A New Improved (Revised) Knowldgebase
To produce our original FAQ/Knowledgebase, Neil had worked hard collecting “words of wisdom” from hundreds of posts and arranging them by topics. Since new ones were added every month, Neil and I became worried that over time it was becoming too long, too disjointed, too repetitive and too intimidating. We decided to revise it. I rewrote it with Neil’s help and editing, trying to weave the ideas together to change it from a collection of separate excerpts into a more or less seamless narrative. We are happy with what we have accomplished and feel that what we have produced is much improved, and we are pleased to present it to you here. We do feel we can improve it further though and will continue to work on it. Enjoy!
Saul’s Investing Discussions - Knowledgebase
The original FAQ/Knowledgebase started out as a collection of excerpts from my posts about investing philosophy which Neil had kindly compiled for us. However, as new ones were being constantly added, it had gotten too long and too intimidating, with considerable repetition and some parts being out of date. Neil and I have decided to rewrite it in a more flowing fashion. It will still pull together the key passages but we hope that they will be woven together more seamlessly. Some of the passages have, of course, been edited in minor ways so that they would fit better into this document. At the end of the Knowledgebase you’ll find an Index of useful posts by post number, should you desire to go back and read the posts from which this has been compiled in their entirety.
I visualize the board as a tool for people improve their investing skills, to share information and ideas, to learn how to choose stocks for themselves, and to learn how to invest intelligently. I certainly expect people to make their own investing decisions and not to try to copy every stock I have. Please remember to make your own decisions about what you buy and sell, and feel free to disagree with me as I certainly make bad purchases at times. The only thing I have ever guaranteed is that I make mistakes at times and that everything I buy doesn’t go up.
Now if anyone actually wants to learn to invest the way I have done, the way to do it is not for you to just blindly copy the stocks I invest in, but to learn the method, which I have explained at length, and learn how to find the stocks for yourself, and find out what part of it suits your personality and financial situation. I’m an old guy and may not be around much longer. If you are just following the stocks I’ve chosen, what will you do when I’m gone? It’s best to learn how to do it yourself! – Hell, I’ve never considered my stocks to be the best possible ones to invest in. They are just the ones I’ve found. Consider my information about them as one of the sources of information you use, but if you find a better stock somewhere else, go for it! And please let me know so that I can evaluate it for myself as a possibility. That’s what the board is about.
I started keeping track of my results yearly in 1989, because my wife and I had a baby and I wanted to retire in about 7 years (I did). My wife panicked (“You can’t retire! We have a new baby!”) so I decided I had to get serious about investing. In Jan 1993, I increased my record keeping and started keeping track of my results weekly, and not just annually.
You should know that my wife and I and my family have been living off what I make in the stock market since my retirement in 1996. That’s 19 years! I have no pension or other source of income except Social Security.
From 1989 to 2007 I averaged about 32% per year compounded. This produced a rather amazing overall multiplication of my total portfolio, In fact, if you sit down with your calculator and multiply 1 by 1.32 (since I averaged a 32% gain) 19 times, you’ll be amazed too. (It’s the power of compounding). You’ll note that this was not a large multi-bagger on one stock, but on my entire portfolio, the whole works!
32% a year compounded doesn’t mean you make roughly 32% every year. For example, here’s a string of the gains of my entire portfolio for twelve consecutive years starting in 1993. Numbers are percent gain. In other words 21.4% means every $100 turned into $121.40, and 115.5% means every $100 turned into $215.50. Here they are: 21.4%, 15.4%, 43.4%, 29.4%, 17.4%, 4.9%, 115.5%, 19.4%, 46.9%, 19.7%, 124.5%, 16.7%.
I lived through the Internet bubble of 1999-2000. I sold out of amazon, Yahoo, and AOL one day in January or February after Yahoo, as I remember, had gone up $30 to $50 per day for three days in a row. I said to my wife, they may keep going up, but this is insane. I’ll let someone else have the rest of the ride. The bubble broke about 3 weeks later. Some times selling can be the most important thing you can do. I didn’t get out of the market, just bought non-internet stocks and was up 19% for the year. Sure I could have held through the decline, and 10 years later amazon came back, even if Yahoo and AOL never did, but why?
I got killed in 2008 like everyone else. Probably worse than someone who was in defensive stocks. It was my first negative year after 19 positive years in a row. I stayed 100% in stocks, selling anything which hadn’t gone down much to buy more of the ones which were down the most.
Finally, I was down so much that I got scared and started to think of selling out and going into cash. All the talking heads were saying, “Sell! Sell! Sell! Get out! Get 100% in cash!”
I said to my wife, “If everyone is shouting ‘Sell!’ and even I am scared enough to be thinking about selling, there’s no one else left to sell… This must be the bottom.” And it was (Nov 2008).
In 2008, in the big meltdown, I dropped 62.5%, which was pretty terrifying. In 2009 I was up 110.7%. The way percentages work though, after dropping 62.5%, gaining even 110.7% doesn’t get you back to where you started, but I sure felt better.
Annual Results since 2000:
At this point I have a little reminiscing: I remember in 2010 there was a lot of talk in the media about the “Lost Decade” for the stock market, which apparently was unchanged in 10 years. At this point I was up 570% in those same 10 years, in spite of 2008, so I was wondering what they were talking about.
2015: 32.4% YTD
We are talking 25 years from 1989 to 2014 and that’s a lot of time for compounding to accumulate. As of the end of 2013, I had a 273-bagger on my entire portfolio. As of the end of 2014, with my 9.8% loss, that had fallen to a 246-bagger. Now, in May 2015 it has risen to over a 300-bagger.
A number of people were very skeptical when I first said I had made 30% per year in ordinary markets. In fact some even implied that I was lying, that even Warren Buffet couldn’t do it (But he was investing billions of dollars, like piloting a battleship instead of a speedboat. He had to buy whole companies!). And that my policy of selling positions that didn’t pan out was sacrilege, as it was opposed to the hold-forever principles of MF (although I made clear that I always bought with the idea of a long term hold, and only sold when a position didn’t work out, or I lost faith in it).
