "Nothing at all. It was exactly what I called for and it was in the right spot. You've gotta tip your hat to the hitter -- he just took a great swing."

Nine out of ten times that pitch would have either led to a strike or an out. Instead, that time around the ball was hit out of the park. The process was right, the outcome was bad. If I could do it again, I would have thrown the same pitch...just perhaps a few more inches outside. 

This story from my glory days was on my mind this week as I was re-reading Michael Mauboussin's More Than You Know (which I highly recommend if you haven't already read it). 

The first chapter of the book is called "Be the House: Process and Outcome in Investing" and addresses the importance of process when making investing decisions. Here's an important quote from the chapter:

Results - the bottom line - are what what ultimately matter. And results are typically easier to assess and more objective than evaluating process.  

But investors often make the critical mistake of assuming that good outcomes are the result of a good process and that bad outcomes imply a bad process. In contrast, the best long-term performers in any probabilistic field...all emphasize process over outcome. 

When the market is strong, it's easy to fall into a false sense of confidence about your investment process because you're receiving almost daily positive reinforcement from rising stock prices. The opposite is true when the market is down -- you could have a good process experiencing bad short-term outcomes.

It's important to remember that there's a lot of randomness and luck involved in short-term market outcomes and they aren't indicative of investing skill.

What really matters is whether or not your investment process can survive short-term periods of positive and negative reinforcement and deliver longer-term results. In a probabilistic field like investing, a good process will produce good results over time and over a large sample.

How do you know if your process is any good? Each investor will have his or her own process, but in my experience I've found six common traits of a good investment process:

1. Stoic: It can endure both good and bad short-term outcomes without getting emotionally swayed in either direction.
2. Consistent: It doesn't adjust to current market sentiment and sticks to core competencies. 
3. Self-critical: The process is periodically reviewed, includes both pre-mortem and post-mortem analysis on decisions, and is refined as needed. 
4. Business-focused: Rather than rely on heuristics like "only buy stocks with P/Es below 15," a good investment process focuses on understanding things like the underlying business's competitive advantages (if any) and determining whether or not management has integrity and if they are good capital allocators.
5. Repeatable: A process gets more valuable with each application -- insights are gained, deficiencies are noticed, etc. 
6. Simple: The less complex, the better. If you can hand off your process to another investor without creating significant confusion, you're on the right track.

What do you think? Let me know in the comments section below or on Twitter @toddwenning. 

What I've been reading this week...

• 5 investing lessons from Markel's Tom Gayner -- David Hanson
• Cloning Neil Woodford's new dividend fund -- Monevator
• Common sense investing guidelines -- Ben Carlson
• A small cap CEO who reads Buffett and Graham -- MinnPost
• Beware when a CEO leaves for no apparent reason -- MoneyWeek

Best,

Todd

@toddwenning 

Why You Should Probably Own Fewer Stocks

I think the average person could know three or four or five companies very well. They could lecture on those three or four or five companies, and if one or two of 'em becomes attractive, they buy 'em...You have to know the story. - Peter Lynch 

Pardon the Saved by the Bell reference. Couldn't resist.

For many individual investors, finding the time to do proper research is a real challenge. After higher-priority commitments to family, friends, work, etc., if you have time to read one annual report a week, you're doing pretty well. 

In my experience, an investor doing all the work himself or herself needs between five to ten hours a year to keep good tabs on each stock they already own -- i.e. reading quarterly reports, the annual report, conference call transcripts, etc. Thoroughly researching a brand new stock typically takes over ten hours.

So, how much time do you have to dedicate to stock research? With 50 hours a year to spare -- about an hour a week -- you might be able to cover ten companies, but it's likely fewer. If you can outsource some research to a reliable newsletter or research service, then perhaps a few more. 

The important thing is to maximize the returns on your research time. In other words, make sure you're giving each holding the appropriate amount of research time and make sure you're investing enough in each idea that it's worth the time you're spending on it.

To illustrate, I recently reviewed my own portfolio and concluded that I owned more companies than I could adequately cover in my spare time. In addition, I had a number of 2% or 3% positions that weren't likely to have a major impact on my returns, even if they did very well.

