The power of assiduity

If there is one word that sums up true stock market success, atleast for myself and for Shaw Logic, it is Assiduity. I know that most of you have probably never heard of the word, but that's because it’s not really a word, atleast not in any dictionary that I know of. However it is a term coined by one of the greatest investors alive. In a quarterly report written in the 1980s Berkshire Hathaways Charlie Munger coined the term ”assiduity” and his explanation of the word was as follows:

”assiduity is the ability to sit on your ass and do nothing until a great opportunities presents itself”

While the stock market is cheap, I cannot pretend that there are many great investments at the moment. The market is cheap for a reason, and that reason is simple, companies are being crushed by a worldwide economic recession, which could possibly get worse before it gets better. While early april until mid may we have seen one of the greatest bull market runs in history, I was tempted to jump in head first asking questions and doing research later. However in this instance I practiced assiduity, which I found to be an incredibly difficult task. I watched the markets explode with a fury never before seen and my only real investment I dared to place was on apple computers which, at the time was trading at a high premium to it’s intrinsic value by traditional value investment principles. And this was at $90 a share.

While the market continued to rage I started placing more bets on different companies that I felt truly secure with such as Black and decker which I sold now at a 103% increase, TNB which has given me a 50% return from august, TRA now over 40%, WLT a 70% return in two months. These where all highly undervalued companies trading with atleast a 50% discount to their intrinsic value. I rarely go digging and hoping, I look for companies with solid balance sheets, income statements and ever increasing free cash flow. I don’t look for the down and out company perhaps making a comeback sometime in the future. I hate hate hate losing money.

I feel the problem with most investors is that they feel they have to be 100% active looking at charts, plotting graphs, reading every bit of news that comes out with regard to weather, politics and polar bears. These are things that one simply cannot control. I can control what I look for in an investment, I can control how much I read about a certain company, it’s annual and quarterly reports and so on. I can control how much I pay for that company. I cannot however guess how bad weather in Europe is going to affect my portfolio. I have never been able to look at a chart and guess with any certainty what is going to happen next. Nobody can, which is why most people lose money on wall-street over the long run.

While I don’t spend every waking hour study charts, plotting graphs and staring at ticker symbols. (in fact most days I don’t even look at the markets). I do spend a lot of time focusing on the things I can control, I read every note in an annual and quarterly report, before every investment I write down a 1 page summary of the company and why I like it. I take notes and I repeat loudly for myself what is good or bad with the company, how it makes money and what potential risks there are. By doing this I never get scared out of a good investment. I might just start buying when everyone else is selling.

At the moment I am sitting on a pile of cash waiting for the next big investment. I know what companies I want to place my money on, and I know what sectors. I just need the price to be right. This could take a week or 6 months. But when these great companies fall to the price I like, I buy as much as I can as long as nothing is wrong with the fundamentals. While this tactic may be boring for most people, my average yearly return is over 60% with this method over the last 10 years. It doesn’t take much to be successful at investing, but it does take patience. Or as the great munger says “assiduity”.

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The Complexities of running money...

When I started my fund a year ago I did it because I knew I could get great results in any market using my own investing style. While my general thesis has been correct and I have been able to pick up new investors along the way; I never quite understood the complexities of it all. Running money for yourself and your own portfolio is a whole different ball game than investing for a fund. When running my personal portfolio I would focus on what is a great company for the long term not concerned with the short term results.

I now know why when Warren Buffett started his hedge fund back in the 50's, he only showed yearly results. When you start showing quarterly results then the yearly gets out of focus. I have found myself on a few occasions getting rid of a great company simply because I did not think they would do anything within the next 3 months. That is not my investing style, and while we are getting great results I feel it is at the sacrifice of even greater results on a longer term basis. While I am not under contract to give quarterly results, the catch is this: in order to pick up new investors quarterly's are detrimental.