Well, this is a very ordinary market (the first five months of 2015), not the dot-com craze. The S&P is up about 3% so far this year, which is a fairly ordinary gain, and my portfolio is up 31% as of todays close (up ten times as much as the S&P). Others on this board, following the principles that we have discussed, are up even more. And it hasn’t been magic. I’ve been transparent and given all my positions and their relative size each month, and basically told exactly what I was doing. You’ve followed along with me. It’s real. It takes some work, but you can do it too. I know there will be pullbacks and I may end up the year with more or less gain than I have now, but it can be done!
Stock picking does work (obviously). Especially if you are lucky, as I must have been. Some people say you can’t beat the market in the long run. They are wrong.
I look for companies that are growing fast, have recurring income, insider ownership, some kind of moat, a reasonable PE, etc, and hope to find most of these qualities in stocks I’m investing in. I don’t try to learn all the financials. While I look for companies that are growing fast, I hope for ones that are not yet discovered and bid up in price. I try to avoid “story” stocks that are always going to make money next year or in two years or in five years. Absence or near absence of debt is important, except in companies where debt is part of their business model, where it’s sort of excusable (like stocks that do a lot of acquisitions). For much more about this see the section on Evaluating a Company.
When you are first starting out you don’t mind concentrating your investments in half a dozen winners. However, when you are retired, and you are investing for a livelihood, and you don’t have any other income to replace potential losses, it’s safer not to let any position get too big. You should never let a position grow bigger than about 15%, and even that is way too much, no matter how much you like the company.
I start with medium or average size positions and let them grow. Sometimes, I start with a small position and add to it while it’s growing. I never start with an oversized position. I usually don’t buy a company all at once or sell all at once, but taper in and taper out, unless I have a good reason to get out in a hurry.
You can’t really keep track of more than 20 to 28 or so stocks, and that’s an absolute outer limit. I prefer a smaller number of stocks, as they are easier to keep track of. You need to read all the quarterly reports, and the transcripts of all the quarterly conference calls, which gives you a busy earning season. They often say a lot more on the conference calls than in the earnings press release. Reading the transcripts works much better than listening to recordings as it takes a quarter of the time, and you can skip the forward-looking statements messages, etc. Look at investor presentations too. And get a news-feed from your broker on each of your stocks.
You can beat any mutual fund over the long run. You can’t tell much from a mutual fund’s results because you are always buying last year’s results. For example, if it’s a oil company fund, and last year oil stocks were in, it will show great results, but this year it could do terribly. Also, you are always buying the results they had when the fund was much smaller and nimbler than it is now (because those good results they had when they were tiny made people pour money in).
I pay no attention to 2-baggers, 5-baggers, 10-baggers or whatever in individual stocks, nor do I count them. This is relevant because this way it never crosses my mind to think anything like “This stock is slowing down, but it’s a 9-bagger. Maybe I should hold it for another year to try for another 10-bagger.” Going from a 9-bagger to a 10-bagger is only an 11% gain. If I’m no longer in love with the stock, I should be able to put the money into a new stock that will be up 30% in a year, and it will never even cross my mind that I missed having a 10-bagger. Here’s another way to think about it: If you have an 80-bagger on a stock that grows to an 85-bagger it sounds exciting, but it’s only a 6% gain on your money. If you take the same money and put it into a new stock where you just get a tiny little 2-bagger, you’ve made a 100% gain on the same money. Which is why I don’t pay attention to trying to get multiple baggers. If they happen fine, but it’s not my focus.
If you were to put a small amount of money in every stock listed on the market, you would eventually pick up every 10-bagger, even every 100-bagger, that occurred. You’d be able to brag “I have fifty 10-baggers now, and three 100-baggers!” But so what? You’d just be doing as well as the markets as a whole, by definition, as you were investing in the whole market. And since you just invested about a hundredth of one percent in each stock, your 10-baggers would be meaningless, and even your 100-baggers would only move your totals 1%. So again, anyone can pick up lots of 10-baggers by just investing in hundreds of stocks, more if your hundreds of stocks are MF picks certainly, but the multi-baggers are irrelevant. What matters is how your total portfolio has done. If you have ten 10-baggers in 25 stocks, that’s darn good. If you have ten 10-baggers in 500 stocks, so what? I pay attention to how my total portfolio is doing. My goal, and my entire focus, is on averaging 30% to 35% per year on my portfolio. As I pointed out above, having a multi bagger on my whole portfolio is what counts, not on individual stocks.
Not accepting that an investment could be a mistake as it continues to go down is a dangerous error, and could be very expensive. A big problem investors have is getting attached to their previous decisions and not being willing to consider that they may have made a mistake. I try to always reevaluate my investments and get out if I’ve made a mistake, or if information changes. Which is why I rarely end up holding stocks for 5 or 10 years.
I make mistakes but I don’t regret my decisions. I figure I did the best I could at the time.
I buy no bonds of any type.
I don’t invest in options. They are too much distraction for too little gain. Also they are a “zero-sum game”. That means if you sell an option, whatever you gain, the person who bought the option loses. Exactly the same amount. And vice versa. And you are competing against professionals.
I’m usually nearly 100% in stocks, and only rarely and briefly as much as 10% in cash. I have a couple of small accounts in which I can buy on margin, but my amount of margin in rarely as much as 4% or 5% of my total investment.
I don’t invest in futures. I tried them when I was younger and saw a bunch of money disappear overnight. They are also zero-sum gaimes and you are competing against experts.
Dividends aren’t a big part of my investing. In general, I treat dividends as just fungible dollars. They just get mixed in with whatever cash I have in the account and I don’t think of them as “income” as opposed to “capital gains.” If I’m wiring some cash to my checking account to live on, I don’t in any way separate out the dollars that came from dividends. It’s just the way I do it and it seems the simplest to me.
Trading in and out is self-destructive. You remember the trades where you made a few dollars and it encourages you, but you forget the losses. Never take a position to make a few percent. You should be investing in stocks that you can see at least tripling, if not going up ten times.
I always buy with the idea of holding indefinitely, never with the idea of a short holding period, but in practice I guess my average holding period is six months to three years. I sell when I’ve fallen out of love with the company or I think the story has changed, or I think that the price has gotten way out of line.
Never miss getting into a stock because you are waiting to buy it a few cents cheaper. The decision is whether you want to invest in it or not. Once you decide, take a starter position, at least. Don’t wait around for a slightly better price. When it’s at $50, I can guarantee that you won’t remember or care whether you paid $10.05 or $10.30, but you’ll be kicking yourself if you didn’t get in. The issue is: Do you want to buy the stock? If the answer is yes, don’t fool around trying to buy it a bit cheaper. You are buying with a long-term perspective.
