Knowledgebase, Newly Revised, Part 1

This is a newly revised “next edition” of the Knowledgebase. In it, Neil and I tried to improve its readability by getting rid of as much repetition as possible, getting rid of dated examples and making them more generic, and including a little new material which wasn’t there before. We both feel that we improved it and we hope that you find it interesting and useful.


Saul’s Investing Discussions - Knowledgebase

## About this Board

The original FAQ/Knowledgebase started out as a collection of excerpts from my posts about investing philosophy. To produce it 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 rewrite it in a more flowing fashion.

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 seamless narrative. We published the new version as the revised Knowledgebase, but we have not had a new edition now in several months. This edition has minor improvements, and if you have read an earlier edition, I would only read it all the way through again if you want to refresh your knowledge (not a bad idea, by the way), but not because you think that it’s all new. Of special interest however, is ## Basic Rules of the Board, which is the second section, right after this introduction.

Please note also that the original posts from which the Knowledgebase was assembled were written over a period of years. Thus some examples that I used at the time are several years old, and are dated, but I’ve left them in because they illustrate points well even though my feelings about the stock, or the current stock price, might now be changed, and it would be silly to keep running around trying to update each illustration every couple of months or so.

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.

The main topics in this Knowlegebase are divided into:

About this Board

Basic Rules of the Board

My Historical Results

My General approach and Philosophy

Evaluating a Company

Portfolio Management

Adjusted vs GAAP Earnings

What is My Buying Policy?

What is My Selling Policy?

Calculating Portfolio Returns

Dips and Downturns

On Insider Trading

Thoughts on IPO’s and Secondaries

Investing Ethically


Professionally Managed Money

Teaching Investing to Kids

Investment Primer

How to Post in Italics, Bold, and make Tables

Post Index

If you are searching for one section in particular you can either scroll to it, or use the “find” or “search” function of your computer to search within this post: topic headers always start with ## so you can add that to the start of your search to go straight to a topic (e.g. “## Some Topic”).

## Basic Rules of the Board

Yes, there are some off-topic subjects that don’t belong on the board.

What comes to mind off the top of my hat are subjects like politics, like extended discussions of technical analysis, or option trading subjects, or like how to cultivate apple orchards (after the initial two or three posts), or private humorous conversations (also after the initial two or three posts). That’s just a few, but you get the idea. There’s nothing wrong with these topics and there are other places where they’d be welcome, but they don’t fit with this board. Expressions of anger because people disagree with you about a stock are definitely out of place here.

There are also companies that don’t belong on the board. Like a company that has seen decreasing revenue and decreasing earnings over a number of years, and now is being considered as a take-over, or a sell-off-the-parts candidate. That’s simply not what this board is about. There are other boards for this kind of situation. Another example would be an early stage biotech, with no actual revenue, but great ideas. Or a new IPO of a company that has revenue, but still has large losses and hopes of breaking even two years from now. You can weed those out yourself.

However, besides such obvious misfits for the board, feel free to introduce stocks you are interested in. But not just with “I heard about an interesting stock called XYZ”. Tell us something about it! What does it do? Is it growing? What are its earnings? Why you like it? That kind of thing.

As far as restricting to “Saul-type stocks”, I don’t know what a “Saul-type stock” is. Seriously. I look at a stock and examine it with the method outlined in the Knowledgebase, which is available to everyone. So let’s not talk about Saul-type stocks, which don’t have any fixed meaning that I’m aware of, and let’s talk about evaluating stocks using the “Knowledgebase method,” or even the “Saul method” if you like a shorter title. Some people will prefer to use other methods. That’s what makes horse racing, to mix a metaphor.

This board isn’t about any particular stocks. It’s about learning how to evaluate stocks using a valuable, effective and common sense method. With the method, you’ll find your own stocks!

I’ve seen calls to move discussions of companies to other boards because I’ve sold out of them. I don’t think that’s a good reason to stop discussing a stock. I sell out of plenty of stocks but welcome discussion of them (CRTO, EPAM, PAYC, WAB, LOGM, ZOES, POL, XPO, etc, etc, etc). We are here to discuss interesting stocks, and whether I am personally invested in them is irrelevant.

## My Historical Results

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, as I had done before.

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 20 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!

