My investment philosophy/strategy( long read)

[feynmanresearch]

Personal value investing philosophy/strategy

I believe it is crucial to have a written, flexible investment philosophy in place before even considering making an investment in securities of public companies. Having a plan increases your chances of succeeding in a field such as investing, which is partially prone to bursts of bad or good luck, especially on the short-term. Moreover, a plan is similar to a lifeboat in times of distress or personal doubt- it provides much needed guidance when you need it the most.

 

When I first started investing, I did not have a solid investment strategy, and as a result, I made a few unsound investments and suffered avoidable loses. Going through difficult times and having a loss at some time is unavoidable, even for investors such as Buffett and Munger- what is not acceptable is the inability to prepare for prevention of those loses.  Being prepared by having a sound philosophy and sticking with it, through easy and tough times, is the hallmark of a great investor/ businessman.

 

Although an investment philosophy can serve as a protective shield to an investor, it is effective to the extent that it is grounded on sound, reliable and persistent principles. It is wise not to delude oneself by having an investment philosophy that looks good on paper, but is predicated upon shaky grounds. In the following section, I will describe what constitutes a sound and coherent investment plan.

 

Value Investing

If you were to ask a typical value investor regarding  the definition of value investing, you would receive answers such as:

- Purchasing a security at discount to intrinsic value and applying margin of safety.

- Buying a dollar for 50 cents.

- Being greedy when others are fearful, and being fearful when others are greedy.

Value investing is indeed all those things, but at the same time I believe, if we were to describe value investing by just what is listed above, we would get a provisional, incomplete understanding of it. Let’s analyze step by step the three statements above:

- Purchasing a security at discount to intrinsic value and applying margin of safety

It is not enough to purchase a company that’s undervalued and applying margin of safety. You need to investigate the quality of the company and management before making such a purchase. A company might be theoretically undervalued, but if it not at least of average quality, the catalysts that are needed to unlock the gap between price and intrinsic value might not be actualized. It is tempting, especially for beginning investors, to buy a company that is trading at a discount and hope that intrinsic value will be materialized- however, that day might never come, if you do not perform a thorough analysis of the company and reasonably assure yourself to the high quality of the company.

- Being greedy when others are fearful, and being fearful when others are greedy

A contrarian mindset, although a necessary component of being a successful investor, is not enough. You need to be right when others are wrong, and even then, you need to assess the probability that your correctness will eventually materialize and not be overruled by the wrongness of the others. For example, there are successful short- sellers, who I believe were correct in their assessments of their investments, but they never realized a gain, because  of the overwhelming power of the others to remain steadfast in their conviction, despite the facts proving them wrong. This phenomenon is not as strong in long only investments; however, you need to be careful to not engage in investments that are overpowered by the wrong, steadfast conviction of others.

 

Company selection

Type of company: I believe in investing mostly in high quality companies that are currently undervalued, and have strong prospects of unlocking their intrinsic value in the next 2-3 years. I might hold the company for a longer time, if the facts warrant it, but 2-3 years is often times necessary to unlock intrinsic value.

Size:  I am mostly interested in companies of at least $500 million in market cap. I am not comfortable with anything significantly below that, as I believe some companies with very small market cap ( nano to micro) can present more unexpected headaches that are worth it. I have, and believe, will continue to make exceptions for strong companies close to $500 million such as $400 million or $300 million, but not anything below that.

I do not have an upper size limit for companies that I am considering a potential investment in.

Industry: I am not industry specific- I go where the value is. However, I am not comfortable with banking companies and technology companies- banks often times contain hidden mines, and technology companies like Facebook enjoy only temporary competitive advantages. However, that is not to say, that banks cannot make attractive investments in times of economic distress- good banks like Wells Fargo, can suffer temporarily declines, like the rest of their peers who are not as fundamentally sound( that is a good time to consider making an investment)

 

How to find value

Stock screeners: Stock screeners are an indispensable tool in the search for value. I prefer stock screeners from www.finviz.com, www.gurufocus.com, www.valuewalk.com    and www.oldschoolvalue.com . It is important to be flexible through screening companies, and to switch the parameters of your search now and then. The 52- week list is a fantastic place to find some bargains.