Any good stock I might want to buy probably traded at a lower price some time before I found out about them…Duh… But so what? I can’t go back and buy them in the past. What I care about is whether the stock is a good buy now. I see too many people who are “waiting” for a lower price, a better buy in point, or whatever. They may get it and save a dollar or two, or they may not get it and miss a $50 eventual rise in the stock.
I definitely don’t sell winners just because they have had a run (not as a policy, anyway). I only sell if I have a specific reason.
Sometimes you have to sell. You can adopt the MF mantra that if you just hold on it will come back in time, and maybe it will. But I hope to employ that money in much more profitable ways than watching a stock go down and then hoping it will start to come back.
I’m in no way a trader. I never, ever, ever, EVER, buy a stock thinking I’ll try to sell it in a week or a few days for a small profit. I always buy for the long term, but sometimes decide I’ve made a mistake, and go on. And don’t worry about whether I made an error in selling. I worry about what I’m going to buy with the money. (I sometimes even buy back something I’ve previously sold (I’ve bought a stock that was an error both times, and I got out both times).
I usually pay little attention to what the indexes are doing as my goal is to average between 30% and 35% per year, and it’s an internal goal. If the market was down 15%, I wouldn’t feel I did well because I was “only” down 10%. It’s not a game. I need to make money at this as my family and I live off what I make. Since the MF compares to the S&P, this year I’ve compared my results to it as well for comparison.
It’s a lot harder to make great returns as the amount you are managing gets larger. You can’t just get in and out of a stock with one or two trades as the dollar amounts become too big. You can’t invest in companies that are really small or illiquid, because it’s too difficult to accumulate a position that will be meaningful to your portfolio. And if there’s bad news you’ll be stuck and unable to get out in a hurry without moving the market. It’s again like turning a battleship instead of turning a motorboat.
You can beat any index over the long run, in spite of what you may hear.
You don’t have to be right about the stocks you sell, just the ones you hold in your portfolio. It simply doesn’t matter what happens to a stock after you sell it. The only thing that matters is what the stocks do that you are holding. Think about that! If you have a portfolio of 30 stocks and sell 10 of them over time because you have legitimate questions about them, and you were “wrong” about half of those sales (they eventually do all right and move up), so what? As long as you replace them with good stocks and end up with 30 you are happy with.
Price Anchoring is a big mistake: Don’t wait for a price slump before getting in to a company. If you like it and are convinced, at least take a starter position now. I’ll never hold off buying, trying to get a stock 15 cents or 25 cents cheaper.
I assume that any good stock I might want to buy probably traded at a lower price some time before I found out about them…Duh… But so what? I can’t go back and buy them in the past. What I care about is whether they are a good buy now and where they are going from here. month.
There’s no such thing as “I was so far down I couldn’t sell”. The stock price has no memory of the price you bought it at. It’s at the price it’s at. That’s the reality of now. The question about any stock is “What decision should I make about it now, at its current price and its current prospects?” Not, “What price did I pay for it?” unless you are planning for tax losses or gains.
Forget the price you bought something at. It’s at the price it is now. If you think you should sell it, say to yourself “I’m fed up with this stock and I no longer like its prospects. Where else can I put the same money where it will do better?” That takes a lot of the emotion out of the decision.
In making a decision to sell, it doesn’t matter now what price you bought it at. What matters is what you think it will do from here. If you think it’s down for the count for several years, don’t focus on what you paid for it. (You can’t make it go back in time to where you bought it.) I’d suggest you put the money into something better.
It’s not logic, it’s common sense. For example: I originally bought some ABC as high as $21 and $22 (as well as around $17 and $18), but when I decided to get out and put my money elsewhere because it wasn’t panning out, it never even occurred to me, and I mean that honestly, it never even occurred to me, to wait until it got back to $22 so I could break even on those shares. I sold at an average price of about $17.50 by the way. (It’s now at $14.48).
Another example which I’ve used before: Early in the 3D printing craze I bought some DEF at about $15.30 I think. That was the price it was selling at. I never considered trying to wait to get it 25 cents cheaper or even a dollar cheaper. Later that same year it got to $190 for about a 12-bagger in less than a year. Do you think I remembered, or cared, whether I spent $15.10 or $15.40 per share?
Then, I recently added to my GHI even though it had run up considerably from my initial purchases. I had initially bought at $16, but I added a lot more at $22. Should I have hesitated because it had been cheaper a few months ago? Should I have berated myself because I didn’t buy more then? And maybe decided to wait and see if it would sell off so I could get some cheap? No way! Its last five quarterly earnings were (in cents), 13, 22, 28, 32, and recently announced, 46! If they just increase by a nickel next quarter they’ll be raising trailing earnings by over 100% and have a trailing PE of 15.6. I’m buying them at the price they are available NOW.
When I first bought JKL at $38 and $40, it had been as low as $25 just seven months before. So what could I do about that??? I wasn’t aware of it then. I bought it when I found out about it because I thought it was a buy then. Now, none of that is “logic.” It’s just common sense as I see it.
The MF has a lot of propaganda about how you should NEVER sell. However, if you make a well thought-out decision to sell several stocks for what you perceive to be good reasons, and then make an equally well thought-out decision to buy several replacement stocks for what you also perceive to be good reasons, it’s simply not plausible, and even silly, to assert that you will not end up better off. It would imply that your judgment in picking stocks is just terrible. If you look at two stocks and say to yourself “This one is a Sell and that one is a Buy,” don’t you think that, on average, the ones you think are buys will do better? I’d bet a bundle that, on average, the ones you figure are buys will do better than the ones you figure are sells! If not, why are you bothering to evaluate stocks at all?
Why hold on to your failed positions? They have little going for them except that you are already in them. I doubt you would dream of buying most of them now if you didn’t already have a position in them. I just don’t think you should hold on to a poorly functioning company on the basis that it may transform itself into something successful some years from now.
I’m not saying my replacement stocks always do better than the stocks that I’ve sold because I thought they were mistakes. What I’m saying is that I do my best and use my judgment, and over time I expect that companies I think are going to do well will, on average, do better than companies I think will do poorly. (If not, I should just put it all in an index fund.) If I sell a particular stock and it then outperforms my replacement stock over the next quarter, so what? I’m not perfect. I’m just trying to do a good job. That’s how I think about it anyway.
