Guerrilla Approaches to Finding and Evaluating Stocks Marc H. Gerstein mgerstein@yahoo.com Portfolio123.com AAII/Better Investing, Washington DC – 4/18/2015 1
Marc H. Gerstein spent his career analyzing stocks, educating investors, and helping to develop stock screening platforms at Value Line and various web sites. He is presently Director of Research at Portfolio123 and Editor of Forbes Low-Priced Stock Report . His commentary can be found on SeekingAlpha.com, Forbes.com and Harvest (hvst.com). He has authored three books, Screening the Market (Wiley, 2002), The Value Connection (Wiley 2003), Atlas Upgrades: Objectivism 2.0 (Create Space, 2013). He is presently working on a novel with a Wall Street setting, and a book with Stanford’s Dr. Charles Lee based on the latter’s course in “Alphanomics.” 2
The Agenda � Recalibrating the Investment Mindset � Case Studies: Developing Strategies � Easy-to-Use Excel Valuation Tools � Organizing and Summarizing your analysis of a stock consistent with the approach to be discussed today � Measuring the relative roles of “Noise” and “Value” in a stock price � A very simple, practical, usable discounted cash flow type model based on “Residual Income” 3
Recalibrating the Investment Mindset 4
The Starting Point � Own great companies whose shares can be purchased at great (cheap!) prices � Own companies with sustainable competitive advantages � Own companies with wide economic moats � Own companies with great management teams � Don’t chase a lot of stocks but be patient and wait to swing at a “fat pitch” � Research the daylights out of prospective investments and put the lion’s share of your money into just a few “best ideas” � Etc., etc., etc. 5
Oops 6
It Sounds Wonderful On Paper, But in the Real World . . . 7
The Problems . . . � Traditional guru advice is so sound and so well disseminated, that today everybody and anybody is a Buffett wannabe, a Graham follower, a Magic Formula devotee, etc. � Really, truly, genuinely great companies are scarce and their shares tend to get popular and, hence, expensive 8
Act Like an Investor, Not a Foodie Judge If there’s a teeny-bit too much seasoning, live with it! 9
My Investment Hero: Monroe Milstein (Founder of Burlington Coat Factory) 10
The “Milstein Moment” � The Bloodletting � On a circa 1990s conference call, Wall Street analyst were taking the Burlington Coat Factory CFO to task, and rather harshly, for disappointing sales numbers � The CFO was having trouble articulating a reason that was considered satisfactory by the analysts � The Rescue � CEO Monroe Milstein, who typically said little during these calls, broke in: � “Gentlemen,” he said. “I’ve been in this business for many years. We have good months and we have bad months. This was a bad month.” � The outcome � Prolonged silence � The analysts were rendered speechless � The call then proceeded to an uneventful conclusion � Epilogue � Milstein cashed in huge when the company was sold to Bain Capital in 2006 for $2.06 billion 11
Don’t Rush to Judgment 12
Life is Harsh: Learn to Accept Corporate Warts � Too many investors are devoting too many hours to quests for perfection, and finding themselves disappointed by when � Subsequent events reveal that the supposedly great company was more human than they had realized, and/or � The price they paid for the great-company shares turned out to be fart less of a bargain than they had originally supposed � On the other hand, too few investors appreciate the opportunities available in companies that are plain-vanilla, mundane, ordinary, mediocre or downright lousy � The shares can benefit as the companies improve (i.e. from horrendous up to mundane) � The shares tend to be cheaper � It can be great to buy a company with 25 units of Pathetic if the stock is priced as if the company had 40 units of Pathetic 13
Divine Revelation 14
On Predictions � Disciple (a/k/a John Denver): “God, can you predict the future?” � God (a/k/a George Burns): “Of course I can predict the future; as soon as it becomes the past . ” � Source: “Oh God!” (Warner Bros. 1977) 15
Human Insight - Aristotle � “[T]he habits of perfected Self-Mastery and Courage are spoiled by the excess and defect, but by the mean state are preserved.” � “At all events thus much is plain, that the mean state is in all things praiseworthy, and that practically we must deflect sometimes towards excess sometimes towards defect, because this will be the easiest method of hitting on the mean, that is, on what is right.” � From Nicomachean Ethics, Book II (D.P. Chase Translation) 16
Human Insight – Lao Tzu � Holding a cup and overfilling it – Cannot be as good as stopping short – Pounding a blade and sharpening it — Cannot be kept for long � Gold and jade fill up the room – No one is able to protect them – Wealth and position bring arrogance – And leave disasters upon oneself � When achievement is completed, fame is attained – Withdraw oneself – This is the Tao of Heaven � Lao Tzu, Tao Te Ching, Ch. 9 (Derek Lin Translation) 17
Relevant Buzz Words � Buzz Words for Aristotle and Lao Tzu � Virtue � The Mean � Withholding � Stopping Short � Buzz Word for Us � Mean Reversion � Corrections � Overbought and Oversold � Business Cycles � Economic Excesses � Supply and Demand (market forces correct excesses and deficiencies in pricing and units) � Company Transition (as growth companies mature) � The overpowering of economic moats 18
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The Destination � Be an Investor, not a foodie judge � Don’t obsess over finding perfection � What looks to some “gurus” like a fat pitch is more likely a slow-moving knuckle ball that breaks erratically and flutters frustratingly past your frantic swing � Don’t be judgmental � Accept normal warts � Recognize that extremes are not sustainable � Embrace the ordinary, or worse � Embrace the ordinary � Invest like a human � Recognize and even embrace our inability to know the future � Diversify, diversify an diversify � Focused portfolios (most money in a few best ideas) are nonsense. They presume too much about our ability to know the future, and if we could know the future, there’d be no reason not to put 1200% of assets into one’s single favorite idea � Accept that it’s better to be “vaguely right than precisely wrong” � British Philosopher-Logician Carveth Read � Don’t fret about being wrong, just try to be less wrong than others � Dr. Aswath Damodaran, NYU Stern School of Business 20
Case Study: Developing a Strategy 21
Introduction to Strategy Development � All of these strategies were developed on Portfolio123 using screens and ranks � If you subscribe to Portfolio123, you will be able to replicate tem and modify as you wish � If you are not on Portfolio123, you can work with these ideas based on financial data you can find in Stock Investor Pro and on several web sites (e.g., Morningstar, MSN Money, Yahoo! Finance) � You’ll see as we go along that it’s not about precise formulas � It’s about broad ideas regarding what to look for � A very important theme will emphasize the “generalist” idea rather than the “specialist” � i.e., a stock that is decent in a lot of respects (and may or may not be excellent in some and/or dreadful in others); as opposed to a stock that seems excellent under a particular formulation � You can apply this approach whether or not you use screeners, etc. 22
How We’re Going to Implement Our New Mindset � We’re going to seek adequacy or OK, as opposed to excellence � And we’ll be open to inadequate, or bad, if we can get indications of improvement � We’re going to seek “fundamental generalist” situations rather than specialists � Example: Prefer company A (score of 70 of better under, perhaps 8 out of 10 factors and no factor worse than 50) over company B (scores of 90+ in two factors and below 30 in all others) � We’re going to tolerate redundancy � Data oddities are ubiquitous and unavoidable, so we’ll use “factor diversification” to diminish the impact of oddball items, such as: � the 643% EPS gain that would have been 3% but for a non-recurring gain � or a sales decline of 45% that would have been seen as 12% growth but for a major divestiture � We’re going to embrace and celebrate stylistic diversification � Even if you’re a committed value investor, would it pain you to take a big profit by selling to an algorithmic day trader? � So why not allow your models strategies to include ideas that might make stocks attractive to the latter? 23
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