The Marshmallow Test

There was a famous study in psychology called the marshmallow (or sometimes cookie) test. It worked like this: Preschool students (about five years old or so) were seated at a table with a marshmallow (or cookie). The authority figure (teacher or researcher) explained that she had to go out for a few minutes, and if the kid didn’t eat the marshmallow while she was gone she would give him a second marshmallow as a reward when she returned, but if he ate the marshmallow he would not be given another. Most kids are not good with delayed gratification, and quickly gobbled up their one and only marshmallow. But some kids had the willpower to wait and get the reward of a second treat! (I wish my investments could compound at such a rate!)

But there’s more to the story. The researchers followed up with the kids years later. Those who were able to delay gratification at the marshmallow table tended to be better off financially as adults. Delayed gratification works! Patience really does pay!

The study, though revealing, wasn’t exactly fair. Kids lack maturity and cannot be expected to display discipline or wisdom in the face of such overwhelming temptation. There is no reason an impulsive little tyke cannot learn to take today’s money and invest it for tomorrow’s consumption. But you’re (probably) not a little kid. Are you investing yet? What’s your excuse?

Will Social Security End?

We in the US often hear that the Social Security program is not sustainable, and that by the time we (or some other group of unfortunates) become eligible to collect there will be no money left for us and we will have to beg on the streets or starve. If you look at the charts and extrapolate that seems like a possibility. But if you do a reality check, it ain’t gonna happen. It’s just an entitlement program funded by taxes, and there will always be entitlement programs and taxes. Think about it–can Congress really allow a huge constituency (of both Democrats and Republicans) to be cheated out of their retirement money which they themselves have contributed for the entire working lives? No way. Congress might defer the age of eligibility, or slow down the rate at which it increases for inflation, but everyone will still get their money (or at least most of it).

Some purveyors of get-rich-quick trading courses (or “systems” as they like to call them) like to use this as a scare tactic. “You’ll end up with nothing! Take our course so you can make enough money so you don’t need social security!” Don’t believe it. Turn on your BS detector. As usual, common sense is your friend.

Social security started during the Great Depression, when people sold apples on street corners to survive. They grew their own vegetables and mended their own clothes. They didn’t have monthly subscriptions for phone, wifi, Netflix, iTunes, and The Cloud. They survived without Starbucks, zumba classes, and meals at restaurants several times a week. Social security enabled people to get by.

I’m not saying you will live comfortably on social security alone. I don’t know of many people alive today with the discipline to get by at that modest standard of living. Most of us would like other sources of income after we’re no longer working. So if you want to maintain the lifestyle to which you have (or would like to) become accustomed, you will probably need to supplement your social security. A disciplined approach to stock investing can certainly help, especially if you start early. Remember the fable of the grasshopper and the ant.

– DG

#retirementplanning #socialsecurity #valuestockjournal


The Only Chart That Matters

Most stock analysts and many investors spend a lot of time looking at charts. They are looking for patterns and price movements, with odd names such as head and shoulders, cup and handle, and double Axel leading into a triple Salchow. OK, so the last one isn’t really a technical indicator, but you get the idea.

Technical analysis is all about charts. You’re looking for momentum or the right opportunity to buy or sell based on what has happened in the last 50 or 200 days. Who knows what will happen in the next 50 or 200 days?

Value investors don’t care about charts. They are more concerned about where they think the stock is going in the long term based on its fundamentals.

I’ll be honest. I do take a peek at the chart to see whether the price is near the low end of its 52 week range. Value investors like stocks that are undervalued, unloved, and provide you with a margin of safety. A stock price chart is but one indicator that a stock is undervalued. Of course you need to look at other numbers as well.

No one knows where a stock will be in a week, three months, a year, or five years. In the long run, the market will go up. As Buffett says, time is the friend of a great company and the enemy of a mediocre one.  

The only chart that matters is the one showing the stock market’s historic gains. It keeps going up and down, but mostly up.

How should you measure performance?

People usually like to point to a number–CAGR or annual return–to demonstrate their performance. The only number that counts is how much you end up with, and you cannot know that until the end. Giving last year’s number is misleading. It suggests a short term focus. A financial adviser or money manager who had a great year or two is probably heading for a fall (due to reversion to the mean), so if you decide to go with them because they’ve been hot you will probably be disappointed.

Of course you need to beat inflation, historically 2-3% a year. Sometimes treasuries can do this. But this is a very low bar. You really want to match (or beat) the market (about 9-10% a year), since a low-cost index fund will do that. You can beat the market with a basket of value stocks or dividend aristocrats–both of these categories perform better than the S&P.