I lived through the Internet bubble of 1999-2000. I sold out of Amazon, Yahoo, and AOL one day in January or February of 2000, after Yahoo, as I remember, had gone up something like $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. Sometimes selling can be the most important thing you can do. I didn’t get out of the market. I 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 that were down the most.

Finally, I was down so much that even 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.

My Annual Results since 1993:

You’ll note that 32% a year compounded doesn’t mean you make roughly 32% every year. Below you’ll find a list of the gains of my entire portfolio 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.

Two enormous years in 1999 (Internet Bubble) and 2003, when my portfolio was still fairly small, sure helped out.

1993: 21.4%

1994: 15.4%

1995: 43.4%

1996: 29.4%

1997: 17.4%

1998: 4.9%

1999: 115.5%

2000: 19.4%

2001: 46.9%

2002: 19.7%

2003: 124.5%

2004: 16.7%

2005: 15.6%

2006: 8.6%

2007: 22.5%

2008: (-62.5%)

2009: 110.7%

2010: 0.3%

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 had finished roughly unchanged after 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.

2011: (-14.5%)

2012: 23.0%

2013: 51.0%

2014: (-9.8%)

2015: 16.0%

We are talking 27 years from 1989 to 2015 inclusive, and that’s a lot of time for compounding to accumulate. As of the end of 2015, I had a 286-bagger on my entire portfolio.

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, for God’s sake!).

Well, 2015 was a very flat market, not the dot-com craze. The S&P was down about 0.7%, and the Russell 2000 Small Cap Index was down 5.7%, and my portfolio was up 16.0%. 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 will end other years with more or less gains than this year, 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.

Please note: 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. Now that my own portfolio size has grown to the size it is, averaging 30% to 35% growth per year just isn’t going to happen. I can no longer put all my money in a half dozen little stocks, or get in and out of a stock position on a dime as I could when my portfolio was a tiny fraction of the size it is now. I just can’t be as nimble as I was and I’ll be very happy now if I can average 22% growth per year instead of 32%.

## My General Approach and Philosophy

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 (Caseys and LGI Homes are examples: They both have invested a lot of cash in real estate. Caseys owns most of their stores. LGIH owns lots to build on in the future.) 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 companies. (By the way, this is part of why when you are managing a smaller amount of money it’s easier to achieve higher results). 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 rarely, if ever, let a position grow bigger than about 15%, and even that is usually way too much.

I usually start with small position and let it grow. Sometimes, I add to a position while it’s growing. I never start with an oversized position. I usually don’t buy a full position all at once, or sell all at once, but I taper in and taper out, unless I have a good reason to get out in a hurry. (Although when I had a smaller portfolio I sometimes would buy or sell an entire position at one time).

You can’t really keep track of more than 25 or so stocks, and that’s an absolute outer limit. I greatly 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 the fund had when it 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’d be 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 now on averaging 20% to 25% per year on my entire 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. Some of the most angry I’ve seen people get on these boards is if you criticize a stock that they’ve fallen in love with.

I try to always pay attention to criticism of a stock, to reevaluate my investments, and to get out if it turns out that I’ve made a mistake, or if the situation has changed. Which is why I rarely end up holding stocks for 5 or 10 years.

Sometimes changing your mind in the face of new evidence, and selling when necessary, is the most important thing you can do. If you are wrong, you can always buy back in. I think that being willing to change my mind in the face of new evidence is one of the most important skills I have. And learning that it’s okay to change your mind when appropriate is one of the most important things I try to teach on this board. Let me remind you that I sometimes make mistakes getting into a company (big mistakes, on occasion), but that I am willing to consider the possibility that I was wrong, and change my mind when I see that I actually was wrong. And that that is very important. Although I realize that I make mistakes, 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 5% in cash. I have a couple of small accounts in which I can buy on margin, but my amount of margin is rarely as much as 4% or 5% of my total portfolio.

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 games and you are again 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 withdrawing some cash to live on, I don’t in any way separate out the dollars that came from dividends. This is 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.

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.