When running my own money I would do my research on a company and update my thesis every year, now when running a portfolio my thesis updating is about every month to three months. And if the market like it is this last week is utter crap, then I look at my thesis on an hourly basis. This is not the path to stock market wealth. I know now why hedge funds which are supposed to be a safer bet than mutual funds should really be called "risk funds". Mangers on a quarterly panic basis are always willing to take extra risks i.e use more leverage, in order to beat their last quarter. 3 months is simply not enough time for a company to turn itself around in times of crisis. 3 months is not enough time for any investment to reach it's potential. I understand that investors feel quarterlys or even daily results are pinnacle to their investment decisions.. One has to wonder, why? Especially when investing in a value orientated hedge fund, where the focus is on long term results. It seems rather silly that everyone is so focused on 3 month results. In any case, I think the markets will have a consolidation soon: Hedge fund managers can only do so much to keep the everyday investor happy. It's really not so strange there are so many insider transactions and dealings on Wall-Street, it's not at all unexpected that so many hedge funds go bunk because of bad investment decisions. Usually resulting in massive losses for the investors.

While I run a hedge fund, I have all of my own investment dollars in the fund. This protects my investors from an overconfident manager, at times I would like to take a little extra risk, but I just can't do it. My own funds are on the line and I will sacrifice a bad quarter for the good of the yearly results. I think that all hedge fund and mutual fund managers should have their own money on the line, this is really the ultimate protection from stupid decisions and over leverage. If it was a requirement for managers to have all their own saving and investments in the fund they manage, I can guarantee you that the quarterly will be considerably more boring, and most mangers will focus more on fundamentals.

So where is this headed you ask? Because of the style of my fund I will revert to my original goal with the fund: To create the worlds best long term value investment firm and fund. To keep my goals aligned with those of my investors. Unlike Buffett in his early days with his fund, I will show 6 month reports to at least let my investors know I am alive. However, I will revert from any quarterly results as it simply is a ridiculous practice that hampers the over all returns of the fund. While I understand that the investment conditions are a bit different than they where in the 50's, with information available to all at the click of a mouse. I can't help but feel that this has not helped the average investor even the slightest. Fund managers are hired because investors don't want to do the investing themselves, they have no interest or time for it. They do however expect a fund manager to work in their best interest. Which is unfortunately rarely the case.

Well, that's it for me for today.. I would like to hear your opinions on this, on quarterly results on fund managers having to invest their own money as well.

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What is CROIC?

What is CROIC:

I use CROIC and I love it.. No it’s not some ugly plastic shoes that should be banned from all humankind. It’s Cash Return On Invested Capital and if I had to choose any one specific measure to test the competence of management and strength of the company this would be it. CROIC in investing is basically the return on cash the company is able to generate with the cash it receives from shareholders and other debtors. As a percentage this gives us an idea of how efficient management is at reinvesting it’s invested capital in-order to generate more cash.

Why I use this measure:

I like to use this measure in order to give me a picture of management. I am not much of a dividend fanatic for several different reasons, taxes being just one of them. However, if management is not able to generate good returns on capital than I see there to be no reason not to pay dividends. If a company like Black and Decker decides not to pay dividends, for me that is fine as they usually can get between 15-20% returns on their investments. That to me is a great return on capital. I would be hard pressed to get that on my own investments. I use the CROIC to gage just how healthy and competent management is at reinvesting it’s capital. Can I do a better job? I don’t like to see anything less than 12% CROIC, this usually tells me the company has a strong moat, or at-least some kind of advantage.

How to calculate:

CROIC is fairly simple to calculate and even easier to understand. Keep in mind when calculation CRIOC in investing we want to look mainly at the long term debt, not short term. We do this because short term liabilities that a company has are often loans for short term cash flow issues. Many companies take short term loans to cover day to day cost because the credit time on accounts receivable is longer than accounts payable. Say 40 days for accounts receivable and 20 days for accounts payable: hence 20 days short term cash flow issues.

I like to look at Morningstar.com where when you look for a stock quote you get these values on the first page. Here is a little print out and how to calculate CROIC:

For 2007 the CROIC would be: 857/3025+629-628 = 28%

2008: 1157/3715+810-611= 29,5%

2009: 1029/4115+1082-818 = 24%

CROIC average over the 3 year period: 28%+29,5%+24%/3 = 27,17%

Of course a 3 year period is to short to draw any kind of conclusions, but we can guess here that this company has been amazing at reinvesting it’s cash. 27% is above average, which means they have some kind of moat that allows them to get such high returns on invested capital. In this particular case the company is a pharmaceuticals, which means their moat is based on Patents. Pretty strong moat, but time limited. To evaluate this company further we have to figure out how long those patents are good for and how many such patents they have and what percentage of income each patent has.

