"Buying what you know about is a very sophisticated strategy that many professionals have neglected to put into practice."[i] - Peter Lynch
The author isn't sure just how descriptive the above statement is when applied to institutional money managers and investment analysts today. The ones we have spoken to seem to have a very detailed understanding of all the companies and industries they cover. The author does believe it accurately describes the average individual stockpicker.
Investing, as practiced by the average investor, is a game rigged so the house almost always wins. Wall Street will take the average investor's life savings, and will do so dispassionately and unapologetically. This fundamental understanding is essential to engaging in buying and selling activity in the market.
"Investing is a zero-sum game. To buy a stock, someone else has to be selling. You are betting you know the company better than the person that is selling it to you."[ii] - Peter Lynch
Make no mistake about it, buying and selling stocks is a competition. It is serious, it is real, and if one is not constantly aware of this fact and doesn't take it seriously, one is apt to be a sucker. Someone is always trying to either sell someone else an overpriced security, or they are trying to buy another person's underpriced security for pennies on the dollar. That is what the market often is,[iii] an exchange to take advantage of the person on the other end of a transaction. This reality is not always appreciated, as one's competitor is rarely seen, but it is a competition all the same, and one with real financial stakes. Every single time you buy or sell a stock, there is somebody on the other side of that transaction betting you are wrong, and they are betting real money on it. They are also betting they know more than you, and they are trying to exploit your ignorance in the business underlying the security.
"There are rich teams, and there are poor teams, and then there's fifty feet of crap, and then there is us." - Brad Pitt's character Billy Beane in Michael Lewis' Moneyball, speaking of the Oakland Athletics
What's more, the game most institutional money managers and Wall Street institutions play is stacked heavily in their favor. They have more resources than the amateur investor, better industry coverage, better contacts, better access to management teams, better technology, brilliant (and let's face it, more intelligent) analysts with more prestigious post graduate and doctoral degrees from the finest institutions in the country. Playing a game even remotely in this machine's wheelhouse is almost certain to be a disaster. The chances are that those institutions are generally on the other side of every transaction the amateur investor enters into.
If the reader is not yet discouraged, he or she should be. Forgetting the above facts and becoming complacent, or even arrogant, will not lend the sense of humility and caution that are necessary for successful stock picking. A measure of arrogance is necessary in picking stocks, but it must always be balanced with humility and awareness, and it is good only when logically supported by research and analysis. All of this brings us to a harsh truth that the reader will be wise to remember.
"Choosing individual stocks without any idea of what you're looking for is like running through a dynamite factory with a burning match. You may live, but you're still an idiot."[iv] - Joel Greenblatt
If we accept Mr. Greenblatt's statement as true, and the author is a firm believer it is true, then why even try to buy and sell individual securities? Well, the real truth is that buying and selling individual stocks is generally only stupid if one engages in the practice in the way almost everybody always does. Put another way, there is a right way, and then there is the way nearly everyone does it. The right way is the exception.
Despite all the above, the amateur may still achieve results in excess of the majority of the professionals if the amateur insists on playing his or her own game on his or her own field. To make money consistently over the long term, the investor needs to only bet when the odds are in his or her favor; in other words, only when he or she has an edge over the competition.
How do we do that? The author will answer the question by posing a few questions of his own:
Wouldn't it be nice if undervalued companies that are profitable, with durable competitive advantages and reliable earnings streams, companies that may even be likely to compound over time had like a flashing light and loud noise going off to attract our attention, but only our attention (meaning most of the competition would miss the signs)?
Wouldn't it be nice if we could take the thing we are best at, that we know the most about, and we could place bets on that, and even then could choose to only bet when we were certain, or nearly certain that we will win?
What we will do in this particular article is to identify a specific "edge" that provides most investors a leg up over the large financial institutions and over the army of financial analysts on Wall Street. An edge is a place where the odds are stacked in your favor, through practice, knowledge, skill, time frame, or location. We will also provide real world examples on how to exploit these edges, but first, please permit us an analogy, to really drive the concepts home into the reader's grey matter.
