New York City was a seedy, grubby den of salacious iniquity in the late 1980s and early 1990s. At the time, and on those very rare occasions when I’d reward myself with a few hours off from my around-the-clock study habits, I enjoyed taking very long walks through the City. Almost always I'd cut through the Times Square area, which lay at the very epicenter of the filth, sleaze, garbage and vandalism that then characterized New York City.
One evening, whilst strolling past the gum chewing hookers, slack jawed junkies and snappily dressed pimps who worked the Times Square area, I spied a large number of crumbled up five dollar bills in the gutter and blowing down the street. Like a kid in a candy store, I picked one up. It was the right size and color, but printed on the back was an advertisement for Peep Land - which was one of those a 24 hour adult video and live peep show venues that festered like an open sore somewhere around 52nd and Broadway.
The Peep Land five dollar bill phenomenon caught on and then rapidly spread across Times Square like an unmentionable and itchy venereal disease. Soon, all of the other topless bars and burlesque clubs festooned Times Square with green paper fliers and advertisements featuring fake currency on one side of the paper, and tits, ass and prurient offers and propositions on the back.
Fast forward about 25 years, and you will find me strolling home from work through the tony, manicured suburbs of Chevy Chase, Maryland. Aha! To my alarm, I suddenly spy a crumpled up one hundred dollar bill lying on the side of the road next to a sewer. Well, I think to myself, I wasn’t born yesterday. Nope, too smart to fall for that old Peep Land trick. So I keep walking.
One hundred dollars. Please. I ponder the rate of inflation that took a fake $5 bill and turn it into a fake $100 bill over a 25 year period. I ponder, why a place like Peep Land would even bother to take the time to place a single fake $100 bill in a boring place like Chevy Chase. Did they really expect someone to pick it up and DRIVE all the way up to New York City to visit a seedy 24 hour adult video boutique? I think to myself "whoever is in charge of their marketing should be fired". It amazes me that Peep Land would even still in business after so many years of urban gentrification and Disney-World-ization that have long since sanitized and neutered New York City.
It takes me almost 10 minutes to finally figure out why nothing in this situation makes any sense. That wasn’t a Peep Land flyer, was it? I walk back to the sewer, pick up the soaked hundred bucks and find a perfectly legal tender note that I will ultimately deposit into my checking account the very next day as I squeal with delight!
Looking back, I can now tell you that the improbability of ever finding another $100 sitting next to a sewer in Chevy Chase wasn’t lost on me, but didn’t stop me from permanently altering my route home after work so I could visit the wondrous, magical, money-spewing sewer, day after day after day (and I never did find another $100 there, by the way).
In time, I began to seek out other forms of the wondrous, magical, money-spewing sewer, only this time the sewers in question took the form of high-yielding stocks in troubled companies trading at seemingly “bargain” levels. As you might guess, this quest provided me with more than a few expensive financial lessons. Ever quick on the uptake, I eventually did figure out that my searches for magical, wondrous money-spewing sewers typically end up with me right back in the same situation that I was in on that very first night when I stopped to pick up the filthy Peep Land five dollar bill. Just another dumb, greedy sucker who got played.
In precise technical investment terms, what is "a magical, wondrous, money-spewing sewer?" The answer is that it’s a business that is either losing money, or struggling in the face of huge difficulties to earn it. And regardless of this unsavory business condition, the company in question pays a whopping dividend that seems almost too good to be true.
I don't give advice anymore. You know that nobody really wants your advice. If someone asks me for advice, I understand that what they are really asking me for is to please confirm that I agree with whatever they have already decided they are going to do anyway. Plus, I'm not qualified to offer legal or financial advice. I can only tell you about the lessons that the investment equivalents of Peep Land five dollar bills and magical, wondrous, money-spewing sewers have taught me.
Lesson NUMBER ONE. If it’s too good to be true, then probably it’s either not good, not true, or both. Let’s take the case of Omega Healthcare (OHI). OHI leases real estate to skilled nursing care providers, offers north of a 9% yield, sports impressive dividend growth and a compelling macroeconomic story to back it up (that being, everyone is getting old and will end up in a nursing home). OHI trades at an absurdly low multiple of earnings. When it comes to the value of OHI stock, either the stock market is stupid or I am. I bet 9 out of 10 people reading this article own shares of OHI themselves.
But now, thanks to the rising dividend and falling stock price, this investment opportunity today appears so good that I have become dubious. Maybe I am jaded because in my sundry perambulations, I have found far, far, far more Peep Land fivers than legal tender hundred dollar bills. I mean that literally, but I also mean it figuratively in terms of the many “too good to be true” investment opportunities that I’ve stepped in and then ultimately had to wipe off the bottom of my shoes as I hold my nose.