How to use CROIC:

Now keep in mind that just because a company has a high CROIC does not mean the company is a great investment, it is a start. If a company has a negative CROIC and no turn around in site, then it is probably a company you should avoid. Once you have a company you like with a high CROIC <12% then you need to compare this to other companies in the same industry. Most car manufacturers and airlines have negative CROIC. So finding an airline with a positive CROIC over many years is probably a great company to research deeper.

Once you have compared the company with other companies in the same industry than it comes down to figuring out why the CROIC is so high. In the example above we came to a 27% 3 year average, they have a strong moat. This moat is based on drug patents, which are due to expire in 3 years time. Is this company still as good?

Summary:

CROIC is only a small portion of the whole picture, so use it with regard to the other key metrics such as P/E, P/S, P/B and so on. While it does not give a total picture it strengthens the picture and gives credibility to management. In order for me to invest my cash in a company, the company must have a CROIC of higher than 12%.

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Evaluating banks

As an answer to a question I received on Facebook regarding investing in banks:

I think bank stocks are very tricky to evaluate, which is why I almost always stay away from them (also why I didn't get burned during the financial crisis). The reason I say that is because you never really know where they invest their money, we know that banks have deposits and in turn they loan out that money for mortgages and so for a higher interest. The tricky part is figuring out just how leveraged a bank is and where they are investing. Banks as we have recently seen are not very liquid, they have a lot of assets, but they can't really do too much with those assets in time of need. (other than write off the losses and so on). When Lehman brothers had fallen so much I was looking at investing in them, but I couldn't understand what they did or where they got their money. So I had to stay away.

In dream world banks should be easy to evaluate, you should be able to see how much money they have in deposits and calculate how much they can loan out from that. At one time I believe in the USA a bank could only loan out 12x what they have in deposits, that got raised under president Bushes era to something like 30x (please correct me if I'm wrong.. going from memory here). However in reality, evaluating banks has become extremely difficult as banks now not only loan out money for mortgages but also have hedge funds, mutual funds, brokerages and everything else under the sun. It's very hard to trace the money and the security behind that money when it comes to the banking sector.

One last thing before getting to the evaluation of the banking sector, one of the main reasons behind the whole banking crash is these mortgage backed securities. While the subprime loans were a cause in the beginning, I think the real answer can be found in Peter Lynch’s Beating the street.[1]

Anyway, to the evaluation:

We can start with what Peter lynch felt was important and that is the equity to assets ratio which needs to be higher than 5%,

“The most important number of all is the E/A ratio. This measures financial strength and survivability. The higher the E/A, the better. E/A’s have an incredible range, from as low as 1 or 2 (candidates for the scrap heap), to as high as 20. An E/A of 5.5 to 6 is average, but below 5, you’re in danger zone for ailing thrifts”.[2]

Another important factor is the Book value, here is where it can get tricky, as you really need to try and figure out what it’s high risk assets are, and how large of a portion are those assets in the bank. Many banks did not considered their investments in mortgage backed securities as high risk loans, which means you could not look at the annual report and see exactly how much risk these assets carried.

Once you figure out what the actual book value is, and how many high risk investments the bank has, than you can look at such factors as the P/E value, (lower the better), a high dividend yield is also very good to see (with low payout ratio, under 60%) This shows the bank is earning cash and is able to pay it’s dividend without having to take out loans in-order to pay the dividend. And a good growth rate both organic and other.

Warren Buffett usually looks at the Return on Assets ratio where he discusses a banks' profitability - equity to assets is important when considering banks' sustainability. The return on assets will ordinarily be about 1%. If a bank has a higher than 1% ratio we can consider this to be a great bank. The assets are its loan portfolio and so the return on assets represents the margin it makes after costs. The return on assets is a product of the different in rates between funds borrowed and lent and the costs per assets. You can understand future profits by considering the return on assets and the growth in assets.

Also don't forget free cash flow (fcf) this is as important with banks as it is with any sector or business.

For a better understanding of investing and evaluating in banks I really suggest reading Beating the street and even watching Jim Cramers Madmoney as he really breaks down the banking sector from time to time which I find very helpful.

Personally I try and stay away from banks, I just don’t trust the assets that banks report. I don’t understand how modern banks function and how they are to be evaluated. The days of just savings and loan banks don’t really exist anymore, this was all to evident in the recent banking crash. I can invest in technology because I understand it, I can invest in industrials, energy and cyclical because I understand them. However with banks I just can’t take that risk and my pessimism has saved my ass on many occasions. With that said I have invested in Goldman sach at $70.00 a share and am currently investing in JP Morgan. These banks I understand, and have made a killing on them.