Value investing websites:  Investing websites are a good hunting ground for value investing ideas. It is important not to be swayed by arguments that sound good, but do not have much meat behind them. For this reason, when I look at the profile of someone who provides an idea that sounds good, I always do my due diligence and look at their previous ideas and rate of success. Some good investing websites are: www.cornerofberskhireandfairfax.ca,  www.valueinvestorsclub.com  ( probably the highest quality one), www.seekingalpha.com( you need to be careful with some authors on this one, as this website contains high quality, medium quality and low quality ideas, unlike Corner of Berkshire and Value Investors Club, that contain mostly high quality ideas), www.theinvestorspodcast( some really good ideas and discussion on this one, and it is a really small community at the moment)

Books: The more books you read, the sharper you thinking gets and you find more investment ideas- it is as simple as that.

Friends/ associates:  When someone I trust, presents an investment idea to me, I listen. It is important to not be swayed by your friend’s argument and treat their ideas the same way you would treat them if you got them from some other source. I only listen to ideas from high quality thinkers/ investors. Life is too short to search for ordinary ideas.

Successful hedge fund managers/ investors: From time to time, I look at ideas and holdings from top value investors, and attempt to find and shamelessly clone high quality ideas from them. Don’t mindlessly copy ideas from top investors though, always perform an in-depth, due diligence. Remember: they can afford to lose money, you cannot and should not. Some of my favorite investors are: Warren Buffett, Charlie Munger, Carl Icahn, Seth Klarman, Joel Greenblatt, Mohnish Pabrai, Jeff Ubben,  Bill Ackman,  David Einhorn, David Tepper etc.

 

Investment process

Once I find a company from the ways listed above, my first step is looking at the financials of the company. If the company does not satisfy my financials checklist, it rarely, if ever, makes it through my first step.

Step 1

In the first step, I take the company through the grinder, i.e see if it satisfies several hurdles. Most of the hurdles in the first step, are financial.

ROIC:  I look for consistent, predictable and reliable ROIC for the past ten years of around 12-15%. Closer to 15% is very satisfactory. Much higher than that is better sometimes, but it is not sustainable and attract competition very quickly.

ROE: Again, consistency, predictability and reliability of this metric over past ten years is crucial. For this one, I look for 10-12%.

ROA: Same as ROIC and ROE. For ROA, I like at least 7-8%.

Gross Margins: Not to beat a dead horse, but consistency, reliability and predictability of gross margins is vital. For gross margins, I have a much higher hurdle: I look for at least 25%.

Net Margins:  This metric is somewhat prone to potential manipulation by management, but the higher the better. History of net margins is very important.

Operating margins: Very similar to net margins.

Free cash flow:  Free cash flow yield is very important. I look for around 8-10% as a rule of thumb.

Gross profits: I prefer them steadily rising over the years.

EPS( Diluted): I look for diluted EPS growth over the years.

Those nine metrics: ROIC, ROE, ROA, Gross Margins, Net Margins, Operating margin, Free cash flow yield, Gross Profit and EPS(diluted) are what I call level 1 metrics( level 1, means of highest importance).

 

Now, moving on to level 2 metrics ( level 2, meaning of high importance)

Debt to equity:  The lower, the better. Less than, or around 0.5 is solid.

LT Debt to Total Assets:  Same as above. Less than, or around 0.3, is solid.

Interest coverage:  The higher, the better.

Quick ratio: Better than 1 is preferable.

Current ratio: Better than 1.5 is preferable.

 

Next, I look at various metrics such at what P/E, P/B, P/S,P/FCF and  EV/EBIT.

I do not have specific hurdles set in stones for these ratios, but is very important to see how they relate to historical numbers, the industry the company is operating in and the overall market level. When I first started investing, I was a big fan of P/E and P/B, but with time and evolving, I have grown to like P/S, P/FCF and EV/EBIT more. That’s not to say that P/E and P/B are not important.