Selecting Your Opponent…
I cannot help but remember my friend from London, in what is known as the East End. Mr. McDonald-Smith is a fairly large man of Jamaican descent, speaks fluent Spanish due to a couple of years living in the Dominican Republic, and is, as they say in England, quite fit. You know the type, someone with arms the size of their head where even an extra-large shirt is in constant danger of popping its buttons? Mr. McDonald-Smith can honestly boast that he has never been beaten in arm-wrestling. This feat is not overly surprising when looking at him, but how is it possible that one can have a 100% success rate in anything? Surely, there is always someone stronger, or more skilled, and even if there were no such person; doesn't everybody just have a bad day once in a while? In fact, Mr. McDonald-Smith is not an undefeated arm-wrestler because he is the strongest man in the world, nor is he undefeated because he is the world's most skilled practitioner of the sport. No, the fact is that Mr. McDonald-Smith is undefeated due to a very simple strategy that is designed to help him be successful.
What is his secret? It is quite simple. He never engages in a match with anybody that he isn't absolutely certain he can beat. In such a manner, he can honestly say he has never been outmatched. He never has, and so long as he continues in his strategy, he never will be. As he grows older, he will undoubtedly accept fewer and fewer challengers until one day he will retire completely from this activity, undefeated and triumphant. Why is this important? Well, Mr. McDonald-Smith has an edge in arm-wrestling. He is large of stature. He is strong. He is fit. He is smart. And he manages his ego. Taken as a percentage, the probabilities of encountering a formidable opponent are quite small. On the rare occasion that he meets such an opponent, Mr. McDonald-Smith graciously declines the match.
Now, here's the key to the strategy: It wouldn't work in a formal arm-wrestling tournament where one was forced to take on every opponent placed in front of him. In fact, it may be quite useless. While Mr. McDonald-Smith is likely to do quite well in a tournament, and he may even advance to the later rounds, he is unlikely to win simply because there is always someone stronger, or who has trained longer and more diligently. Luckily for Mr. McDonald-Smith, he needn't ever enter such a tournament. There is no reason to outside of ego.
What is the point? Don't play if (and when) you can't win.
Examples of Utilizing One's Edge
Now for some real-world examples to illustrate the value of investing in what you know, and using one's individual knowledge and skills to avoid losing money, and to achieve out-sized investment returns. As the author is trained as a tax CPA, these particular examples revolve around corporate income taxes. One needn't understand GAAP accounting for income taxes in order to understand the underlying point (If the author had been a used car salesman, we likely would have made some investments in car manufacturers or rental car companies (one could have made a lot of money investing in Budget, Avis, Hertz, Dollar, etc. if they understood the business). The point is to invest in what one knows and understands).
It does not take many home runs and grand slams to result in a satisfactory investment record if one does not lose money in the process. This bears repeating, with emphasis. It does not take many home runs and grand slams to result in a satisfactory investment record if one does not lose money in the process. That's not to say we try to swing for the fences. Most investors equate swinging for the fences with risk, but that is not the only way to hit a home run. When a perfect pitch comes along, a well-rehearsed swing can result in the ball just flying off the bat with ease. Likewise, sometimes, the most conservative investments can produce the most significant results; particularly if one understands the space and can recognize the opportunities and the risks. This also bears repeating. Sometimes the most conservative investments can produce the most significant results; particularly if one understands the space and can recognize the opportunities and the risks.
Vonage (NYSE:VG) and Spectrum Brand Holdings (NYSE:SPB) are both examples of the author finding signals in financial statements to reveal attractive investment opportunities. In both cases, our attention was drawn by the inclusion of atypical effective tax rates in the respective company's SEC filings. Because of our experience with accounting for income tax provisions in our day job, we were able to quickly identify and interpret these signals despite working fairly hectic schedules, and after a review of the rest of the financial statements and the companies' business operations, market positioning, management, and outlook, were able to open an investment in a fairly timely manner, which turned out to be key, as the shares appreciated substantially post purchase.
Stock High: $7.88 (01/13/2017)
Recent Price: $6.88 (02/03/2017)
Price Paid: $2.31; $1.71; $2.25 (01/24/2012; 5/25/12; 4/2/12)
Vonage Holdings Corp. is an example of how experience in financial statement preparation, specifically the accounting for income taxes can lead one to a compelling investment thesis.