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[1] In Peter lynch’s Beating the street starting on page 265 he goes into a discussion about how the “new Freddie mac” had started on something new. Packaging mortgages and selling them off to other investors. While Peter viewed this as something new and great that would lead to amazing profits (which it did). We can also see the after effects of it.

[2] Peter Lynch, Beating the street. Simon & Schuster paperbacks. 1993. Pg 201-205

The art of speculation

There really is a difference between speculating and investing. In my view to keep interest in the stock market you have to do both. While the majority of my investments are purely value based investing ideas, I do from time to time allocate a certain percentage of my portfolio to speculation. I do occasionally like to play the market like a slot machine, though granted, these risks are highly educated guesses and more than naught they work out great for me.

So why should you speculate? and most importantly how do you speculate with the odds in your favor? I will start off with the why because as many of you know, I am a rather successful value investor. The why is quite simply to score big on stocks that, because of a current trend in the market or because they will be bought; just explode. There are many reasons why a highly speculative stock can pay off handsomely if your guess is correct.

I speculate from time to time because I think it’s fun, it keeps me interested in the markets and just like playing a slot machine, the thrill of winning is amazing. Now there really is a difference between just buying anything hoping for the best and making educated guesses. So how do you make an educated guess that has a higher percentage of being right? You do your research.

1. Look for trends – Right now a big trend, as Jim cramer on Madmoney has pointed out consistently, is the Mobile internet tsuanami (or smartphones and the infastructure needed to make it work)


2. Look for the small fries in that industry who have a great story but maybe had a bad quarter or even year. This is usually the reason it is so cheap


3. In speculating I still do all the regular ground work, I look for undervalued securities, or securities with amazing stories or some kind of catalyst that will push it higher.


4. For speculation plays I like to look more for growth than undervalued. This is important for me as growth shows health. If the company is highly undervalued but no growth and is a really small company.. Well this usually spells disaster.

So how do we spot trends? How do we not spot them is the real question! Trends are everywhere if you keep your eyes open. Four years ago Crocs was the trend, had you got in early it would have paid off big. 10 years ago the internet was the trend. Today the trend is the mobile internet (Ipone, blackberry and all the infastructure needed to make it work), energy is a hot trend (coal, oil and soon natural gas), Green energy or green anything, china is a trend, south America, and most commodities (we can call trends bull markets).

How do we spot good spec stocks in a trend? How do we know which one to invest in and which one to stay away from? Personally I am terrible at market timing, so I go for the stocks that are already moving, that already have a newly lit fire under them. I figure out why the fire is lit, and if it has a possibility to continue. I look for growth in both revenue and cash flow and for future prospects. What will make this stock take off?

I stay clear from stocks that have a lot of debt and very little free cash flow, I don’t care how good the story is; if the cash flow is bad and they have a lot of debt, they will have a hard time doing anything. What is the reason the stock is so beaten down to begin with (if not a small company), is the problem fixed? What do the analyst say? You will usually have more luck if you bet against them. There are several reasons for this:

1. Most analyst rely too much on using macro-economics, beta, capm, technical analyst and popularity among other things to value a stock. This will not make you money.


2. Perhaps analyst work as analyst because they haven’t made any money as investors?


3. This is my favorite reason why: Only so many people can hate a stock or love a stock before the opposite has to happen. If all the sellers have sold, what more can happen?

With that said, have fun speculating but don’t get stupid. Keep the speculation side of your portfolio at less than 20% of your capital. There is no reason to risk all your capital on something that might not turn out as planned.

What is a stock part 2

It is so easy to get caught up in the complexity and exuberance of the stock market, the Beta, the CAPM, the hot tip from the mailroom guy, the biotech company which has just gone into the first phase of clinical testing for it’s cancer cure, the company that has just created a new solar power plant.. The list goes on and on. Everyday you will get a new hot tip, or read about a new biotech company, everyday you will be tempted to try your hand at the stock market roulette, but why would you do it? Knowing that 90% of all people who play the stock market this way lose, why would you want to place your money in such high risk companies that you know nothing about?