I've owned OHI for years - largely because I see demand for skilled nursing homes rising substantially in the future. But the reality is that businesses don't make money simply because of a tidal wave of demographic trends. Here's an example of what I mean: the USA is in the middle of an oil-producing renaissance thanks to fracking technology. On account of those massive volumes of oil that we now produce, it stands to reason that pipeline companies should be minting money, right? Shareholders should be getting filthy rich! You'd think, but here is a piece of art that is emblematic of the US Oil Renaissance:
By contrast, when was the last time you ate a Tootsie Roll? I'm guessing you haven't had one in years. And would you say that demand is booming for this dubious looking piece of chocolate... and is it even really chocolate at all? You read about Amazon taking over the planet, right? Are you reading companion articles about Tootsie Roll taking over the planet with innovative lumps of gooey sticky chocolate thingies wrapped in wax paper? Articles proclaiming that Tootsie Rolls are the next new, big thing? Bigger than Bitcoin, even??? Are we in the early throws of a Tootsie Roll Renaissance? I think it's fair to say "uhhhh..... no."
And yet, here is a snapshot of what a Tootsie Roll NON-Renaissance looks like:
Notice that is a 16,000% return. Let me say it again because it sounds so nice. A 16,000% return. Ahhhh, that just rolls off the tongue and straight into your wallet, doesn't it? So I am just saying. Rising demographic demand tells you nothing about rising profits. Demographics and macroeconomics are red herrings when it comes to earning money as an investor, and yet somehow it is so compelling to imagine the case to be otherwise.
But let me get back to the original point I was making. OHI looks like a solid bargain to me right now, like the stock market is just giving away free money to anyone smart enough to reach in and take it. But there is another interpretation of OHI's sky-high yield and slumping share price: the business is sick and feeble, and I'm too dumb to see it. Take a wild guess what odds I will assign to each of those possibilities. Remember, I've been too smart for my own good enough times to know that I'm not all that smart after all.
Do I trust the market to tell me the correct value of a company's stock? Hell no - the stock market is stupid and a liar to boot. But here is the point: sometimes, I trust myself even LESS than the stock market. I have earned far more money, and avoided losing even larger amounts of money, by tempering my enthusiasm with frequent, humiliating reminders of all the other times I’ve gotten it wrong and paid for it with my own hard-earned money.
When am I most wrong most often? It seems to happen mostly when I conflate an indisputable premise (the population of the USA is aging) with a conclusion that does not logically follow from that premise (companies that serve aging clients will make a lot of money, and so will I if I buy the stock at a bargain-basement price). It's when I am so entranced by big picture thinking that I confuse a Tootsie Roll with a puddle of crude oil. Frequently, it's a high dividend yield that encourages me skip the Tootsie Roll and to instead swirl my finger around in the crude oil and then lick it off.
Lesson NUMBER TWO. It is extremely difficult to make money by owning a business that is either losing money, or struggling very hard to earn money. Ultimately, shareholders prosper only when the businesses they own prosper. The only exception is when investors outsmart the entire market and correctly identify the elusive, wondrous magical money spewing sewer that actually DOES spew money. It's easier to identify businesses that are consistently earning money that trade at a reasonable PE ratio in the area of 20 or maybe 24, than it is to correctly identify a bargain priced money spewing magical wonder sewer.
I'm looking at OHI again now. When it comes to investing, the promise of a potentially massive reward is typically subsumed in the certainty of downside risk to the company’s earnings. Perhaps the stock market over-reacted to the downside when OHI announced it was having trouble collecting rents from some tenants. Perhaps this over-reaction has created a wondrous opportunity for savvy investors who are smarter than everyone else to scoop up bargains. But of course it’s equally plausible that the stock market has actually under-reacted to OHI's bad news. Am I smart enough (or lucky enough) to spot the difference?
Let's look at my track record. I'm sorry to admit it, but I've sometimes bought companies that looked like bargains at the time, but ended up looking wildly expensive even after the price has dropped by 50%. My baleful 20 year investment in GE comes to mind. You can make a lot of money buying struggling businesses at low stock prices, but you can also make a lot of money owning thriving businesses - even if you pay top dollar for the stock. You can lose a lot of money buying struggling businesses at low prices. But you probably won't lose too much money buying a thriving business. Once you put these four possible outcomes into a probability matrix, the relative attractiveness of investing in healthy, thriving businesses becomes clear.
Lesson NUMBER THREE. There is a difference between being stubborn and piggy piggy, and being disciplined and steadfast. Trying to delineate the difference between these two things is so complex, and so idiosyncratic, that I have no advice or pithy quips on how you should set about doing that.