VG is a voice-over IP (VOIP) communications company (i.e. an Internet-based telephone provider) with catchy television advertising spots featuring either someone on the beach getting hit in the head with a flying box with the Vonage brand on it, or with various personalities declaring their independence from land lines by stating "this is my last phone bill" and then crumpling it up and tossing it into a massive pile in the middle of a warehouse, suggesting that everyone is doing it. It was a trendy IPO that promptly plummeted and lost 80% of its market value. Having, for years during college, used AOL's (NYSE:AOL) dial-up Internet CDs that came free in the mail to access the Internet, we appreciated how the bargain basement telephone service that Vonage provided could be attractive to low-income users, particularly those with non-resident family and friends. Having also been an early fan of Google's (NASDAQ:GOOG) (NASDAQ:GOOGL) Gmail chat and calling features (now called Hangouts), we and our work colleagues were already adopters of the technology. We recognized that, much like AOL's dial-up CDs had previously, land-based telephone lines were fast going obsolete. The Company had paid down approximately $130M in debt, bringing its leverage to about 0.5x net income, and reducing its interest expense year over year by 2/3. The Company had a fairly clean balance sheet, stable revenue, new apps and overseas partnerships, so good news on the horizon. Add to that a swing to significant profitability, and the Company was trading at a PE of less than 5x and an EV/EBITDA of 3-4x. The Company looked cheap on those metrics alone, and there were no signs that business would deteriorate any time soon.
So where did our edge come in? What drew our attention to Vonage was the published effective tax rate (ETR). For calendar 2011 the ETR was a -375%, as in a benefit (another word for a tax gain, the recognition of which actually increases net income rather than decreases it) and not an expense. Now, in some situations, ETRs can be misleading, particularly when companies are operating near break-even, but Vonage was profitable in 2011 with pre-tax earnings of $86.3M. It pays to take a look at the footnotes and tax rate reconciliation in such situations to see what is driving the tax benefit.
We reproduce the Company's tax rate reconciliation below from its 2011 Form 10-K:[v]
Here we see that it was the release of a valuation allowance (VA) on the deferred tax assets (DTAs) that was driving the tax benefit (A valuation allowance is a fancy way of saying that an asset can't be recognized because it is uncertain if it will ever provide a benefit to the Company). By removing a VA, the Company is sending a signal that the benefit of the assets will be recognized, and the independent auditors must agree that such a position is reasonable. The next step then is to determine what deferred tax assets the Company is now benefiting from.
Again from the 2011 Form 10-K:
"Our net deferred tax assets primarily consist of net operating loss carry forwards ("NOLs"). We are required to record a valuation allowance against our net deferred tax assets if we conclude that it is more likely than not that taxable income generated in the future will be insufficient to utilize the future income tax benefit from our net deferred tax assets (namely, the NOLs), prior to expiration. We periodically review this conclusion, which requires significant management judgment. Until the fourth quarter of 2011, we recorded a valuation allowance fully against our net deferred tax assets. In 2011, we completed our first full year of taxable income and completed our budgetary process for periods subsequent to 2011, which anticipates continued taxable income in the future."[vi] (Emphasis added)
To interject some commentary here, what this means is that, by the fourth quarter of 2011, the Company had not only just demonstrated a pattern of profitability, but it was projecting profitability in the future at least sufficient to recognize the NOLs as DTAs without an offsetting VA. So now we know the Company expects to continue its pattern of significant profitability, and will largely be able to avoid paying taxes during the lifetime of the NOLs. But what exactly does that mean? Let's continue, and remember that the below numbers are shown in thousands (000s), so for example, $300,000 is really $300 million.
"Based upon these factors and our sustained profitable operating performance over the past three years excluding certain losses associated with our prior convertible notes and our December 2010 debt refinancing, our evaluation determined that the benefit resulting from our net deferred tax assets (namely, the NOLs), are likely to be realized prior to their expiration. Accordingly, we released the related valuation allowance against our United States federal and Canada net deferred tax assets, and a portion of the allowance against our state net deferred tax assets as certain NOLs may expire prior to utilization due to shorter utilization periods in certain states, resulting in a one-time non-cash income tax benefit of $325,601 and a corresponding net deferred tax asset of $325,601 in the fourth quarter of 2011."[vii] (Emphasis added)
Accountants and attorneys love using run-on sentences. The $325M benefit they are talking about recognizing now that they are removing the VA is not how much income the NOLs are expected to offset, rather, it is the tax effected (think cash tax savings impact) amount of U.S./Canada taxes that will not have to be paid in the future. The gross amount of income the NOLs can offset is shown below:
"As of December 31, 2011, we had NOLs for United States federal and state tax purposes of $794,714 and $423,963, respectively…"[viii]
One can see this activity occurring on both the balance sheet and the income statement. A quick review of the NOL expiration schedule in the tax footnote provides additional insight into the minimum projected profitability of the Company over the next 18 years.