To simplify, the Gardners’ point of view is that if you buy the same amount of 19 stocks and 18 do poorly, the one that is a 20-bagger will make up for the losses. Therefore you should never sell your losers. That works in theory, and on paper, but in the real world, if it’s a portfolio with your money in it, it doesn’t work at all. That’s a pretty radical thing to say, so I’ll make clear why it is so.
First of all, if you don’t sell any of the successful stock on its way to becoming a 20-bagger, it soon becomes 70% or 80% of your entire portfolio, as the losers shrink. Now you have a portfolio with 19 stocks but one is 70% of the entire portfolio. You are not going to sleep nights with one stock at 70% or more of your portfolio and bouncing up and down. Not with your real money in the portfolio. You will probably sell some of it at varying points all the way up, keeping the percentage at a maximum of 20% or 25% of your portfolio, or maybe less. And the rising stock will thus never balance all the losers.
Add this to the fact that the ones that go down keep sopping up more and more percent of the total investment as you “double down”, “reduce your average cost”, “buy at better value points”, and generally put in more and more money in at lower and lower prices. For example, on the WPRT board, when the price dropped from $32 to $25 lots of people felt it was a bargain, and bought more, and at $20 “doubled down”, and “doubled down” a second time at $15, etc. It’s hard for people to see a stock they believe in go down to what they think are ridiculous levels without buying more (it’s at $5.39 as I write), especially when it’s misleadingly still labeled a “Buy.” They’ve got this “Buy” that is down to half what they paid for it. Of course they will sell some of a winner that is making them nervous to buy more of the “bargain” stock.
Unfortunately, if you had 18 stocks that went to zero and one that was a 20-bagger, you probably would have ended up putting much more into each of the ones going down than into the one that went up AND you would have sold a lot of the one going up on the way. It’s natural. I’ve done it myself but try hard not to do it any more. Which is why the MF hypothesis doesn’t work in real life. It’s the difference between a series of recommendations and a real-life, real-money portfolio.
If the market was efficient no stock would never go up or down 30% in a week (it would have been already accounted for), and you’d never be able to make a 10-bagger. Fortunately for us, the market is OFTEN very wrong about a stock (either too high or too low at times).
A weekly graph on your stock on old fashioned large graph paper helps you keep things in perspective. A drop from $51 to $49 doesn’t look so bad if you look back and see that it’s been between $52 and $48 for the past six weeks, or if you see that your stock rose from $40 to $51 in the previous two weeks and the “drop” to $49 is meaningless. (The problem with graphs that your computer makes is that a move from $10.00 to $10.05 will fill the whole space if that’s the whole move for the day or week. There’s no fixed scale.) Mark where you made purchases.
Peter Lynch also suggested a monthly graph of stock price vs trailing earnings on a log scale map, which I have found very helpful. I scale it so that if the stock is twenty times trailing earnings the price and the earnings graphs will overlap. That gives you a quick visual perspective of whether the stock is cheap, reasonably priced, or wildly priced, and also give a nice visual of how fast earnings are growing that you can compare with your other stocks, as you use the same scale for all of them. (There’s more about this in the section about graphing.)
On the Estimates Game. I exaggerate a little for the clarity of the message, but what I am saying is essentially all true. I hope you find these ideas useful:
The earnings and revenues estimate game that the analysts play has put the company CFO’s, who give the outlooks, in a no-win situation. Here’s how it has come to work over time:
It doesn’t seem to make any difference how good or bad the actual results are, whether they are up 3%, or 30%, or 70%, or more. The only thing that the headlines pick up is whether the earnings beat or missed analysts’ estimates. (Who cares???)
For example, a company whose earnings are up just 3%, but beats estimates by a nickel, will get screaming headlines. The headlines won’t say “ABC earnings only up 3%!” Oh no! The screaming headlines will say “ABC beats estimates by five cents!” The price will undoubtedly rise.
On the other hand, a company whose earnings are up 70%, but misses estimates by two cents, will get equally screaming headlines, not saying “DEF earnings up an amazing 70%”, but saying “DEF misses estimates!!!” The price will undoubtedly fall.
The whole estimates game is only about whether the earnings and revenue beat or miss a number that some analysts have picked. It totally ignores the question of how well the company is actually doing, and how good (or bad) the revenues and earnings really are.
However, the companies aren’t stupid. They have figured this out. And they have started to give lower and lower estimates for their next quarter, picking numbers that they are almost certain to beat (by a lot). They don’t want the bad publicity of missing analyst estimates. (Again, who cares!!!)
So what happens? The companies give low estimates and the analysts say “Good earnings, but disappointing estimates for the next quarter. We’re downgrading them from a buy to a hold.”
Thus the companies are screwed whatever they do. If they estimate high, where they think they will be, and miss, they get the “missed estimates” headlines, and if they estimate low, to let themselves beat estimates handily, they get the “disappointing estimates” headline. They lose either way.
How do we as investors deal with this puzzle? Think “How is the company doing? How much are earnings and revenues actually up?” What matters to me is that the company is growing earnings at 75%, and if the company sells off because of an “earnings miss” (which is a ridiculous term for a company increasing earnings by 75%), I might take advantage of it by adding to my position.
I base my purchase decisions on how well the company is doing, and my evaluation of how it will do in the future, and how well its price matches its prospects, rather than whether the company came in two cents above, or two cents below, what the analysts predicted.
Evaluating company results against consensus analyst estimates can produce perverse and peculiar results. Consider this hypothetical: A small stock with three analysts following it has an average estimate of 50 cents for the quarter. Another “analyst” representing a firm that is secretly short the stock, puts in an estimate of 82 cents. This raises the “average estimate” to 58 cents. By raising the estimate he sets the company up to “miss” estimates. After all, it doesn’t matter what the actual results are, just whether they met expectations. Right???
Sure enough, if the company makes 53 cents, what would have been a nice beat becomes a 5 cent miss. The stock sells off for a few days, until people figure out that 53 cents was a very good result, and meanwhile, the firm closes out its short at a profit. Pretty ridiculous, isn’t it. But this hypothetical scenario could, and probably does, play out in the current market.
