Common Stocks and Uncommon Profits

Date

2020/06/27

Description

Amazon Link

Takeaways

• Scuttlebutt
  • A method for doing research about an investment that helps answers the 15 points
  • Most investors probably don’t have the time to fully investigate
    • it is worth understanding since it will be helpful in picking an advisor
  • Process
    • Go to multiple competitors and ask the company what they think about their competitor
    • Talk to vendors and customers about the nature of the company
    • Talk to research scientists in university, government and competetive companies
    • Talk to former employees
      • It must be clear the source will never be revealed
• 15 Points
  • Does the company have products and service with sufficent market potential to make possible a sizable increase in sales for at least serval years?
    • growth should be judged over several years
    • correctly judging the long-range sales curve of a company is the goal
  • Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when growth potentials of currently attractive product lines have largely been exploited?
  • How effective are the company’s researh and development efforts in relation to it’s size?
    • Even in groups of well run companies this can vary as much as 2 to 1
    • If averagely run companies are included this can vary even more
      • As products and processes get more complicated more people need to be involved to make progress
    • Crash programs
      • When a team is formed quickly around some problem
      • Occasionally necessary
      • Often expensive with no real outcome
      • Interrupt regular research goals and often lead to average results, even though top management “feels good about it”
    • Study how much in dollar sales or net profits comes from the results of the research orgnanization over the span of a decade
  • Does the company have an above average sales organization?
    • This one is best found using scuttlebutt
      • both competitors and customers will reveal the answers
    • Production, sales and research are all important to a business, if any are missing the company is not healthy
  • Does the Company have a worthwile profit margin?
    • Determine the cents of each dollar of sales that is brought down to operating profit and compare across comapanies
    • Some companies speed up growth by spending all or a very large part of the profits on research or sales promotions
      • In some companies this can be a good thing so long as it is spent wisely
  • What is the company doing to maintain or improve profit margins?
    • When profit margins of a whole industry rise because of price increases this is a negative signal for the long-range investor
  • Does the company have outstanding labor and personnel relations?
    • Not having a union is usually a good sign
    • If there is a labor union there should be a relationship based on trust with the company
    • High turnover rights is a sign of trouble
    • Paying below standard wages is another sign of trouble
  • Does the company have outstanding executive relations?
    • From the lowest levels on up there should be a feeling of promotions based on ability not factionalism
    • Managers will bring outsiders for starting jobs, unless there is no one in the company who can fulfill the role
  • Does the company have depth to its management?
    • Eventually the comapany will reach a size where it will require executives to use different skills (gain more depth) to continue growing
    • Delegation of authority is necessary in order for managers to grow
    • Topa management who interfere and try to handle routine day to day rarely turn out to be good investments
  • How good are the companies cost analysis and accounting controls?
    • A company needs to be able to break down costs and revenues at each step of its operation
    • A clear breakdown allows the company to invest more in what is working and less in what isn’t
    • Scuttlebutt will tell of things are insufficient, but not more than that
  • Are there other aspects of the business, due to the nature of the industry, which give an indication that a company is doing well compared to its competitors
    • In some lines of business, total insurance costs can be part of a certain percent of a dollar. In these lines of business comparing the type of plan can provide more information about the business
    • Some companies have patents which can be good in the respect that they can be liscensed to other companies, but they have an expiration date
  • Does the comapany have a short-range or long-range outlook in reguard to profits?
    • Favor companies with a long-range outlook on profits
  • In the forseeable future will growth cause enough dilution to require equity financing?
    • The effectiveness of the investment depends on amount of dilution the greater number of shares will cause to the current stockholders
    • If equity financing will be occuring in the next several years of the time of stock purchase and if the equity financing will leave common stockholders with only a small increase in per-share profits, the stock is not worth it
  • Is management transparent with investors?
    • Do they only provide good news and then “clam up” when troubles or dissapointments occur
    • Avoid any company that hides bad news from investors at all costs
  • Does the company have a management with unquestionable integrity?