So what did our quick check of the footnotes in the SEC filings yield? Not insignificantly, we discovered that the $326M tax benefit in calendar 2011 was due to the release of a valuation allowance on $885M of Federal net operating losses (NOLs) booked as an asset on the balance sheet. What this means, in essence, is that the Company was not only demonstrating an impressive return to profitability in the prior year (2011), but that it also had significant expectations of profitability into the foreseeable future. Generally speaking, independent auditors are reluctant to sign off on such a large tax benefit/VA release without compelling income projections and a solid history of recent earnings that are more than sufficient to offset the NOLs. We have seen exceptions to this of course, but provided the auditor is reputable, those exceptions are few and far between.
Bottom line; all else being equal, when a company with a $400M market capitalization and enterprise value recognizes a $326M GAAP gain due to the more-likely-than-not expectation of at least $885M of taxable income over the coming years, and then add to that the PE and EV/EBITDA under 5x and very little leverage, it's a good bet that company is worth a whole lot more than the current $2/share. It also may provide a competitive advantage over new market entrants that must pay taxes over the coming decade. The cash that would otherwise go to pay taxes may be used to amortize debt, invest in the business, repurchase shares, pay a dividend, or any number of activities management may think of to create value and increase earnings further.
With the Company's stock trading around $2 per share, and armed with the confidence provided by our edge in financial statement analysis (with particular focus on the income tax provision), and further armed with a sufficient understanding of the business in which it operates, we felt safe entering a position. The results were satisfactory, as illustrated in the share price chart below. Although the shares dipped not insignificantly immediately after our purchase, we took the opportunity to increase our position (remember, we could act with confidence because we understood what we owned, and what the Company and the auditors believed the future held). The shares doubled within the year, and have trended upwards since.
When a company's shares are trading at an aggregate market capitalization of under $400M, is not heavily levered, and then that same company recognizes over $100M of annual EBITDA, $86M of pre-tax income, and on top of all that, books a $326M deferred tax asset for NOLs, that is a good sign that not only is the company expecting to earn income equivalent to the gross underlying NOLs prior to expiration, but also coupled with a clean balance sheet and sufficient cash that the company is worth looking at more closely.
Spectrum Brand Holdings was in many ways the opposite of Vonage, but our attention was attracted for much the same reasons.
Spectrum Brand Holdings
Recent Price: $132.76 (02/03/2017)
Price Paid: $25.07 (10/19/11)
"Decisions to buy and sell stocks should be based solely on the investment merits" - Joel Greenblatt
Spectrum Brand Holdings owns a number of household brand names, including Rayovac Batteries, Black & Decker, Russell Hobbs, Black Flag, George Foreman Grills, Spectracide, Cutter, Repel, Armor All, STP, etc. SPB's debt-financed, acquisition spree in the 2000s resulted in a bankruptcy filing that wiped out shareholders in 2009. One can read more about the Company's background here.[ix] The Company was still recovering the following two years, when in 2011 we noticed the effective tax rate. We only even saw that as we were looking up Prestige Brands Holdings (NYSE:PBH) and mistyped the ticker symbol. Incidentally, we ended up entering positions in both companies (better lucky than good).
"Our effective tax rate on income from continuing operations is approximately 24% and 249% for the Fiscal 2011 Quarter and Fiscal 2011 Nine Months, respectively."[x]
The impact to the tax rate reconciliation for the quarter was even more pronounced, in the event that a 249% effective tax rate wasn't enough to raise eyebrows.
Thus, whereas Vonage had recognized a large tax benefit due to the lifting of a valuation allowance, Spectrum was recognizing a large tax expense. This is generally not good. The question of course was why? Were earnings deteriorating? Was it merely do to a change in control? Were there not sufficient income projections going forward to offset NOLs? Reading further we got more information:
"At July 3, 2011, we are estimating that at September 30, 2011 we will have U.S. federal and state net operating loss carryforwards of approximately $1,156 million and $1,006 million, respectively, which will expire through years ending in 2032, and we will have foreign net operating loss carryforwards of approximately $143 million, which will expire beginning in 2011. Certain of the foreign net operating losses have indefinite carryforward periods. As mentioned above, limitations apply to a substantial portion of the U.S. federal and state net operating loss carryforwards in accordance with IRC Section 382. As such, we estimate that approximately $299 million of our federal and $463 million of our state net operating losses will expire unused."[xi]
That last bit about the §382 limitations really just says that due to one or more changes in control (i.e. ownership transfers of more than 5% of the company, which will generally occur in a Chapter 11 bankruptcy reorganization) that there is a limit to how much of the NOLs may be used in any given year, irrespective of profitability. For example, if the Company were to earn $1.2B in fiscal 2011 (implausible we know, but we are making an illustration), Spectrum would be limited to how much of the NOLs could be used to offset that income, and so on, and so forth until the NOLs expired.