On trading in and out: No one knows how long a stock price can keep climbing. If you sell now at $135 it could keep going up to $200 before it takes a rest. When it was up $15 from where you sold, would you buy back in or just watch it go? And if you timed it right and sold now, and it dropped $15 would you get back in, or would you wait for down $20? And then if it got to down $19 and started back up, would you panic at down $12 and buy back in? And then, what if it goes down $5 from there? Do you buy, sell or hold? In other words, trying to time the market in these stocks will drive you crazy. If you don’t have a good reason to sell just stay with it and enjoy the ride.
On staying fully invested: You’d be much better off staying nearly 100% in the market and just deciding WHICH stocks you want to invest in, instead of complicating it with deciding WHEN you want to buy, and trying to time the market. For example, you don’t want to buy now because the market is up, but I suspect you didn’t want to buy at the bottom either, because then everyone was saying that the market was going lower. And if these stocks go up 10% from here you certainly won’t want to buy, but if they go down 10% from here, you’ll wait for 20%, and then if they start back up you’ll wait for them to get back to down 10% again, which may never happen. Just think, if you stay fully invested you can forget about all those crazy-making decisions, and just concentrate on which stocks you want to own for the long term.
My feelings about PE ratios: Just out of curiosity some time ago I figured the average PE ratio of my eight biggest positions. These were rapidly growing companies but the average PE was 20.1. Note that that goes against the MF RB idea of picking overpriced stocks, or even ones with no earnings. An exciting company with a PE over 200 or something, may do just fine over the long haul, but I’ve decided “Not for me.” If I can find a rapidly growing stock with a reasonable PE, why buy expensive stocks where you have to hope they’ll grow into their price?
About being Number 1: A poster on the board seemed concerned that I’d feel bad because his totals were higher than mine. But that’s not what this is all about. It’s not a game where there is just one winner. We can all be winners. The goal is not to have the best record. Not even to beat a benchmark like the S&P. The goal is to be successful, to make enough money at investing to support your family eventually and be able to purchase the goods and services that you need in life. I have never dreamed that I’d be the best investor in the world, or the most successful. Worrying about that will make you crazy. I just want to be a good, successful, investor.
You can think of possessions the same way. There will always be someone with more money, a bigger and better house, a nicer wedding ring, a more exciting vacation, whatever. Don’t sweat it. It doesn’t matter. Happiness isn’t getting what you think you want. Happiness is being content with what you have - on the way to possibly getting what you think you want. It’s today you want to be happy, not in the future. The future never gets here. It’s always today.
I look for companies that are easy to follow. A lot of my companies are recommended by the MF. I invest mostly in MF recommended stocks because I want to be an informed investor. Other services recommend a stock because “two analysts have raised estimates this month” or “they’ve beaten estimates two quarters in a row” or some such nonsense, where I don’t think the person doing the recommendation even knows what the company does. There is little or no follow-up and no place to discuss the stock.
When there is a recommendation from MF, someone has already screened the company and written a full recommendation. That’s very important to me. Besides which there are the boards for discussion and I feel that that is a very valuable service. Very valuable! I will get important ideas pro and con, and I won’t miss important news.
I want a company with rapidly growing earnings. I usually won’t touch a “story” company that is losing money, but that “will break even two years from now,” no matter HOW enticing the story is.
I look for recurring revenue. I LOVE recurring income and the razor and razorblade model.
I look for substantial insider ownership.
I look for a company with rapidly growing revenue. By rapidly I’m looking for usually at least 25% per year. (That usually rules out companies with no revenue like start up biotechs, as well as slow-growing old fogies).
Wanting to be an informed investor means that I generally avoid foreign companies. And I won’t touch ANY Chinese company. Not even Baidu. This is due my experience in 2010 or so with 13 little companies (some recommended by MF Global Gains, since closed down), of which fully 11 turned out to be fraudulent in one way or another. You simply can’t tell what’s going on in a Chinese company. Consider that Yahoo is a major company and owned 40% of Alibaba, and the Chinese CEO blithely gave himself the fastest growing subsidiary as a present without telling Yahoo. If it can happen to a big company like Yahoo, what chance do I have? I probably wouldn’t invest in companies in other emerging markets either.
Get the information yourself. I suggest that you don’t get earnings (or other information that’s important to you), off Yahoo, or eTrade, etc, but get earnings off the company’s earnings press releases, which you can always find on their Investor Relations site. You just don’t know what Yahoo’s computer is grabbing.
I look for a company that has a long way to grow. A company that I can hope will be at least a 3 bagger and maybe a 10 bagger. I’d never buy a stock at $45 hoping it will get to $55 or $60. I wouldn’t buy a stock at $45 unless I though it could get to $200.
That means a company that has a long runway. One that ideally can grow almost forever. What I mean is a company where the addressable market is so big that their share of it allows them to keep growing for the foreseeable future. That’s no guarantee that they will, but it’s better than a company that already has 40% of it’s total addressable market, for instance, and can only double once.)
How do you know when a company is too big? Let me try some answers off the top of my head: First, let’s look at Skechers. Their market cap is less than 1/20th of Nike’s so you can easily imagine it doubling and doubling again, and if Nike just rises 5% to 10% per year with the market, SKX will still be under 15% of their market cap. On the other hand, can you imagine Nike doubling and doubling again? It’s impossible. They already have most of the market.
Now to generalize that thought: If a company owns just 5% of a market, it has a lot of room to double and keep on doubling, especially if the market is growing too. If the company already has 80% of the market, all that it can grab is the other 20% of the market (which is unlikely, anyway). If a company has most of the market because it just invented the market and has first mover advantage, and the market is hardly penetrated, it has plenty of room to grow (think Apple 10 years ago and the first iPod/iPhone). If it’s an old market and is saturated, that’s a different story. (I haven’t followed Starbucks, and don’t know how saturated their market is, but my guess is that it was a good buy some years ago, but that the coffee shop market doesn’t have too many doubles left now.)
Finally, there is the problem of big numbers. If you have a chain of 200 stores and you can add 50 a year, the first year you add 25%, but the same 50 stores only adds 20% the second year and 16.6% the third year, etc. To maintain the same growth rate, you have to add a larger number of stores each year, and you run out of places to put them.
If you have another kind of firm, with $100 million in sales, and double it, the next year you will need to add $200 million to maintain the same rate of growth, and $400 million the next year, and it soon becomes impossible, except in rare cases.