In my case, experience has taught me that if I buy shares of a thriving business, like Berkshire Hathaway (ticker BRK.A), Google (ticker GOOG) or McCormick, Inc. (ticker MCK) when prices are dropping, it turns out later that I was acting disciplined (or that I just got lucky). By contrast, whenever I buy shares of a very high yielding sewer as the stock price swoons, mostly I just end up losing even more money. And losing money can only mean one thing in retrospect. It means I was acting like a stubborn little piggy, not like a disciplined value investor.
The agony of it all is that I almost never know at the time whether I am being greedy whilst others are fearful, or whether the dazzling, shiny looking dividend yield has blinded me to obvious business risks that have inspired other, smarter investors to dump the stock.
The real essence of this lesson is that after you burn yourself a few times, why not just stop doing whatever behavior caused you to get burned in the first place? In my case, the behavior is confusing high yields with bargain prices, and the solution is simple. Don't chase high yields in companies that seem to be managing a difficult earnings environment. Eschew them. Learning from your mistakes is actually pretty easy - it’s actually following your own advice that ends up being next to impossible for most investors (me included).
Lesson NUMBER FOUR. The main thing I aim to do is to own businesses that generate stable, growing earnings. I do this because those earnings can be reinvested (either by the company or, if the company pays a dividend, by me) and thereby generate compound earnings growth. The only force that an investor needs to build wealth is the power of compounding, so whatever I can do to unleash that force is what I should try to do. I found that the key is to make sure that the corporate earnings will actually materialize - otherwise there ain't nothin' to reinvest. This is why owning healthy, thriving businesses is so crucial to this investor’s long-term results.
Now, I also happen to be a dividend growth investor. I live off dividend income, and my idea is that this should help me avoid the temptation to sell stocks simply because the price is crashing. I like to look at my keyboard and see the "buy" button worn and burnished by constant use, and the "sell button" gathering dust. To enable that to happen, I need a constant influx of fresh cash - just like a shark needs water flowing across its gills. That's why I make an effort to save and reinvest some of the dividends I earn. Naturally I feel like the more dividends I have, the better.
Here's the rub. Many exceptionally good businesses pay low dividends or, in fact, sometimes even pay NO dividends. Many lousy companies offer very high dividends - just look at General Electric (NYSE:GE) last week with it’s yield in the area of 5%... right until the dividend got slashed by 50%. There is an imbalance between business quality and dividend yield is what makes dividend growth investing one of the trickiest areas in personal finance. It is an area stuffed with value traps, sucker yields, and businesses that seem glorious, but are too expensive or low yielding to be affordable. Remember all those wretched Peep Land five dollar bills scattered all up and down the streets of Times Square? Keep that image in mind as you contemplate all the value traps and sucker yields littering the floor of the New York Stock Exchange. The really good companies end up being like the diamond necklace in the display case at Tiffany's; beautiful and separated from you by one inch thick plexiglass and equally impenetrable financial realities.
I have learned to put most of my attention on a company’s earnings and growth in the intrinsic value of the business. I have learned to pay top dollar for quality businesses, if I can't find them at bargain prices. Dividends and dividend growth are an important facet of an overall picture of business quality, and provide a meaningful glimpse into how shareholder-oriented the company is, but it’s ultimately the steady drumbeat of rising corporate earnings that truly matters. And clearly, undue focus on dividends at the expense of consideration of any other factor is a mistake bordering on idiocy. Don't take my word for it. Here is a comparison of Ishares Dividend Select ETF (NASDAQ:DVY) to the S&P500:
Granted, that doesn't factor in reinvested dividends, but you get the point that if you want to trounce the S&P500 with your investment savvy, it’s not enough to simply look at a company’s dividend growth rate. You need to think like a business person, inform yourself about the industry and the company, and then determine whether it’s a business that is likely to thrive in the future or to struggle and limp along while you wait for a turnaround that will never come about. It is reasonable to expect that your investment outcomes will mirror the types of companies you own - thrivers, or limpers. It's really silly to think that you can regularly deviate from this immutable fact by means of clever timing, ultra-savvy stock pricing, or by following one or two basic financial metrics such as past dividend growth rates.
Lesson NUMBER FIVE. In the investment business, you are going to make mistakes. Expect several of your investments to really bomb - and it will probably the ones you didn’t think ever possibly could. It's those so-called "high conviction" stock picks that will utterly crush your portfolio if you aren't smart enough to ensure that you never have high conviction in anything, ever, no matter what. The difference between a crappy investor and a good one isn't that the good one can pick a lot of winners. The difference is that the good investor quickly recognizes his or her mistakes, readily removes thumb from mouth, and sells the stupid investment before it drops another 50%.