"The ultimate realization of our deferred tax assets depends on our ability to generate sufficient taxable income of the appropriate character in the future and in the appropriate taxing jurisdictions. We establish valuation allowances for deferred tax assets when we estimate it is more likely than not that the tax assets will not be realized. We base these estimates on projections of future income, including tax planning strategies, in certain jurisdictions. Changes in industry conditions and other economic conditions may impact our ability to project future income. ASC 740 requires the establishment of a valuation allowance when it is more likely than not that some portion or all of the deferred tax assets will not be realized. In accordance with ASC 740, we periodically assess the likelihood that our deferred tax assets will be realized and determine if adjustments to the valuation allowance are appropriate. As a result of this assessment, we determined that a full valuation allowance is required against the tax benefit of our net deferred tax assets in the U.S., excluding certain indefinite lived intangibles. In addition, certain other subsidiaries are subject to valuation allowances with respect to certain deferred tax assets. During the Fiscal 2011 Quarter we decreased our valuation allowance against net deferred tax assets by approximately $30 million. Our total valuation allowance, established for the tax benefit of deferred tax assets that may not be realized, was approximately $350 million and $331 million at July 3, 2011 and September 30, 2010, respectively. Of this amount, approximately $339 million and $300 million relates to U.S. net deferred tax assets at July 3, 2011 and September 30, 2010, respectively and approximately $11 million and $31 million relates to foreign net deferred tax assets at July 3, 2011 and September 30, 2010, respectively."[xii] (Emphasis added)
The Company's footnotes for fiscal 2010[xiii] revealed somewhat more detail on the NOLs and their expirations.
Therefore, in contrast with Vonage, Spectrum did not anticipate being able to utilize its NOLs prior to expiration, due both to §382 limitations and/or insufficient taxable income against which to offset the NOLs. In addition, the Company was still fairly levered with $1.7B of long-term debt[xiv] on its balance sheet.
So why were we interested? Well, we liked the assets and brands, which were consumer goods with respectable, durable competitive advantages. Although not always the market leader (e.g. Rayovac was competing fiercely with Energizer and Duracell on the platform of "equal or better value at a lower cost"), the value proposition and barriers to entry were considerable. In addition, due to the heavy debt load which required about $200M of annualized interest payments[xv] per year, the income tax provision was skewing the effective tax rate; therefore, net income (and hence the PE ratio) were, if not entirely worthless, not necessarily reflective of the Company's cash generation capabilities, nor the value of the entire business.
"Companies that spend money like drunken sailors, especially on acquisitions and real estate, are left with a huge depreciation allowance and a lot of debts to pay off, which gives them a high cash flow/low earnings profile."[xvi]
The truth was the Company had significant operating income[xvii] and was throwing off significant amounts of cash before interest payments and debt amortization.[xviii] The ETR attracted our attention, but upon closer inspection, we became comfortable with the Company's value strategy, its place in the market, the growth in its earnings and cash flow, its ability to service and amortize its debt, and the defensibility of its business. All things considered, we initiated a position and determined to watch the year-end results[xix] closely.
SPB was trading in the $25 range prior to our entry. SPB has subsequently traded up to north of $130 per share. In this case, the ETR merely attracted our attention to a compelling investment possibility so we could study it further. It was a couple months later when the Form 10-K came out that we believed we had something really special. The Company had reduced its long-term debt by $180M from $1.72B to $1.54B[xx] and net cash provided by operating activities was $227M.[xxi] It seemed clear to us that the Company could service its debt load, and worst-case scenario could sell off one or more brands to de-lever further, but we didn't expect that would be necessary.
Further research into SPB prior to the shares taking off similarly revealed an interesting arbitrage opportunity via the shares of Harbinger Capital Group (NYSE:HRG), where one could take advantage of the value gap in SPB at the same time as one could take advantage in the value gap in HRG. This is further discussed immediately below, and is really an extension of the same investment.
- "The best stock to buy may be the one you already own."[xxii] - Peter Lynch
- One should listen to Peter Lynch and use one's unique edge to capitalize on opportunities in one's circle of competency.