Apple is already the largest company in the world. Even they come out with an exciting new product, it has to be truly enormous to budge the dial significantly on sales. That’s not saying its sales won’t grow, but how many doubles can you imagine? Can you imagine even one? Over how many years? (All my computers and phones are Apple and I love the company, by the way).
I want a company that does something special, a rule breaker, not a company that just makes a commodity product well.
I avoid mining and drilling and natural resources stocks, which tend to go in cycles from boom to bust.
I don’t usually buy restaurant chains. They seem inherently limited. How many outlets can you build without getting to a point of diminishing returns? I know the Fool has done well with some of them but it’s just not my thing.
I want management to be interested in making a profit. That’s why I sold out of amazon, for instance, even though I love the company. Making a profit just isn’t on Bezo’s radar screen. He never even mentions it. (I realize amazon has gone up, but I just wouldn’t be comfortable with it.)
I look for companies that are growing fast, have recurring income, insider ownership, some kind of moat, reasonable PE, etc, and hope to find most of these qualities in stocks I’m investing in.
Some ideas for evaluating a new company.
Go to the company website and find out what they do. To get there, google, for example, “Zillow investor relations” and you’ll get the Zillow investor relations website.
Read the text part, at least, of their last quarterly report. “Analyzing the financials” sounds intimidating, and probably isn’t necessary. They usually tell you what is going on in words.
Read the transcript of the conference call. You should be able to find it on Seeking Alpha “Zillow Q1 2015 Transcript” should get it. (Yep, I put it in on Seeking Alpha and it came right up.)
Go back through at least two years of quarterly reports and pull off at least adjusted earnings and revenue. Make a table for each. Let’s look at stock ABC. Here’s what their Revenues looked like:
2012: 18 24 25 33 = 100
2013: 32 39 51 56 = 178
You see what a good visual image this gives you. You can see both sequential change and year-over-year change at a glance. And that 78% increase in revenue from 2012 to 2013. And other patterns jump out to the eye as well. For example, you notice that earnings don’t rise between the fourth quarter and the first quarter of the next year (it’s called seasonality), and then rise in the second and subsequent quarters. When that happens in the future it won’t bother you because you’ll say “Oh yeah, their first quarter’s always a little light.”
Here’s Adjusted Earnings, showing an incredible rate of growth.
2012: 02 04 08 08 = 22
2013: 08 10 22 19 = 59
Then do a running 12 month trailing earnings:
12 2012: 22
03 2013: 28
06 2013: 34
09 2013: 48
12 2013: 59
03 2014: 70
This gives you a picture of where they are going and how fast. You should graph this on a piece of log paper. (On log paper a move from 10 cents to 20 cents is the same length as a move from 50 cents to a dollar (100%).
To compare, here’s the earnings for DEF. Regular good growth, but not as fast. Since ABC is growing a lot faster it will probably sell at a higher PE than DEF. There’s a limit how high a PE you should pay for rapid growth though.
2012: 58 64 67 70 = 259
2013: 74 78 85 91 = 326
12 2012: 259
03 2013: 275
06 2013: 289
09 2013: 305
12 2013: 326
03 2014: 352
A quick glance will show you that DEF does not have the same seasonality, but rises a little each quarter.
Here’s another a nice way to evaluate companies for investment. Using this method, the first step is to look at Cash Flow. You want to make sure the company is self-sustaining, producing positive Free Cash Flow, and not eating away at its Cash Balance. You’d also like to see Free Cash Flow as a percent of Revenue (Free Cash Flow Margin.) grow from year to year
See if Revenue is growing year over year, and whether operating expenses grow at a slower rate so that Operating Margins can increase as revenue expands.
Make sure that the share count is not increasing unreasonably fast.
Take the market cap (stock price times total number of shares) and divide it by Free Cash Flow to get the Free Cash Flow multiple. It’s actually a P/FCF ratio instead of a P/E ratio, and rational ratios should also be somewhere in the 20’s or so, depending on rate of growth.
Check levels of cash and debt.
Look at the 10K to evaluate the business, its competitors and its risks.
Read the last couple of conference call transcripts to see how management feels about the business now and in the future.
A COMPANY may do well, but the STOCK may do poorly, if the stock price has too much growth already factored in.
To get an idea how my method of evaluating stocks works, here’s a post I made on the XONE board a couple of years ago when MF was touting XONE as the next greatest thing and the price was $59.
“Why would a stock with negative earnings, that has never had a profitable year, be selling at such a huge inflated price. Granted, some is about prospects for the future, and some is the 3D printing hype, but some must be hopes of the company being acquired. Look, last year they lost $10.2 million on $28.7 million of revenue. That’s a negative margin of 35.5%. It means they lost 35 cents on every dollar of sales!!!
In the first quarter of this year they lost 20 cents the first quarter in spite of great revenue. Say that by magic they overcome the loss in the next three quarters and finish the year with 25 cents profit. I’m not rejecting the possibility. With that miraculous result, they’d then be selling at over 200 times earnings. (220 times to be exact)…What can I say? I think the technology and the company may have great futures, but the stock may be miles ahead of itself. Miles and miles and miles. I may be totally wrong, and greatly underestimating, but it’s worth considering those figures.”
That post got all of 2 rec’s. No one listened. XONE’s price at yesterday’s close was $12.76, well less than a quarter its price of $59 when I was writing. And it’s still a misleading “Buy” in MF RB. Eventually, even some time soon, for all I know, it may turn around and start making money (or be acquired), but there was a lot of opportunity loss for anyone who has held it all this time. And it’s trailing the S&P by 102% according to MF !!! Tell me again how it’s always a mistake to sell out of a position. Intelligent stock picking (and selling) does pay off. And buying stock in companies that are losing so much money that they’d have to quintuple their revenue to break even is not a smart move.
Given a choice between a low PE company and a high PE company, growing at comparable rates, I’d go for the low PE company every time. Which is why my big three positions all have reasonable PE’s. What’s reasonable? You might say a PE of 15, I guess, if you were talking about conservative, slow-growing, Dow-type stocks. Mine are much faster growing. If I can get rapid growth at a PE of 20 or 25, I consider that cheap.
There are reasons why some stocks are priced unreasonably high and others are not.
Public Facing: Everyone has heard of Amazon, and most people have bought something from them. It gives the illusion that they are very profitable (they’re not). No one who’s not in the railroad business has heard of WAB. The fact that WAB grows earnings much faster than AMZN doesn’t matter. AMZN gets the big PE.