If you’re the average Joe or Jane all you really want is for your portfolio to grow without much effort, worry, or risk. Focusing on numbers is distracting. You don’t have to justify your performance the way a fund manager does. Instead, you should be focusing on buying and holding quality companies at value prices.

Kings, Aristocrats, and Princes

It has been shown that dividend paying stocks outperform non-dividend payers. And those that have paid out increasing dividends for 25 consecutive years are collectively referred to as Dividend Aristocrats. There is an even more select group of Dividend Kings, with at least fifty years of rising dividends. Only very solid companies can pull off such a feat, and a group of them would make for a strong portfolio.

What about a company that has paid increasing dividends for only 24 years? Should we arbitrarily exclude it from consideration? What about a 19 year track record of increasing divvies? There are many companies on their way to Dividend Aristocrat status but don’t yet qualify for that elite club. I call them Dividend Princes. They may still have more growth left in them than a Coke or McDonald’s, while maintaining solid financials and top-notch management. It would be worth poking around in the bushes to find them.

Value Investing: More than just numbers

I was perusing Aswath Damodaran’s website and came across some interesting observations in his March 10, 2017 post. Many investors use various value indicators as proxies instead of doing a heavy number crunch. Damodaran reminds us that we cannot rely wholly on numbers. One number we tend to over-rely on is the P/E ratio:

“I mistrust PE ratios for many reasons. First, the more accountants can work on a number, the less trustworthy it becomes, and there is no more massaged, manipulated and mangled variable than earnings per share. Second, the sampling bias introduced by eliminating a large subset of your sample, by eliminating money losing companies, is immense. Third, it is the most volatile of all of the multiples as it is based upon earnings per share.”

What about other ratios? P/B and EV/EBITDA can also be misleading:

“In many ways, the price to book ratio confronts investors on a fundamental question of whether they trust markets or accountants more, by scaling the market’s estimate of what a company is worth (the market capitalization) to what the accountants consider the company’s value (book value of equity).”

“The EV to EBITDA multiple has quickly grown in favor among analysts, for some good reasons and some bad. Among the good reasons, it is less affected by different financial leverage policies than PE ratios (but it is not immune) and depreciation methods than other earnings multiples. Among the bad ones is that it is a cash flow measure based on a dangerously loose definition of cash flow that works only if you live in a world where there are no taxes, debt payments and capital expenditures laying claim on those cash flows.”

Damodaran concludes with some useful advice:

“Rules for the Road

  1. Absolute rules of thumb are dangerous (and lazy): The investing world is full of rules of thumb for finding bargains. Companies that trade at less than book value are cheap, as are companies that trade at less than six times EBITDA or have PEG ratios less than one. Many of these rules have their roots in a different age, when data was difficult to access and there were no ready tools for analyzing them, other than abacuses and ledger sheets. In Ben Graham’s day, the very fact that you had collected the data to run his “cheap stock” screens was your competitive advantage. In today’s market, where you can download the entire market with the click of a button and tailor your Excel spreadsheet to compute and screen, it strikes me as odd that screens still remain based on absolute values. If you want to find cheap companies based upon EV to EBITDA, why not just compute the number for every company (as I have in my histogram) and then use the first quartile  (25th percentile) as your cut off for cheap. By my calculations, a company with an EV/EBITDA of 7.70 would be cheap in the United States but you would need an EV to EBITDA less than 4.67 to be cheap in Japan, at least in January 2017.
  2. Most stocks that look cheap deserve to be cheap: If your investment strategy is buying stocks that trade at low multiples of earnings and book value and waiting for them to recover, you are playing a game of mean reversion. It may work for you, but there is little that you are bringing to the investing table, and there is little that I would expect you to take away. If you want to price a stock, you have to bring in not just how cheap it is but also look at measures of value that may explain why the stock is cheap.
  3. If you are paying a price, you are “estimating” the future: When I do an intrinsic valuation (as I did a couple of weeks ago with Snap), I am often taken to task by some readers for playing God, i.e., forecasting revenue growth, margins and risk for a company with a very uncertain future. I accept that critique but I don’t see an alternative. If your view is that using a multiple lets you evade this responsibility, it is because you have chosen not to look under the hood. If you pay 50 times revenues for a company, which is what you might be with Snap, you are making assumptions about revenue growth and margins, whether you like it or not. The only difference between us seems to be that I am being explicit about my assumptions, whereas your assumptions are implicit. In fact, they may be so implicit that you don’t even know what they are, a decidedly dangerous place to be in investing.”