Step 2

If I am satisfied with the financials of the company, I usually perform a DCF calculation to arrive at an estimated intrinsic value range for the company. I perform bear, base and best case scenarios. I try to be realistic and not overzealous with my estimates. I use conservative discount, terminal value and free cash flow growth numbers. Depending on the company, I might use single stage, or multiple stage  scenarios. Sometimes, however, the discount to intrinsic value is so obvious that you do not need to be over-concerned with doing an exact DCF calculation. I look for at least 25% discount to intrinsic value, and add 5% margin of safety, for a total purchase discount of at least 30% from current company price.

Step 3

After I am satisfied with the financials of the company, and it is undervalued, I look at the 10-Ks for the past three- five years, in order to get a deeper understanding of the company. Some of my favorite sections of 10-Ks are: Management Discussion and Analysis ( MD&A), footnotes, proxy statement, risk factors section.

Step 4

When I believe, I have a more detailed understanding of the company, I start listening to quarterly conference calls for the past 2-3 years. I look for deviation from what management said in 10K report to what actually happened. I am also interested in management that takes responsibility for mistakes and starts correcting them. Once you listen to enough conference calls, you can notice what management team is honest and on point, and what management team seems evasive and dances around the question.

Step 5

I start looking at the general dynamics of the industry and its strongest players. I prefer industries that are oligopolies or near-monopolies, versus industries with intense competition. I also like the companies that I invest in, to have large shares of the market, and other competitors to have small, fragmented rest of the market share divided between them. Generally, a company that has been a market leader, can be expected to remain a strong competitive player, but you need to look at current conditions and try to realistically predict how strong can the company be over the next couple of years.

Step 6

I try to gain a general understanding of the current state of the economy and how it might unfold in the short-term; however, it is very difficult to predict bullish or bearish conditions with accurate timing, so I continue to invest in whatever company I have chosen as a suitable investment candidate, despite what might look like unfavorable economic conditions. Unless economic conditions are dire, or near dire levels, I am not  persuaded enough not to make an investment.

Step 6,basically concludes the buying process. I buy gradually into my investments, and add to the positions if they deteriorate for non-fundamental reasons, or if they show improvement in their intrinsic value.

 

Monitoring of investment

Once I make an investment, I monitor it once a month or so. I have high conviction in my ideas, so it’s not really necessary for me to monitor it more frequently. When a company that I have invested in, decreases in price temporary for reasons that are not fundamental, such as market pullback or sector pullback, I add a bit more to my position.

 

Most of the time, I just wait for the stock market to pitch me more attractive ideas. In the meantime, I read all kinds of books to distract myself from the itch of wanting to be invested continually in the market and making new investments.  In addition to reading books, I try to follow “stoic” philosophy and not be disturbed by temporary market volatility. I have gotten really good at not caring about market prices, although initially, I was concerned about them. I believe, putting my own capital at stake and having no one to guide or order me around, has proved to be a helpful experience in growing as an investor and having internal strength.

 

Selling

I sell when the company reaches 85-90% of intrinsic value, or thereabout.  Other conditions that I consider when selling an investment are:

- Finding a much better investment

- Fundamentals of the company have deteriorated or were not as strong as I thought( has happened only twice at the beginning of my investment journey)

 

Allocation

- Around 10% for high conviction ideas. On special occasions, 12-15% for extremely high conviction ideas.

- Ideally, I would hold from 10-15 companies.

 

Asset classes

- Overwhelmingly common stock. No bonds, and as far as I know, I do not intend to invest in bonds in the future.

- No leverage, no margin, no shorting

 

What is your investment strategy/philosophy?

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

[Guest Grey512]

Excellent post.  Thanks for sharing.

I do not think that my post (below) will be as insightful, but what the heck.

 

My philosophy is generally similar to yours but I am a little bit less ratio-driven, and perhaps more opportunistic. Some of the ways in which I deviate from most value investors are:

 

1. Cash. I tend to hold lots of it, but my cash balance varies. This year, I went from 50% cash to 5% cash to 15% cash, and am currently around 20% cash. I do not have to be fully invested today. I am thinking hard about what opportunities may arise tomorrow, next week, next month or even next year.