Boring: Railroads are boring. The MF SA board for WAB has had a total of 143 posts since it was recommended back in 2012. Just 15 this year. The MF HG board has had 33 posts total since 2012. That’s 33 posts! The fact that the STOCK isn’t boring and has gone straight up didn’t make a difference. XPO and WPRT had exciting stories. The fact was that neither of them had ever made a dime of profits. They crashed.
Glamorous: UA has glamor. You see it on TV at all the sporting events. SKX has earnings growth. Who gets the high PE? I’ll leave it to you to guess.
UA’s trailing earnings the last three years have been
Does that warrant a PE near 100 times earnings???
SKX’s trailing earnings the last three years have been
Does that warrant a PE of under 25??? But Skechers shoes are comfortable and boring (my wife has never bought another brand shoe since her first Skechers).
And with UA making 95 cents a share, and SKX making $2.99 a share (more than three times as much), which has the higher share price? UA! Based on these facts, would you pay more for UA stock, just for the glamor? People do! It’s insane!
Here’s a new metric – The 1YPEG - Normally a PEG ratio is the PE ratio divided by the estimated average earnings growth rate for the next five years (lower is better, of course). But that’s a total guess! No one knows what a company’s average earnings growth rate will be for five years.
I think a more useful ratio is a one-year PEG looking backward. In other words, the one year trailing PE divided by the one-year trailing earnings growth rate. It has the disadvantage or flaw that you are looking backward, but at least you are using a real number, NOT A GUESS! Who would have dreamed at the end of 2012 that ELLI would have an essentially zero earnings growth rate over the next two years? Or that SKX would have 1500% earnings growth in the next two years? I guarantee you, no one! A five-year estimate is nonsense.
Here are some examples. (A growth rate the same as the PE gives a PEG of 1.0. A faster growth rate gives a lower PEG. A slower growth rate gives a higher PEG). The examples below are out of date but are presented as examples:
BOFI has a PE of 21.2 divided by an earnings growth of 39% so its 1YPEG is .54
SWKS has a PE of 25.1 divided by an earnings growth of 64% so its 1YPEG is .39
MIDD has a PE of 30.9 divided by an earnings growth of 24.5% so its 1YPEG is 1.26
SKX has a PE of 24.4 and earnings growth of 158% so a 1YPEG of .15
UA has a PE of 88.6 and earnings growth of 27% so a 1YPEG of 3.28 (huge).
This is important because you can see that for every dollar invested SKX gave 21 times as much growth of earnings as UA (3.28/0.15). Or you can think of it as 6 times the earnings growth times 3.6 times smaller PE (dollars paid per earnings dollar) gives 21 times more growth per dollar invested).
Please remember that the 1YPEG isn’t a magic formula that replaces everything else. It’s a good indicator, but it doesn’t replace looking at the company and evaluating what it does, reading the conference call transcript, making sure the company isn’t weighted down with debt, and all the other factors I’ve talked about.
I also consider acceleration or deceleration of earnings. They show up nicely on my trailing earnings monthly graphs. I have a very nice visual of an ascending line. This is at about 45 degrees for BOFI, for instance, but with a slight increase in the slope to show that its earnings growth is accelerating. CRTO goes about straight up (coming off a small base), but because of the law of large numbers it’s starting to slightly flatten from perhaps an 80 degree ascension to a 70 degree one, and I can see that it will reduce its rate of growth, but because it is so high, it can reduce quite a lot and still be growing pretty fast for a good long time so that doesn’t worry me for now. PSIX and POL decelerated this quarter, and their outlook was for more of the same. Their 1YPEG’s are still under 1.00 though because 1YPEG’s look back four quarters, but looking ahead I can see that the 1YPEG’s will be rising in future quarters as the trailing growth rate reduces.
I’m not sure I can come up with a single calculation that will give you all the information that went into my thinking about SWKS, for instance. For me it was the CEO explaining how they are included in the planning way in advance, and how they are an integral part of a complicated system, and my concluding that no one is going to replace them because they find a new supplier a dollar cheaper. They simply can’t! They are in all the platforms longterm. And their margins are rising to prove it. And the CEO said that they are in every manufacturer, and almost every platform of every manufacturer. Holy Mackerel ! And they are at a PE of 22 with a rate of growth of trailing earnings of 77% ??? The market is blinded by them being up over 100% in the past year, but if investors would stop price anchoring and look at them as they are, right now, they’d see them as wildly undervalued. (Gee! I might convince myself to buy some more!) It’s hard to imagine a single metric that would give one that much confidence. It’s largely subjective, I think.
Ideas about how to look into the future of a stock: Let’s start with imaginary stock ABC, which has a PE of 45, but a TTM earnings growth of 45% too, so it has a respectable (but not great) 1YPEG of 1.00. This stock price, at a PE of 45, is inherently unstable because, by the law of large numbers, that rate of growth is going to come down. For example, say this quarter their earnings only went from 30 cents to 39 cents, which is not bad, but “only” up 30%. If that continues for a few quarters and they keep their PE of 45, with their rate of growth at 30%, their 1YPEG will rise to 1.50 and they will appear overpriced. Indeed they’ll BE overpriced.
And note that, in keeping their PE at 45, the stock price rose at the same rate their earnings grew, at only 30%. To get their PE down to 30 their stock price will actually have to grow slower than 30%. It’s a double hit. Here’s the calculation:
Year 1 – Earnings $1.00, stock price $45, PE 45
Year 2 – Earnings $1.30 (up 30%). To get to a PE of 30 we take $1.30 times 30 and we get a stock price of $39!! So the stock price will actually have to fall in the year from $45 to $39 to accommodate the new 30% rate of growth and give a PE of 30! This is why high PE stocks are dangerous !!! Stocks whose PE’s are even substantially higher than their rate of growth (with 1YPEG’s well over 1.00) are even more dangerous.
Let’s consider Facebook. Before this quarter’s earnings they were at about $82 with trailing adjusted earnings of 1.73 and a PE of 47. This is a high PE! However they were growing trailing earnings at 94%, and thus had a 1YPEG of just 0.50.
