2 More Good Questions

by: David Merkel, CFA

I had two more good questions in response to my piece Why I Resist Trends. Here we go:

I think you have some idea which ones are the best by the discount to intrinsic value. If you were running a business (which you are when you are investing) and you had 10 projects with lets say a minimum return of 5% but a spread of 20% to 5% wouldn’t you first invest in the 20% return project and fund each project in descending order of return. By equally weighing aren’t you equally investing in the 5% and 20% projects? If you were a CEO shouldn’t the shareholders fire you? I know the markets have more volatility than projects due to the behavioral aspects of investing but in my view equally weighting is more important when you do not know much about your investment and less important when you do. I think you know a lot about the companies you invest in. Why not try an experiment. Either in real time or historically take a look at what would have happened overtime if you would have weighed you selections by discount from intrinsic value. I think you will be pleasantly surprised. I and John Maynard Keynes have been pleasantly surprised.

I do this in a limited way. In the corporate bond market we have the technical term “cheap.” We also have the more unusual technical term “stupid cheap” for bonds that are very undervalued.

When I have a stock that is “stupid cheap” I make it a double weight, if it passes margin of safety and other criteria. On one rare occasion I had a triple weight.

But I meant what I said in Portfolio Rule Seven — “Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best.” I have been surprised on multiple occasions as to what would do best. Investing is not as simple as assessing likely return. We have to assess downside risks, and possibilities that some things might go better than the baseline scenario.

I don’t use a dividend discount model, or anything like it. I don’t think you can get that precise with the likely return on a stock. My investing is based on the idea of getting very good ideas, as opposed to getting the best ideas. I don’t think one can get the best ideas on any reliable basis. But can you find assets with a better than average chance of success? My experience has been that I can do that.

So, I am happy running a largely (but not entirely) equal-weight portfolio. It is an admission of humility, which tends to get rewarded in investing. Bold approaches fail more frequently than they succeed.

By the way, though Keynes was eventually successful, he cratered a couple times. I have never cratered on a portfolio level, because of my focus on margin of safety.

On to the next question:

What are the tests you use to check if accounting is fair?

Start with my portfolio rule 5, here’s a quick summary:

Over time, I have developed four broadbrush rules that help me detect overstated earnings. Here they are:

  1. For nonfinancials, review the difference between cash flow from operations and earnings. Companies where cash flow from operations does not grow and earnings grows are red flags. Also review cash flow from financing, if it is growing more rapidly than earnings, that is a red flag. The latter portion of that rule can be applied to financials.

  2. For nonfinancials, review net operating accruals. Net operating accruals measures the total amount of asset accrual items on the balance sheet, net of debt and equity. The values of assets on the balance sheet are squishier than most believe. The accruals there are not entirely trustworthy in general.

  3. Review taxable income versus GAAP income. Taxable income being less than GAAP income can mean two possible things: a) management is clever in managing their tax liabilities. b) management is clever in manipulating GAAP earnings. It is the job of the analyst to figure out which it is.

  4. Review my article “Cram and Jam.” Does management show greater earnings than the increase in book value plus dividends? Bad sign, usually. Also, does management buy back stock aggressively — again, that’s a bad sign.

Then add in my portfolio rule 6, here’s a quick summary:

Cash flow is the lifeblood of business. In analyzing management teams, there are few exercises more valuable than analyzing how management teams use their free cash flow.

With this rule, there are many things that I like to avoid:

  • I want to avoid companies that do big scale acquisitions. Large acquisitions tend to waste money.

  • I also want to avoid companies that do acquisitions that are totally unrelated to their existing business. Those also waste money.

  • I want to avoid companies that buy back stock at all costs. They waste money by paying more for the stock than the company is worth.

  • This was common in the 50s and 60s but not common today, but who can tell what the future will hold? I want to avoid companies that pay dividends that they cannot support.

Portfolio rule 6 does not deal with accounting per se, but management behavior with free cash flow. Rules 5 and 6 reveal large aspects of the management character — how conservative are they? How honest are they? Do they use corporate resources wisely?

On Ethics in Business and Investing

I would add in one more thing on ethics of the management team — be wary of a company that frequently plays things up to the line ethically and legally, or is always engaged in a wide number of lawsuits relative to its size.

I know, we live in a litigious society — even good companies will get sued. But they won’t get sued so much. I realize also that some laws and regulations are difficult to observe, and interpretations may vary. But companies that are always in trouble with their regulator usually have a flaw in management.

A management team that plays it “fast and loose” with suppliers, labor, regulators, etc., will eventually do the same to shareholders. Doing what is right is good for its own reasons, but for investors, it is also a protection. A management that cheats is in a certain sense less profitable than it seems to be, and eventually that reality will manifest.

All for now, and to all my readers, I hope you had a great Thanksgiving.

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