**I assume that any good stock I might want to buy probably traded at a lower price some time before I found out about it…**Duh… But so what? I can’t go back and buy it 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 price to go back to where it had been, for a lower price, a better buy in point, or whatever. They may get it and save a $1 or $2, or they may miss getting in, and miss a $50 eventual rise in the stock. Don’t try to wait for the price to go down before getting into a stock. Geez, you are getting into it in the first place because you think the price will go up, not down. If you like it and are convinced, at least take a starter position now.

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. It you sell it five years later because it never came back (as they occasionally do), you not only suffered the loss, but you suffered the opportunity loss as well. That money could have been making a profit for you in another company’s stock during those five years.

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 just sell it. And I 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 20% and 25% 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. Because the MF compares to the S&P, since I started this board I’ve also compared my results to the S&P for comparison, and more recently added the Russell 2000 as it is more representative of the small-cap companies I tend to invest in.

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 happens to the stocks that you are holding. Think about that!

If you sell 10 stocks over time because you have legitimate questions about them, and you were “wrong” about some of them (they eventually do all right and move up), so what? As long as you put the money in stocks that you are happy with, that’s what counts!

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. Price anchoring is a big mistake.

Forget the price you bought something at. It’s at the price it’s at 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 suspect that it may be down for several years, or even down for good, 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 some 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 was at $14.48 when I wrote this post).

Another example that 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 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! They were growing trailing earnings by over 100% and had a trailing PE of 15.6. I bought them at the price they were available.

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 even aware the company existed seven months before! 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 almost 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 it’s 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 might 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. 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 terribly but one is a 20-bagger, the one that is a 20-bagger will make up for all 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. Remember, this stock doesn’t have a sign on it saying it will end up as a 20-bagger. It’s just a stock and all you know about it is that it’s 70% of your portfolio and bouncing up and down. You will probably sell some of it at varying points all the way up, keeping it 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 my 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 $2.79 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 ever 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. There’s a lot more about graphing below in the section on 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%!” No, the headlines will say “ABC beats estimates!” The price will undoubtedly rise.

On the other hand, a company whose earnings are up 70%, but misses estimates by three 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 this company doing? How much are earnings and revenues actually up?” What matters to me is that the company is growing earnings at 40%, and if the company sells off because of an “earnings miss” (which is a ridiculous term for a company increasing earnings by 40% if you think about it), 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 down 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. 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 One: A poster on our 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.

## Evaluating a Company

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 it helps me 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, most importantly, 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, which I feel is a very valuable service. Very valuable! I will get important ideas pro and con, and I won’t miss important news.

Do I need to understand the technology or the industry to buy a company? Someone commented that “but I can’t imagine following them because I don’t feel that I understand the industry.” Well I almost never understand the industry or the technology. I don’t know anything about banking but I am invested in SBNY and INBK. I don’t know anything about microchips but I have invested in SWKS and others. I don’t know anything about the shoe business but I have invested in SKX, etc. All successfully so far. I invest not based on knowledge about the industry, but on the fundamentals and progress of the company itself.

Wow, if I thought I had to understand the industry, I doubt I could find any stocks at all I could invest in. To think of it simplistically: If you are considering buying stock in Apple, do you need to understand how to build an iPhone, or do you need to know how successful the company is?

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 usually looking for at least 20% 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 at least triple or quadruple. I’d never buy a stock at $45 hoping it will get to $55. I wouldn’t buy a stock at $45 unless I though it could get to $150.

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 the market is hardly penetrated, that’s fine, it has plenty of room to grow (think Apple 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 great 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 usually don’t usually buy restaurant chains (although I have bought Caseys, which is a restaurant chain of sorts). 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 usually not my thing.

I want management to be interested in making a profit. That’s why I sold out of Amazon some time ago, even though I loved the company. Making a profit just didn’t seem to be on Bezo’s radar screen. He never even mentioned it. (More recently they have begun to have rapidly increasing positive Cash Flow, and I have bought back in.)


Hi Saul,
I have meant to ask: what were your main holdings in 2010 and 2011? Given the market had hit bottom in late 2008, I would have guessed you overperformed in 2010-2011, but it stuck out to me that you were flat/negative.

I know your 2009 was great and your overall results are amazing.
So this isn’t a knock - just curious.


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I have meant to ask: what were your main holdings in 2010 and 2011?

Hi Dreamer, I don’t keep any kind of records like that of past positions. When they’re gone they’re gone and I don’t even think about them.