- One should continue to listen to Warren Buffett and not sell out of a company with great long-term prospects, a durable competitive advantage, and growing earnings, which was purchased at a fair price. Just hold it forever (unless it is a cyclical).
- "As I study these reports now, I realize that many stocks that I held for a few months I should have held a lot longer. This wouldn't have been unconditional loyalty; it would have been sticking to companies that were getting more and more attractive…. By abandoning these great companies for lesser issues, I became a victim of the all-too-common practice of 'pulling out the flowers and watering the weeds'" - Peter Lynch
Harbinger Capital Group
Recent Price: $16.79 (02/02/2017)
Price Paid: $4.06; $4.10; $4.01 (12/29/11; 12/29/11; 12/31/2013)
In 2010, Harbinger Capital Group controlled Russell Hobbs, and merged it with Spectrum Brands, leaving HRG with a majority stake in SPB. HRG also owned a valuable insurance company. HRG was owned primarily by Harbinger Capital Partners (NYSE:HCP), a hedge fund that made billions betting against subprime mortgages during the credit crisis.
HCP and its founder, Philip Falcone, were at the time under indictment by the SEC, which alleged that Falcone had misused fund assets for personal use, and that HCP had engaged in unfair redemption practices, allowing favored investors such as Goldman Sachs to redeem partnership interests, while locking up other investors (Note these allegations were later settled). The indictment had the result of temporarily depressing the shares of HRG, in our view, understandably, but excessively given the nature of holdings and operations in HRG. One may read a little about this arbitrage play in the comments of the above referenced article on Spectrum Brand Holdings, reproduced again here.[xxiii] One may further read an article on this special situation here.[xxiv]
There was certainly some control risk in this arbitrage play, but during 2011, HRG actually traded at a value that was less than its publicly-traded ownership in SPB, giving a negative value to the insurance company. As SPB was similarly undervalued at the time, an investment in the undervalued HRG was another way to obtain the similarly undervalued shares of SPB at a significant discount to their trading value. This was just one of the odd, short-term arbitrage opportunities that occasionally arise in an otherwise efficient market. We held the position while the arbitrage gap narrowed, and then exited.
It is important to note a couple of items. We were not comfortable holding HRG long-term due to the ownership situation. We would have been comfortable holding SPB forever, and SPB has certainly performed better than HRG over the subsequent time period. Sometimes we can be too smart by half, as we then missed out on the subsequent run-up in SPB shares. Thus, it often makes sense to pursue the simplest course. Complexity often equates with risk. The arbitrage play did work, however.
- Sometimes we can be too smart by half, as we then missed out on the subsequent run-up in SPB shares. Thus, it often makes sense to pursue the simplest course.
- Complexity often equates with risk.
Do you start to see how, with a little awareness and knowledge and skill and discipline you can win, most of the time, and you can win big? It just requires a little patience, and a little uncommon, common sense.
It is instructive to note that both examples occurred after the recent bull market was well underway. The Dow had recovered from a low of around 6,000 to 11,000-12,000, and despite not yet recovering its pre-Great Recession level of 14,000, many prognosticators and value investors were opining that the bull market was running out of gas and that values were few and far between. In August and September of 2011, just a few months earlier, the market experienced a slight correction. By investing in what we understood, we were able to find all kinds of bargains after our initial purchases during the Great Recession had significantly appreciated, and this was during a period of time when many were fretting the direction of the market and that there were few if any compelling values available. In our own wheelhouse, we were nearly tripping over them in late 2011 and early 2012.
If that Didn't Convince You…
In 1994, Mr. Peter Lynch of Fidelity Magellan fame said the following about edges during a lecture at the National Press Club. We are reproducing several paragraphs to drive the point home:
"You need an edge to make money, too. People have incredible edges and they throw them away. I'll give you a quick example of, uh, Smith-Kline. This is a stock that had Tagamet. Now you didn't have to buy Smith-Kline when Tagamet was doing clinical trials. You didn't have to buy Smith-Kline when Tagamet was talked about in the New England Journal of Medicine, or the British version, Lancet. You could have bought Smith-Kline a year after Tagamet came out.
Let's say your spouse, your mother, your father, your nurse, your druggist. You're writing all these prescriptions. Tagamet was doing an amazing job curing ulcers. And it was a wonderful pill for the company because if you stopped taking it, the ulcers came back. It wasn't a crummy product if you took it for a buck and then it went away. But it was a great product for the company. But you could have bought it two years after the product was on the market and made five-to-six times your money. I mean all the druggists, all the nurses, all the people, I mean millions of people saw this product. And they're out buying oil companies or drilling rigs. It happens.