But that PE of 47 left them vulnerable. This quarter they just grew earnings at 23.5% (from 34 cents to 42 cents). Their stock price has fallen from $82 to $78.50 in a rising market. Their PE has dropped from 47 to 43.4. Their rate of growth of trailing earnings has dropped to 63% from that 94% we just saw, and their 1YPEG is up to 0.69 from 0.50. And all that was from just one quarter, not of a loss, but of only 23% growth! They warn of increased spending this year. Because they are Facebook, people will give them some slack, but you can see their stock price won’t be rising much, if at all, this year.
Let’s do the same calculation for them that we did for the imaginary company ABC. Say they start with the same imaginary $1.00 in earnings for an easy comparison, and their current PE of 43.4. That gives them a starting imaginary price of $43.40. If they improve on the first quarter a bit and grow by 25% for the year, they will have earnings of $1.25. If their PE holds up well and only drops to 38 (because they are Facebook), they will have a year end price of $1.25 times 38, or $47.50, up 9% from the current price of $43.40. Not very exciting.
Now look at CRTO. They have a PE of 40, but a trailing rate of earnings growth of 220%. If their rate of earnings growth drops this year to 120% instead of 220%, they’ll still be fine, because they’ll push the earnings up so much. Let’s do the same calculation for them that we did for ABC. Start them with earnings of $1.00, and imaginary price of $40, giving us their current PE of 40 times earnings.
Now next year, earnings were up 120% to $2.20. Say PE dropped to 35 (actually “low” for a stock growing earnings at 120%). $2.20 times 35 will give them a price of $77 next year, up 92% for the year. They are pretty safe. An earnings growth rate of 220% gives them ample protection for a PE of 40, even if the PE drops by 5 points each year as the rate of earnings growth comes gradually down to earth.
Now let’s look at a low PE stock, SWKS. Their PE is 22.4 and their rate of growth of trailing earnings is 77%. Their 1YPEG is just 0.29. However, they seem to actually be accelerating. Their rate of growth of earnings last quarter was 85.5%. Their margins are improving. Their revenue was up 58% organically!!!
Let’s do the same calculation for them. Start them with imaginary earnings of $1.00 for comparison. A PE of 22.4 puts them at $22.40 stock price. Say they grow earnings for the year at a rate between the trailing rate of 77 times and last quarter’s rate of 85.5% - lets say 80%. That will give them earnings for the year of $1.80. With a tiny PE expansion to 25 (quite low for a company growing 80%), their stock price ($1.80 x 25) will be $45, up 101% for the year from $22.40.
Okay, that was what we expect. But how safe are they? What if something goes wrong, and they only grow 50% instead of the 80% we expect? A huge “miss.” That would give them earnings for the year of $1.50, up 50% from $1.00. Let’s say their PE drops from 22.4 down to 19 (how low can it go with 50% earnings growth?) and a stock price of 19 times $1.50, or $28.50, which is up 27% on the year from $22.40. If up 27% is the bad news, which we consider pretty unlikely, they are pretty well protected by their low PE.
This was just exercising my mind in looking ahead. Hope you found it interesting. I think one message is that stocks with PE’s of 45 or more, are quite unstable and dangerous unless they have enormous earnings growth to protect them. Low PE stocks are much safer. The other message is that you can make an intelligent guess about what may happen over the course of the year.
The number of stocks in my portfolio waxes and wanes according to a number of things, but probably never EVER is less than 10, or more than, say, 25 to 28. Okay, so what makes the difference?
A. If I have a number of stocks that I have strong convictions about I will tend to add additional funds to them instead of looking for new stocks, and I end up with a more concentrated portfolio.
B. When I have less conviction I will try out a lot of smaller positions in order to decide which ones I should add to and thus make ongoing positions, and which ones were mistakes, and I can therefore eliminate.
C. Consider, for instance, if something were to happen and I were to have to exit my largest position now. That would be a big part of my total portfolio. I wouldn’t put that much into any one or two new stocks, nor would I add that much to existing positions. I’d probably have to reallocate the money to five or six smaller (3% to 4%) positions, and maybe one or two “put it on the radar” (1% to 2%) positions.
D. When the market tanks irrationally, I tend to reduce or eliminate the stalwart stable stocks that haven’t declined much, the WAB’s for instance, and reinvest the money in the great, fast growing stocks, which have declined a bunch with little or no reason except that the market is falling. This also tends to concentrate my portfolio. I might buy some of a new stock that has fallen in one of these panics, but it’s difficult emotionally to put money in an unfamiliar stock when there’s panic all around.
E. When I think my main stocks have gone up irrationally and are over extended, I tend to trim them and put some of the funds back in the stable stalwarts like WAB, and some of the money in new “try-out” stocks. This increases my number of stocks. (This is similar to B.)
F. Right now, I’m very content (which can always be an error). My three largest positions have an average PE under 25 and they are growing earnings at 83% per year. I only have three positions with PE’s over 30.5 and they have rates of growth of earnings that average over 100%. I have NONE with PE’s over 46! While this is a scenario A, it’s also, paradoxically, a little like scenario D above. I say this because, although the market hasn’t declined, my major stocks seem quite undervalued in relation to their growth, perhaps because they have advanced rapidly and are victims of price anchoring, perhaps, as with SWKS, because they have risen 100% in the past year, perhaps, as with SKX, because no one was taking them seriously, perhaps, like INBK, because they are small and considered unproven, perhaps, like BOFI, just because they are a bank. At any rate, as with scenario D, I have tended to add more to these already large positions, to the detriment of slower growing positions like POL and FB, which I eliminated, and WAB and CELG, which I have reduced somewhat.
I really like it better when I have fewer, but high conviction stocks. I’m more comfortable, and I can probably make more percentage gain for my portfolio with 12 positions than with 24. Fewer are easier to follow, and the chances of finding 12 that will average 30% gain (if you can find them), is MUCH better than the chances of finding 24 that will average 30% gain, and HUGELY better than your chances of finding 100 that will average 30% gain.
When do I sell? I tend to sell a piece if my position has gotten too big for me to be comfortable with. However, I have let rare positions get very big if I was in love with the company.
I tend to sell a piece if I feel the price has shot up wildly. On the other hand, a stock might go straight up for ever since I bought it, but if my position isn’t too big, the rise isn’t too fast, or with lots of hype, if their revenue and earnings are moving up nicely, and the PE is still under 25, I may add multiple times along the way instead of selling. In other words I don’t sell just because something is going up.
I tend to sell a piece if I feel the story has changed. I had IPGP for a long time but