    • It is costly to the investor when insiders abuse their power in issuing common stock options
• What To Buy: Applying This To Your Own Needs
  • The successful investor is usually an individual who is interested in business problems. When seeking data this can cause companies to be interested that you’re interested in their business problems.
  • Investment Advisor
    • When choosing an investment advisor don’t necessarily trust certifications. The state can deny the certification but it doesn’t mean the advisor has gone through rigorous training
    • Ask for a fair cross section of results obtained for others, compare those results to other securities (like the S&P 500 for example) to understand how well they did so you can asses their ability over time
    • A requirement is unquestioned honesty
    • To understand their approach, look at how they behaved during times when the market was low and high
      • They might mitigate loss by investing in bonds during highs or increase gains by investing in growth stocks during lows
  • For the smaller investor, it is often the choice between a few hundred dollars a year starting now or many more times the few hundred dollars per year at later date
  • Growth stocks, over a period of 5-10 years have proven to be better in their increase in capital value
• When to Buy
  • Economic forcasting is likened to chemestry in the days of alchemy. In the middle ages we didn’t have all the tools we needed and considerable human energy was spent of fruitless tasks. The wasted effort was the cause of considerable human suffering
  • High quality companies are often on the forefront of scientific technology
    • This does mean that there is no way to predict when discoveries will happen and that some amout of failure is normal
  • Trading one company for another can have its pitfalls, even if they have one line that is not doing well another business line can pick up and still be an excellent long term investment
  • A company might spend time and effort in building a top management team, and then go an fix the rest of the company. This can be a great time to buy.
  • A company that is operating under exceptionally able management is more likely to be a good investment
  • Another great buying opportunity can be if the company expands one of its factories, this usually has a lower cost than building something new and provides great results
  • Look for companies that have had an uptick in revenues that have not yet been reflected in the stock price
  • Start buying as soon as you have identified the good stock
• When to Sell and When Not To
  • There are a number of personal reasons to sell, such as buying a home or paying for college
  • When a mistake has been made
    • The company is turning out to be less favorable by a significant margin
    • Money is doublely lost when holding on too long, the funds tied up in the investment are losing out on profits made by another investment
  • If the company no longer meets the 15 points
    • This means you need to check in regularly
    • Usually management deteriorates or the market as a whole changes
  • If there is a particularly spectacular investment
    • Good investments are hard to find
    • Having both the funds and finding the right investment rarely happen to overlap
  • Overpriced?
    • What does it mean to be overpriced? Getting the degree of preciseness is not really possible, but you can get a general sense of “about the same”, “up moderately” or “up tremendously”
    • When a company has gone up, it doesn’t necessarily mean can’t keep going up
  • Once you’ve done the research to find a good company the right time to sell is almost never
• Dividends
  • Sometimes it has a greater benefit to the investor for a company to re-invest in the company rather than pay out dividends
  • Retained earnings
    • Stockholders get no benefit from companies that are stock-piling cash rather than paying out dividends
    • Another example of ratained earnings is when management increases their earnings on the grounds that they are doing a bigger job
    • Sometimes retained earnings are required but do not have a positive impact on the company, but rather keep the company from sinking
      • An example would be a company that needs to add an air conditioning system to keep customers
      • Ratained earnings can be used to offset the costs of depreciation, this is less of a problem with growth companies
  • Common misconceptions
    • If a company does not raise its dividend it will be favoring its large stockholders at the expense of the small ones, since the big stockholder is in a higher tax bracket.