I’m going to say something very controversial here, something that will lead many to leave this site and even possibly burn their computers for having read it.. Here it is, be prepared.. The Stock market is logical! Making money on the stock market is easy.Whether we are in a bear, bull or range bound market[1] money on the market is easy to make.

Not by using complicated methods such as shorting a stock, or using complicated options, or any other complex super method.. It is easy to beat the market simply by buying low and selling high. Doesn’t matter what the overall mood of the market is. The market will always fluctuate because one major ingredient for the stock market is the human emotional psyche. Or as the great Benjamin graham puts it, imagine you have a business partner called Mr. Market

“Mr. Market is very obliging indeed. Every day he tells you what he thinks your interest is worth [in the company] and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly”[2]

Or in modern terms, Mr. Market is an utter manic-depressive lunatic, some days he is very optimistic and is willing to pay huge sums for your half of the business, while the very next day he can be extremely depressed and can’t give his share away fast enough, even at substantial loses. Sound familiar? We see it everyday! One day the stock market is optimistic as if the sky is the limit, then the very next it can sink like the titanic! Talk about manic-depressive.

This website is not going to have an amazing amount of charts and statistics, that is not the purpose of kennethshaw.se, this site is for those who simply do not understand the stock market, who believe it is an imaginary casino where people can through in huge amounts of money and possibly win or lose. This site will try and bring the logic back, or at least give the average investor a little more confidence when making investments on the stock market. Kennethshaw.se is not intended for the investment professional, but instead for the average investor. And hopefully when after reading my posts you will not have the need to run for the hills every time Mr. Market is overly depressed.

Summary:

1. Most people fail to beat the stock market, including investment professionals.


2. Efficient market hypothesis, Modern portfolio theory and Greek letters will not be used anywhere within kennethshaw.se.


3. When logic is used, beating the stock market can be easy no matter what the market conditions are!


4. Kennethshaw.se is for the beginning investor who thinks the stock market is a complex ball of confusion.


5. Mr. Market is utterly insane!

Suggested Reading:

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[1] One of my favorite books on stocks and investing creates the term Range bound market, which in essence is a market that goes neither up or down but simply flat. Usually falling between a bear and bull market. Look it up yourself as this is a great book. Active value investing by Vitaliy N. Katsenelson

[2] Graham, Benjamin The intelligent investor, Collins business essentials, revised 1973. Pg. 204-5



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What is a Stock part 1

A very simple question really, what is a stock? A simple question when viewed through the eyes of logic, however people have been indoctrinated to believe that a stock is its own little entity, doing as it pleases separate from the corporation with which it belongs. How can this be? Isn’t a stock simply a small portion of what the company is worth? A fraction of the total value of a company?

Well it is! Though you simply would not believe that when looking at the stock market from day to day, how the prices can fluctuate anywhere from down 10% to up by 20% in a single day! Imagine this happens everyday to a vast majority of stocks, even when no news has been reported stocks still go up and down. It’s easy to get sucked into the likes of the Efficient market hypothesis (EMH) and the Modern portfolio theory and believe that Beta is the true answer to all stock market dreams. But how can a measurement that calculates human emotional reaction as its main data source truly be reliable? Isn’t that what Beta does? It measures human psyche in it’s calculations giving us a fair value for what a given stock is worth. And when combined with CAPM then we have truly measured a stock and human psyche to perfection.. or?

It is easy to believe that a stock is a separate entity enjoying its own little life, it is even easy to believe that by looking at the movement on a chart we can decide where the price is heading, or by using complicated calculations with Greek symbols and all, that we can truly find the value of a stock.

My question and the reason behind this website (besides my own addiction to stocks) is, where and when did logic disappear from the stock market? With every passing day more and more complicated theories with an impressive amount of Greek symbols are created in order to determine the proper value of a stock. But isn’t a stock simply a portion of a corporation? Isn’t a stock in reality the valuation of that corporation? While the stock price may fluctuate (and thankfully for that) it is still a part of a corporation.

A good example of this and my favorite is, what is a cell phone? I will use Nokia in particular because everybody knows who they are. When most people see a cell phone they only see a cell phone, however isn’t a cell phone a stock? And if everybody is walking around with this one stock (cell phone), if everywhere you look this stock is in someone’s hand, isn’t that a telling sign for the company? Or if everyone has the same Mp3 player with the white little earbuds, isn’t that a good sign for the company and stock as well?

End of part 1