 

2. Trading. I trade around my positions quite a bit. I may take 20-30% of a position and once it gets volatile, I will take advantage to trade around. For instance - Google is one of my largest positions. Last few months were volatile. For instance, if I establish a 10% position at $640, I will sell 2% of it if Google soon hits $670 for no particular reason; this locks in a high IRR on a tiny portion of my portfolio. Once Google goes back to $620, I will buy back the 2%. etc. A good example of this is eBay. It plunged a couple percent today. I increased my eBay position meaningfully today. Because of this trading, my overall portfolio turnover is generally high even though the names that I keep in my portfolio tend to stay the same.

 

3. Eclecticism. I do occasionally "take a flyer" on some not-so-good businesses when the selling is overdone and the risk-reward starts to look interesting. I bought some ZINC and SUNE recently despite the fact that I am not a fan of either business model. I look at their equity as under-priced call options. For similar reasons, in recent past I was (for a short time) a shareholder in for-profit education stocks. I bought after negative news events and was out less than 2 months later on short-squeezes. For value investors who only buy businesses that they can stick with for 10+ years my behavior probably sounds like anathema. But I have a preference for staying opportunistic and nimble. This also has an effect on my process: I research some companies for a few weeks or months before I pull the trigger; some companies I research for 2 hours.

 

4. Shorting. My gross short ratio has moved from 0% to 5% to 50% and back, meaning that my net long exposure moved from anywhere between 90% to 10% to 40%, depending on what I found in the market. Shorts have reduced volatility and have allowed me to come out of the volatility in 2015 YTD relatively unscathed. In my shorts, I simply look for the opposite of what I look for in long situations: companies are too highly regarded; analysts are too bullish; high valuation and cash burn. BTW: people say "don't short on valuation". I disagree. I do not have to find the smoking gun or evidence of accounting fraud. I do not even have to find evidence of earnings management - almost all companies out there manage earnings. I am happy to short on valuation and ridiculously low FCF yields (or even negative low yields), even if the companies are actually fundamentally reasonable companies and I think they will continue to exist 10-15 years from now. E.g. I was short Deere even though it was not a bad company, in the classical sense of the world.

 

[feynmanresearch]

Excellent post.  Thanks for sharing.

I do not think that my post (below) will be as insightful, but what the heck.

 

My philosophy is generally similar to yours but I am a little bit less ratio-driven, and perhaps more opportunistic. Some of the ways in which I deviate from most value investors are:

 

1. Cash. I tend to hold lots of it, but my cash balance varies. This year, I went from 50% cash to 5% cash to 15% cash, and am currently around 20% cash. I do not have to be fully invested today. I am thinking hard about what opportunities may arise tomorrow, next week, next month or even next year.

 

2. Trading. I trade around my positions quite a bit. I may take 20-30% of a position and once it gets volatile, I will take advantage to trade around. For instance - Google is one of my largest positions. Last few months were volatile. For instance, if I establish a 10% position at $640, I will sell 2% of it if Google soon hits $670 for no particular reason; this locks in a high IRR on a tiny portion of my portfolio. Once Google goes back to $620, I will buy back the 2%. etc. A good example of this is eBay. It plunged a couple percent today. I increased my eBay position meaningfully today. Because of this trading, my overall portfolio turnover is generally high even though the names that I keep in my portfolio tend to stay the same.

 

3. Eclecticism. I do occasionally "take a flyer" on some not-so-good businesses when the selling is overdone and the risk-reward starts to look interesting. I bought some ZINC and SUNE recently despite the fact that I am not a fan of either business model. I look at their equity as under-priced call options. For similar reasons, in recent past I was (for a short time) a shareholder in for-profit education stocks. I bought after negative news events and was out less than 2 months later on short-squeezes. For value investors who only buy businesses that they can stick with for 10+ years my behavior probably sounds like anathema. But I have a preference for staying opportunistic and nimble. This also has an effect on my process: I research some companies for a few weeks or months before I pull the trigger; some companies I research for 2 hours.