The more I read about valuation methods, the more I like Buffett’s simple maxim on buying good companies at fair prices. It’s faster, easier, and perhaps more reliable in the long run. But Buffett himself spends a lot of time going through the numbers, he just makes it sound easy. Value investing is not for the lazy.

Chasing Heat

When I was a young football fan the Miami Dolphins were unbeatable and the New England Patriots were a joke. As the years went by their fortunes have changed. This pattern holds throughout the sports world–the mighty fall, and the meek inherit the championship. Occasionally you find a team that outperforms over many decades, such as the Kentucky Wildcats basketball team, but such gems are rare. The same pattern holds in the world of stocks, though the cycles often play out over a longer time horizon. You might find a Kentucky Wildcats stock like Berkshire Hathaway, but most companies have their ups and downs.  

Ken Fisher, one of the few money managers I truly respect, warns against buying the hottest performing sector or fund of the last few years. By the time you get there, the party’s over–it reverts to the mean. The next few years’ performance will not be so stellar, and it will probably underperform. Those who chase heat end up buying high, selling low, and repeating the cycle until broke. Fisher advises that you pick a fund (whether small cap, value, growth, tech, or whatever) and stick with it, as they all do about the same in the long run.

People tend to extrapolate from trends. If a stock, fund, sector, or money manager has been doing well, they think that performance will continue. This might work in the very short term, which is why momentum traders do what they do, but it is not a value investing strategy. It is not sustainable in the long term.

A good company that has had a few subpar years has a better chance of outperforming in the next few years than a company on a hot streak. This is not true of every company, but it is true for a basket of underperformers. This is why value investors like beat up, unloved companies. They are fundamentally sound, have hit a rough patch, and are likely to come back strong. This is essentially the rationale behind the Dogs of the Dow strategy, which has beaten the market over the long term. But why be limited by the Dow? Given a choice between two similar companies, I prefer the one that has been disappointing of late rather than the one that’s on fire (all things being equal, which they never are). It’s better to have the next big thing than the last big thing.

A long term value investor should not assume the good times will keep on rolling and jump on the bandwagon. Instead, he should keep his eyes open for companies that have fallen but are likely to come back strong.

The Post-Buffett Future of Berkshire Hathaway

For several years now we have been hearing that the dynamic duo of Buffett and Munger won’t be around forever, and when they’re gone the price of BRK will drop sharply and possibly never recover. The assumption is Todd and Ted (and Ajit and Greg) are no match for WB’s capital allocation skills. We also hear that this is no secret and is already baked into the price. I am unconcerned about the latter and disagree with the former for two reasons.

First, as Buffett will be the first to tell you, he does not have a crystal ball or any supernatural powers. He just follows a set of proven value investing principles that anyone (theoretically) can follow, if they were so inclined (and disciplined). Presumably, his successors will also follow them and achieve excellent results (just like the other superinvestors of Graham-and-Doddsville). The method will survive the man.

Second, I would not be surprised to see BRK improve its performance, which many have lamented has paled in recent years as the company has grown to an unwieldy size. As time goes by, the number of simple businesses that Buffett understands has shrunk in comparison with the number of businesses he doesn’t understand. Younger blood might understand them better. The recent position BRK has taken in Apple has provided a welcome boost. Relatively small, I know, but suggesting the shape of things to come.

Apple is transitioning from a riskier tech company that Buffett wouldn’t understand to a stalwart consumer goods company he would be comfortable owning. It’s currently a hybrid, with one foot in each camp. There are a lot of similar companies coming to maturity. When you combine the timeless principles of value investing with a fresh knowledge of modern business, the possibilities are exciting. I will keep adding to my position in BRK on the dips.

What it means to like a stock

In the age of social media it is common to browse through posts and “like” them one after another without even paying attention to them. The word “like” has lost a lot of its meaning.

So what do we mean when we say we like a stock? It means that it is a possible addition to a diversified portfolio of value stocks, but whether you should buy it depends on a few factors, such as:

Does it fit your needs? Think in terms of risk, growth, income, volatility, etc.

Does it fit your time horizon? As value investors we like to play the long game, but that can change as we get older. If you’re ninety years old you may not want to wait for a bear market to turn around. Or you may anticipate the need to liquidate some of your positions in the short term, for example, if you’re planning to buy a home or send a kid to college.

Is it an appropriate addition to your portfolio? If you already have a lot of exposure to a certain sector or industry (such as tech, pharma, financials) it may not be wise to add yet another stock of that type. You don’t want to be overly concentrated.

Just because we say we like a stock does not mean you should go and buy it. We like a lot of things, but we can’t (and shouldn’t) have everything we like! If you also like what we like, do your research before you decide to pull the trigger.