With the market still riding high, it seemed like an ideal opportunity to go through my portfolio and eliminate smaller holdings. I started by asking myself the following questions for each stock I own:

Did you read the company's latest annual report/10-K?

Did you vote your shares and read the annual proxy statement?

Is the company's competitive position getting better or worse?

Where is the company in its business cycle?

What was the company's last major capital allocation decision (M&A, special dividend, etc.)?

If I answered "no" or "I don't know" to at least one of the above questions, it was clear that I wasn't thinking about my investment like a part-owner of the business. Either I needed to re-commit to researching the company or it was time to sell the position.

There are a number of clear benefits to owning a smaller, more manageable number of stocks. For one, you'll have fewer holdings set on autopilot, more time to focus on your best ideas, and more money to put behind your best ideas.

You might even realize better performance. A 2008 study by Ivkovic, Sialm, and Weisbenner found the following:

Among households with portfolios large enough to diversify among many stocks, if desired, the holdings and trades made by those focusing their attention on a few securities tend to perform significantly better than the investments made by those diversifying across many stocks.

Diversification is important, of course, but much of your core diversification needs can be met through low-cost index funds and ETFs. For the portion of your portfolio directly invested in stocks, however, it's important to have sufficient time and resources to monitor each company and make the most of the research time you have.

What do you think? Let me know in the comments below or on Twitter @toddwenning.

What I've been reading this week:

• Yet another reason why investing is better than trading - Irrelevant Investor via Reformed Broker
• PBS interview with Peter Lynch (c. 1995) -- PBS
• Why dividend payers aren't boring - Simon Lack
• Universal lessons from every investment discipline - A Wealth of Common Sense
• The Davis Dynasty book review - Total Return Investor
• Investing for beginners: time value of money - Monevator

Stay patient, stay focused.

Best,

Todd

@toddwenning

When to Stop Researching a Stock

1. Don't look for perfect companies -you'll never find them. Just look for imperfectly priced ones.
— Amni Rusli (@AmniRusli) June 6, 2014

The above tweet from Amni Rusli (you can follow her on Twitter and I recommend doing so) struck a chord with me. In my eleven years of researching stocks, I have yet to come across a "perfect" one.

There's always something you won't like about the company you're researching. More to the point, if you can't find anything wrong with the company, you're not looking hard enough.

Some of the most common negative factors that I come across in my research are:

• Concerns about the company's durable competitive advantage (if it has one)
• Misaligned management incentives
• A bad recent capital allocation decision (e.g. paying too much for an acquisition)

Sometimes these factors are enough for me to walk away from the research idea, yet if I like most everything else about the company, I'll keep researching. 

WD-40 Company (WDFC) is a good example of this -- I love the business, think management is doing a fine job, but really don't like that it uses EBITDA as a performance and bonus measure. Still, I wouldn't not buy WD-40 at the right price simply because it uses EBITDA. 

If the company you're researching meets at least 80% of the criteria you look for in a stock and is trading at a good to fair price, that's an attractive opportunity. Don't let perfect be the enemy of good, as the saying goes, and miss the opportunity because you're looking for that last 20%.

But watch out for these red flags

It's one thing if the negatives are fairly benign, but there are a few negatives that I consider massive red flags and will immediately stop researching the stock if I find one of them. 

1. Untrustworthy management: If there's anything in management's background that is particularly off-putting to you, just walk away. A common exercise is to ask yourself if you'd trust them to watch your kids/dog/cat while you were away on vaction. 
2. Blackbox revenue stream: To borrow a phrase from Peter Lynch, if you can't illustrate with a crayon how the business makes its money, you shouldn't own the stock. 
3. Aggressive accounting: This can be tricky to detect. Here's a tip I picked up from my friends John DelVecchio and Tom Jacobs who wrote What's Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio -- focus on revenue recognition as it is crucial to confidence in everything below it on the income statement and, by extension, the cash flow statement. One simple test you can run is looking at Days Sales Outstanding (DSO), explained here. 
4. Government entity as a major shareholder: Government owners have different motivations than regular shareholders.
5. Unethical actions: Similar to the first point, but different in the sense that the unethical action could have been made by someone outside the executive suite. This speaks to a lack of risk management within the company and reflects poorly on management.