In my worldview, you see, investing isn't about making money - it's about keeping what you made, if you can. Did you know that I don't even bother trying to avoid the occasional 30% loss here and there - that's just part of the cost of investing. It's the 90% + losses that make me sick to my stomach. I have learned that it's better to admit you made a mistake, sell at a 30% loss and then watch the stock rally, than it is to hold onto a stinker and take a 95% loss on a single investment. I'm okay with the idea that someone is going to make a ton of money if and when the stock rebounds, and that someone is not going to be me. It took me many painful years to attain this degree of non-competitiveness. Investing isn't a game to be won. Investing is a chore to survive.
However, and very much to my delight, I have also learned that it's unusual to take a 90% + loss if I invest in companies with really healthy, thriving businesses - even if I pay a bit too much for the stock. Where the 90% losses seem to happen are with stocks that have several or all of the following four characteristics: (1) it's a struggling company in a moribund (or fiercely competitive) industry; (2) the company has a lot of debt, and the industry is characterized by high debt; (3) the company has a very low stock price; and (4) the company pays a brilliant dividend. I have only had three 90%+ losses in my investment life and I remember them like it was yesterday. Lehman Brothers (one of my "high conviction" picks), Navios Maritime Partners (another "high conviction" pick) and an investment into an insurance company that had already declared bankruptcy but seemed to have more cash on it's books than debt on it's balance sheet (where I was simply a moron who didn't know what he was doing, knew it at the time, and at least had the good sense to invest less than $1,000). I think about those failures all the time, and what they all had in common.
The most important factor in my most glorious failures wasn't one of the four I previously mentioned. It was me. I refused to cede the fact that I was wrong and had been beaten. I know that I promised to spare you any advice, but I cannot help myself sometimes. If you are playing around with investments that have most of the dreaded four characteristics (which can be a wonderfully profitable endeavor, by the way), you really better be someone who can quickly realize "hey, I blew it! Time to sell!" and then actually follow through, sell, and move on to other greener pastures.
How do you know when you made a mistake about an investment? Generally, you don't until many years in the future. That's the rub. But, as impossible as it is to know whether you misjudged an investment, it is EASY to figure out when you have misjudged yourself. Always remember that investment returns are as much a function of the stockholder's behavior as they are a function of the stock itself, and you have a huge advantage when it comes to knowing the former even if you know relatively less about the latter. Know thy self. Never were more sage words of investment wisdom ever spoken.
In my case, I have found some very clear indicators that illuminate when I have misjudged my abilities as a shareholder. Here are the warning signs that I have learned to recognize in my case: (1) the stock price is dropping and is already over 20%, 40% maybe even 50% lower than my purchase price; (2) I have already owned the stock for four, five or more years and am still waiting for the company to start earning a lot of money; (3) I am bargaining with myself that I will liquidate the entire position once the stock price rebounds even slightly; or (3) I am reluctant to sell the stock because I don't want my overall portfolio income to go down. When I spot any combination of two or more of these factors bleeding into my investment experience, I have learned that I should sell (or very dramatically trim) my position immediately. Why? It's not that I trust the stock market to tell me the correct value of stock. It's because when it comes to correctly valuing the stock, I trust myself EVEN LESS than I trust the stock market. Experience has taught me that when I can no longer objectively evaluate a stock, I will end up losing money, and will continue to lose money until I stop owning it.
And those are my five most important investment lessons.
To conclude, let me just say that value investing is an inherent contradiction. You have to simultaneously be adaptable on the one hand, and consistent and disciplined on the other hand. You must have the self-confidence to disregard the stock market's panicky pricing for stocks, and yet be totally aware of your own fallibility. But it's all worth it if you can find just one hundred dollar bill in a sea of Peep Land phoney fives.
Now, you might be asking whether I quit my job or something, because I haven't been writing much or doing much with the crazy boss man's portfolio. Looks are deceiving. I've been doing what I mostly do, which is to read, read, read and read. If that were the only investment activity I ever undertook, it would suit me fine. Well, there is that and the fact that I dumped General Electric (GE) from the portfolio. Now that you know my story about money in Peep Land and lying in front of sewers, you know EXACTLY why I made that choice (which saved the boss man 20% of losses). And as always, when the dribbles of dividends come through, I reinvest. This time, I bought $400 worth of shares of Bank of the Ozarks (OZRK). Great business, lots of growth, very healthy.
You'd think that this scant level of activity wouldn't garner much, if any, rewards, but in the world of investing, you mainly get paid for doing nothing besides being patient while the power of compounding works it's magic. The boss man's portfolio is up by around 3% since he hired me, compared to a benchmark of passive index funds I use, which is up 1.97%. Annualize that performance, plus the higher yield of the boss man's portfolio, and you get around 8% outperformance. The income growth is coming along slowly, but took a hit when I dumped GE.
Disclosure: I am/we are long OHI, OZRK.
Additional disclosure: This is not investment advice and I am not an investment advisor.