      • It depends on the type of investor, since over time certain types of investors will prefer dividends and others will not
      • One shot extra dividends typically have no long term effect on the market price of the shares
    • In most cases for the long term growth investor it is better for the company to re-invest profits back into the company
  • Most early companies do not offer a dividend until cash flow from depreciation has reached appropriate levels
  • Within the 15 points, dividends should be given the least consideration
• Five Don’ts for Investors
  • Don’t buy into promotional companies (startups)
    • This includes companies without at least 2-3 years of commercial operation and one year of operating profit
    • Too often one or two individuals who have great talent for certain phases of business but lack talent in other phases
      • More often they have skills in inventing or operating and less on the business side
  • Don’t trade over the counter
    • Stocks that aren’t listed on any major stock exchange
  • Don’t buy stocks because you like the tone of its annual report
    • The company may be good a writing the report, which may or may not reflect the status of the company
  • Don’t assume that the high price to earnings ratio is an indication of future growth in earnings
    • If the company is developing new products with earnings potential, the earnings will catch up to the price
    • If the company has a one times earnings boost the price will slump back down
  • Don’t worry about eighths and quarters
    • Sometimes waiting for a price to come down a fraction of a point can cost you dearly
• Five More Dont’s
  • Don’t overstress diversification
    • Since high quality companies are hard to come by and it takes a considerable effort to find them, investing in too many companies is doomed to fail because you won’t have enough time to keep track of them all
    • Some companies especially larger companies have diversification built in
    • Since larger companies often have diversification built in a low effort investment plan could look like this: pick 5 large companies in different industries and invest 20% in each of them
    • With medium to large growth companies a moderate effort plan is to pick ~10 companies and invest 8-10% in each of them (hold the rest as cash)
    • The above plans can be mixed and matched depending on the investment preferences
    • In addition to the above picking a few small growth companies an investing no more than 5% can also be done for further diversification
      • These type of investments have the highest chance of complete loss
  • Don’t be afraid of buying in a war scare (i.e times of crisis)
    • every time the international stress of our world produce a scare of war or an actual war the common stock reflect it
    • if there is a buying opportunity buy some up front and then slowy buy more over time to reduce the chance of buying too high
  • Don’t be influenced by what doesn’t matter
    • Some people want to see a table of highest and lowest price from the last 5 or 10 years
      • They make a nice round number in their head about what the actual price is
      • This is a financially dangerous practice
    • The historical price is of no significance when making the choice to (or not) buy a stock
  • Don’t fail to consider time as well as price in buying a true growth stock
    • If you’re waiting for an event to happen, say a factory getting completed, decide to buy the stock at a certain time rather than wait for certain price
  • Don’t follow the crow (think for yourself)
    • Sometimes multiple conclusions can be made from the same set of facts, if you do your homework you can sometimes find things the market missed
• How I Go About Finding a Growth Stock
  • One method is to talk to business executives, scientists and engineers
  • Another method is to talk to other investors who are also researching companies
  • In the author’s case most of their findings came from conversations with other investors
  • Method
    • First go into the financial reports and filter out companies
    • Next go through scuttlebutt process
    • Next talk with management
      • It is important to do scuttlebutt before talking with management, since scuttlebut helps you ask more informed questions and come from a place of knowledge
      • As a guideline you should have at least 50% of the questions answered before talking with management
• Conservative Investors
  • Introduction
    • A conservative investment is one most likely to conserve purchasing power at a minimum risk
    • Conservative investing is having an understanding of what a conservative investment is and then following a procedural course of action to identify conserative investments
    • Only when more investors feel financially secure will they invest in the market
  • The First Dimension of a Conservative Investment
    • Low Cost Production
      • When a bad year hits the industry low cost producers are more likely to survive than high cost producers
    • Stong Marketing Organization
    • Outstanding Research And Technical Effort
    • Financial Skill
  • The Second Dimension: The People Factor
    • At each level detailed attention should be paid to wether those at the observed level are doing the same thing for those one level below them
    • A large companies need to bring in a new chief executive is a sign of trouble
    • If the top salary at the exec level is very different than other execs this is another sign of trouble, if the salaries are gradual it isn’t
    • The company must recognize the world is changing
      • People must make the changes or else the company will die
    • Everyone must feel like the company is a great place to work
    • Management must be prepared for the disciplines required for growt