And then three years later or four years later, Glaxo, even a bigger company, this is a huge company, a British company, brought out Zantac which was a better, at that time an improved product, and you could have seen that take market share, do well, and you could have bought Glaxo and tripled your money. So you only need a few stocks in your lifetime. They're in your industry.
I think of people, if you'd worked in the auto industry, let's say you're an auto dealer, the last ten years. You would have seen Chrysler come out with the mini-van. If you were a Buick dealer, a Toyota dealer, a Honda dealer… You would have seen Chrysler dealerships packed with people. You could have made ten times your money on Chrysler a year after the minivan came out. Ford introduces the Taurus Sable, the most exceptional line of cars in the last twenty years. Ford went up seven-fold on the Taurus Sable. So if you're a car dealer, you only need to buy a few stocks every decade.
When your lifetime's over, you don't need a lot of five-baggers to make a lot of money, starting with ten thousand dollars or five thousand dollars. So in your own industry you're going to see a lot of stocks. And that is what bothers me. There are good stocks out there that are looking for you, and people just aren't listening. They're just not watching it. And people have incredible edges. People have big edges over me.
They work in the aluminum industry. They see aluminum inventories coming down six straight months. They see demand improving. And in America today it is hard to get an EPA permit for a bowling alley, never mind an aluminum smelter. So you know when aluminum gets tight you just can't build seven aluminum smelters. So when you see this coming you can say, wait a second, I can make some money.
When an industry goes from terrible to mediocre, the stock goes north. When it goes from mediocre to good, the stock goes north. And when it goes from good to terrific the stock goes north. There's lots of ways to make money in your own industry. You can be a supplier in the industry, you can be a customer. It happens in the paper industry, it happens in the steel industry. It doesn't happen every week, but if you're in some field, you'll see a turn, you'll see something in the publishing industry. These things come along and it is just mind boggling, people throw it away."[xxv] (Emphasis added)
The point is that nearly everyone has an edge. If they choose only to play their game in which that edge exists, they are more likely to come out on top. Of course, one must exercise the discipline of investing in one's own circle of competence, and then waiting for their pitch.
Participating in the market is like fishing in waters teeming with both fish and sharks. If one just jumps in and tries to swim with the sharks, bad things are likely to result. And while we are on the subject of sharks…
The author's spouse enjoys watching the CNBC show Shark Tank. Last week, she made the comment that "Mark Cuban is always 'out'. It has been a long time since he has made a deal." Although she likely was frustrated by this observation, her comment caught our attention. We did a quick google search for "Mark Cuban" and "investing" on YouTube, and we found an interview[xxvi] from August 2011. Now, August 2011 was a month in which, after the market had gained maybe 80% since the 2009 great recession lows, the market started gyrating and was threatening to correct, and professional commentators were beginning to throw around the word "recession" again. A great many professional money managers believed the market was fairly, or even overly valued, and fear was again beginning to creep into Wall Street. In this interview Mr. Cuban said the following:
"Any time there's volatility and any time there's change there's opportunity. Now I say it's great because I've taken a whole different approach to investing than most people. You know, I think buy and hold is a crock of sh--. I think, you know, the idea that you always have to invest your cash is not far behind, and so I've always been of the attitude that unless you really have a commitment to something, just keep your money in cash, knowing that at some point in time, there's going to be a week or two like we've had…"
When the interviewer observes there has been a lot of "stuff" hitting the fan lately, Mr. Cuban continues:
"Exactly the point. That's where the opportunity is. Then when everything starts getting crazy, I call it the world series of investing, you know, that's where you start digging in…
You've got all these professional people on the other side of trades. When I started investing in stocks in the early 90's after I sold my first company, you could understand different elements of the market better than the professionals… Today there's so much money in these huge hedge funds, and they have such professional research, and in depth research, there aren't any advantages for the individual traders, and so my approach has always been, unless I know something specific, put it in cash." (Emphasis added)
We might take the creative liberty to amend that last sentence to replace the word "any" with the word "many," but the point is largely the same. Most investors significantly underperform the market over the long run, because they invest in things they do not understand, they try to time the market, or they become emotional and jump in and out of securities rather than just staying put and letting the number of bargain purchases and the extent of the bargains in companies dictate how much of their capital is invested. Finally, they throw their edges away and play Wall Street's game. However, by following certain investing principles and by taking deliberate steps, the average investor can play their own game, on their own terms, and come out ahead.