When do you stop researching a company? I'm curious to know. You can let me know in the comments section below or on Twitter.

Stay patient, stay focused.

Best,

Todd

@toddwenning on Twitter

The Best Investor You've (Probably) Never Heard Of

Earlier this month, I came across a great interview with one of my favorite investors, Chuck Akre of Akre Focus (disclosure: I own shares of his fund) -- thanks to Kevin Holloway (@kevin_holloway on Twitter) for pointing it out.

I've followed Akre for a while and have long been a fan of his "Compounding Machine" approach, which I think works particularly well with small caps. What I like most about his investing philosophy is it's a well-defined, cohesive, and repeatable framework for making investing decisions. Few investing gurus lay out their process in such detail.

Source: Akre Focus Fund

You can watch the interview with WealthTrack below:

Here are a few of the key takeaways from the interview:

• We want businesses that can reinvest their free cash flow back in the business to earn above average rates of return on capital. 
• Average rates of return in the market are about 10%. We look for companies that can earn significantly more.
• Dividends reduce a company's ability to compound.
• We seek above average returns with below market risk. Key is to own businesses with more growth and higher ROIC opportunities, have higher quality balance sheets, and pay good prices for them. That will provide below market risk. (See: A Simple Equation for Investing Success)
• Akre has held some portfolio stocks for decades
• Great business, great people, great history of reinvestment = Compounding machine
• Business models get better or worse, people's behavior will get better or worse, reinvesting opportunities get better or worse. You need to stay up on these changes. 
• Hard to find companies with those three characteristics. 
• Akre has owned Markel for over 20 years. The growth in book value was about 14% compounded over that period. BVPS growth will fluctuate with time, pricing cycles, interest rates, etc. We didn't sell during down times. We look at things at Markel differently than the sell-side. In 2013, growth in BVPS was over $70 per share and the stock price was in $620 range -- still less than 10x the real economic earnings in 2013. The change in BVPS is the real economic earnings. 
• American businesses have single digit net margins on average. ROE, ROOC in low teens. We research companies with returns significantly greater than that. Then we get curious. 
• We may not know precisely why the company has a moat, but that's okay. The company may not want to share its secret. 
• American Tower -- more towers, more tenants per tower, more rent per tenant. Contracts have annual price escalators of 3-4%. The 3G>4G progression requires denser tower network. Growing outside the U.S. 
• MasterCard & Visa -- much harder to determine why the companies earn such high ROICs. Generate enormous free cash flow and have almost too much cash on hand, which can reduce compounding opportunities. They get paid a percentage of the amount of currency -- inflation hedge. 
• Workbench companies -- Start with a small investment while investigating whether or not to invest more. Colfax started out this way and is now a top holding.
• In management, you want to know how they measure their own success in the business. Avoid those managers who are too focused on the stock price as a measuring stick of success.  
• Ultimately, investing isn't about punching numbers. Quants are trading against prices in their models; we're investors in businesses. 
• Not enough investors/fund managers are striving to think long-term. You attract the shareholders/following you deserve. 
• Late 2008 and early 2009 felt terrible. The shareholders who knew what we were about have done wonderfully as a result of sticking with the program. We want to make sure shareholders know what we're about.
• Markel will benefit from rising rates, better industry pricing, recent acquisition, more opportunistic balance sheet management, and Markel Ventures program that moves business away from insurance. 

That's a lot of information in a twenty minute interview. If you're interested in screening for "Compounding Machine" ideas, I'd start with the following criteria:

• Market Cap >$100m, <$10b
• ROE >15% (ideally, screen for average five year ROE >15%)
• Payout ratio <30%
• Book value per share growth >10% CAGR (5-10 year period)
• P/E ratio <20x or free cash flow yield > 5%

What did you think about the interview? Let me know in the comments section below or on Twitter. 

Stay patient, stay focused.

Best,

Todd 

@toddwenning on Twitter