      • Especially in earlier phases the job is going to be constantly changing and management needs to adapt
  • The Third Dimension: Investment Characteristics of Some Businesses
    • Some businesses have something special that gives them the ability to be unusually profitable
    • There are a couple ways a company can protect iteself
      • Becoming a monopoly (illegal)
      • Operate more effeciently than everyone else
        • Economies of scale is a common strategy here
    • Getting there first and having good enough characteristics in every other dimension is usually enough to gain an advantage and keep it
    • Established companies that require multiple disciplines to create a product are more difficult to overthrow than companies the require a single discipline
    • Companies that offer recurring orders are also difficult to overthrow
    • A profit margin of 2-3% over the next best company is likely to be a great investment over the other company
  • The Fourth Dimension: Price Of A Conservative Investment
    • Involves the price to earnings ratio
    • The goal is to find a company that increases their earnings and then the market recognizes this and increase the price (often overcorrects at times)
      • Every significant price move of any individual common stock in relation to stocks as whole occurs because of a changed appraisal of that stock by the financial community
    • Lowest risk: meets the first 3 dimensions but p/e is still low
  • More About the Fourth Dimension
    • The price of the stock is a blend of the following
      • the appraisal of all common stocks
      • the appraisal of the industry in which the company operates
      • the appraisal of the company itself
    • The conservative investor must be aware of the nature of the current financial-community appraisal of any industry in which they are interested
  • Still More About The Fourth Dimension
    • the investor can best tell which stocks are undervalued or overvalued by comparing the facts to the current appraisal of the financial industry
    • even if 2 companies in the same industry have different p/e ratios, the higher ratio company could be a better investment if the financial industry has undervalued the company
    • just because a stock has been trading a the same value for a long time does not mean it reflects the actual value of the company based on the facts
• Developing An Investment Philosophy
  • Origins of Philosophy
    • Management should be capable of both long range goals as well as handling the day to day business operation
    • An excellent product is not enough to make for a successful company, you also need people who can convince people to buy your product
  • Learning From Experience
    • One of the most important investment fundumentals is to train yourself not to go with the crowd
    • When buying into an investment wait at least 3 years before making the decision to call it a poor investment and call it
      • There are extremely rare exceptions to this rule, ex. a trustworthy exec makes it clear the company is not doing well
    • Focus efforts on making major gains over long periods of time
  • The Philosophy Matures
    • Management Philiosphy: maintain an infromal relationship where people at different levels and in various departments can interact with each other in an unstructured way that does not create management chaos
    • Never promote someone who has not made some bad mistakes, they’ve likely never done anything
    • A truely worthwhile accomplishment nearly always requires a fair degree of pioneering, in which inginuity has to be paired with practicality
    • If you can’t do a thing better than others, why do it at all?
    • Invest in industries you know well, its easy to make mistakes in new territory
    • Don’t assume you can sell a stock off at a high and buy it back at a low
  • Is the market efficient?
    • No!
    • If it was there would be no great investiment opportunities
    • Efficient market theory comes from acedemics
      • They concluded that it was difficult to identify trading strategies that worked well enough after transaction costs to provide an attractive profit compared to the risks
    • Experiment with students had them analyze the price of a few stocks picked at random over the course of 10 years
      • Investing 10K in the best 5 stocks analyzed would yeild $70K
      • Investing 10K in the worst 5 stocks analyzed would yeild $3K
      • Taking the 5 of the 10 best would yeild $50K
      • Taking the 5 of the 10 worst would yeild $5K
      • Conclusion, the rewards far outweigh the risks. Especially if you do the required research into the companies
      • Repeated the experiment years later with very similar results
  • Conclusion
    • Buy into companies that have disciplined long term plans for long term growth. Especially that make it difficult for newcomers to share the growth
    • Focus on buying the companies when they are out of favor
    • Hold the stock until either there has been a fundumental change in its nature (weakened management) or it has grown to a point where there is no room left to grow
    • For those primarily seeking appreciation of capital, de-emphasize the importance of dividends
    • You will make mistakes, limit the damage that can be done
    • There are a relatively small number of truely outstanding companies. Their shares can rarely be bought at great prices, when this happens take advantage of the situation
      • 20 different stocks is too many
      • 10-12 is usually a better number
    • A basic ingredient of outstanding common stock management is the ability neither to accept blindly the oppinions of the market, nor completely ignoring it for the sake of being contrary
    • Handling common stocks well requires hard work, intelligence and honesty