The successful, self-directed investor must adopt a proven, viable investment framework, insist on a margin of safety, and only play the game when the odds are stacked in the investor's favor. In other words, the investor must insist upon exploiting his or her edge. If this results in their being in cash, not when market prognosticators are preaching doom and gloom, and not when their emotions are telling them the market is overvalued, but when they simply cannot find compelling investment opportunities in their own wheelhouse, then holding cash may be the smartest thing one can do. The average active, self-directed investor should not be worried about having a significant amount of their portfolio in cash. Seth Klarman of Baupost fame has strung together a 30-odd year track record of significant out-performance, and absolute performance in nearly every year while holding nearly one-half of his fund in cash, on average. It is very difficult to lose one's money in cash. By being cautious and conservative when compelling bargains are not prevalent, and then by insisting on an edge before investing that cash in a security, truly amazing results can occur. This requires patience and discipline, but those are concepts for separate articles.
As Peter Lynch has written, it only takes a few five-to-ten-baggers to result in an amazing long-term investment record (provided the investor doesn't make too many stupid mistakes in the meanwhile).
"It was huge gains in a few huge positions that led to Magellan's superior results."[xxvii] - Peter Lynch
"I've said before that an amateur who devotes a small amount of study to companies in an industry he or she knows something about can outperform 95 percent of the paid experts who manage the mutual funds, plus have fun doing it."[xxviii] - Peter Lynch
If one is hell-bent on being fully invested at all times, one may conceivably invest the balance of their portfolio in Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), just don't go investing in stocks in which you do not have an edge, merely because compelling bargains within your wheelhouse are few and far between. We all worked hard to save enough money to invest; in most cases for years, or even decades. Don't go betting it willy-nilly in a rigged game on something you know nothing about.
[i] Peter Lynch, Beating the Street, copyright 1993, 1994, Simon & Schuster Paperbacks, p 28.
[ii] Peter Lynch Speech, National Press Club, October 8, 1994. See for instance.
[iii] The author acknowledges the original, primary purpose of stock exchanges was to provide a market for companies to raise capital to further expand their businesses, but Wall Street has a way of bastardizing the markets for publicly traded securities.
[iv] Joel Greenblatt, The Little Book that Beats the Market, John Wiley & Sons, Inc., 2006, p 100. Originally appeared in a slightly different format in Mr. Greenblatt's earlier book, You Can Be a Stock Market Genius: Discovering the Secret Hiding Place of Stock Market Profits, First Fireside Edition, 1999.
[v] Form 10-K for calendar year ended December 31, 2011, p F-19.
[vi] Form 10-K for calendar year ended December 31, 2011, p F-18.
[vii] Form 10-K for calendar year ended December 31, 2011, p F-18.
[viii] Form 10-K for calendar year ended December 31, 2011, p F-19.
[x] SPB Q3 for Fiscal 2011 10-Q, p 46.
[xi] SPB Q3 for Fiscal 2011 10-Q, p 46.
[xii] SPB Q3 for Fiscal 2011 10-Q, p 47.
[xiii] SPB's Fiscal 2010 Form 10-K, pp 59, 139, 141.
[xiv] SPB Q3 for Fiscal 2011 10-Q, p 3.
[xv] SPB Q3 for Fiscal 2011 10-Q, p 4.
[xvi] Peter Lynch, Beating the Street, copyright 1993, 1994, Simon & Schuster Paperbacks, p 80.
[xvii] SPB Q3 for Fiscal 2011 10-Q, p 4.
[xviii] SPB Q3 for Fiscal 2011 10-Q, p 4.
[xix] SPB's Fiscal 2011 Form 10-K, pp 55, 56-57, 119-123.
[xx] SPB's Fiscal 2011 Form 10-K, p 87.
[xxi] SPB's Fiscal 2011 Form 10-K, p 91.
[xxii] Peter Lynch, Beating the Street, copyright 1993, 1994, Simon & Schuster Paperbacks, p 129.
[xxiii] Spectrum Brands: Focusing On The Right Metrics
[xxv] Peter Lynch Speech, National Press Club, October 8, 1994.
[xxvii] Peter Lynch, Beating the Street, copyright 1993, 1994, Simon & Schuster Paperbacks, p 120.
[xxviii] Peter Lynch, Beating the Street, copyright 1993, 1994, Simon & Schuster Paperbacks, pp 18-19.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The businesses and stocks mentioned represent securities in which we were invested, but do not currently have a position.