 

4. Shorting. My gross short ratio has moved from 0% to 5% to 50% and back, meaning that my net long exposure moved from anywhere between 90% to 10% to 40%, depending on what I found in the market. Shorts have reduced volatility and have allowed me to come out of the volatility in 2015 YTD relatively unscathed. In my shorts, I simply look for the opposite of what I look for in long situations: companies are too highly regarded; analysts are too bullish; high valuation and cash burn. BTW: people say "don't short on valuation". I disagree. I do not have to find the smoking gun or evidence of accounting fraud. I do not even have to find evidence of earnings management - almost all companies out there manage earnings. I am happy to short on valuation and ridiculously low FCF yields (or even negative low yields), even if the companies are actually fundamentally reasonable companies and I think they will continue to exist 10-15 years from now. E.g. I was short Deere even though it was not a bad company, in the classical sense of the world.

 

Thanks for your perspective. We differ mostly in the trading aspects. I don't buy and sell often, because I don't want to pay too much in short-term capital gains taxes. Also, I want to have as much appreciation potential as possible.

I also don't short, because although I understand it, my temperament doesn't match well with short-selling. For instance, I know Zillow Group( Z) is ripe for shorting, but can't bring myself to do it.

 

[Guest Grey512]

Thanks. I respect your approach; the maths on tax means that in 20-30 yrs from now, your net compounding rate will be significantly higher if you push out the tax expense as far out into the future as possible. I would like to invest that way. The reason I am investing the way I am is because I think there is a high likelihood that we are in for some choppy markets in the next few years. So I am just aiming to take advantage of the volatility. I would love to get Nestle, Pepsi, Hermes or JNJ at 7x earnings today - if I did, I would just put 90%!of my portfolio in them and forget about them for the next 20 years and still expect to do very well. But despite the fact that I do not see opportunities meeting that "perfect" hurdle, I am inclined to still be active today by moving down on the quality scale and moving up on the trading frequency scale. It also suits my personality. E.g. even in the "perfect" scenario where I put 90% of capital in exceptional businesses at depressed prices, I would keep some cash to do trade in events.

[innerscorecard]

Excellent post.  Thanks for sharing.

I do not think that my post (below) will be as insightful, but what the heck.

 

My philosophy is generally similar to yours but I am a little bit less ratio-driven, and perhaps more opportunistic. Some of the ways in which I deviate from most value investors are:

 

1. Cash. I tend to hold lots of it, but my cash balance varies. This year, I went from 50% cash to 5% cash to 15% cash, and am currently around 20% cash. I do not have to be fully invested today. I am thinking hard about what opportunities may arise tomorrow, next week, next month or even next year.

 

2. Trading. I trade around my positions quite a bit. I may take 20-30% of a position and once it gets volatile, I will take advantage to trade around. For instance - Google is one of my largest positions. Last few months were volatile. For instance, if I establish a 10% position at $640, I will sell 2% of it if Google soon hits $670 for no particular reason; this locks in a high IRR on a tiny portion of my portfolio. Once Google goes back to $620, I will buy back the 2%. etc. A good example of this is eBay. It plunged a couple percent today. I increased my eBay position meaningfully today. Because of this trading, my overall portfolio turnover is generally high even though the names that I keep in my portfolio tend to stay the same.

 

3. Eclecticism. I do occasionally "take a flyer" on some not-so-good businesses when the selling is overdone and the risk-reward starts to look interesting. I bought some ZINC and SUNE recently despite the fact that I am not a fan of either business model. I look at their equity as under-priced call options. For similar reasons, in recent past I was (for a short time) a shareholder in for-profit education stocks. I bought after negative news events and was out less than 2 months later on short-squeezes. For value investors who only buy businesses that they can stick with for 10+ years my behavior probably sounds like anathema. But I have a preference for staying opportunistic and nimble. This also has an effect on my process: I research some companies for a few weeks or months before I pull the trigger; some companies I research for 2 hours.

 

4. Shorting. My gross short ratio has moved from 0% to 5% to 50% and back, meaning that my net long exposure moved from anywhere between 90% to 10% to 40%, depending on what I found in the market. Shorts have reduced volatility and have allowed me to come out of the volatility in 2015 YTD relatively unscathed. In my shorts, I simply look for the opposite of what I look for in long situations: companies are too highly regarded; analysts are too bullish; high valuation and cash burn. BTW: people say "don't short on valuation". I disagree. I do not have to find the smoking gun or evidence of accounting fraud. I do not even have to find evidence of earnings management - almost all companies out there manage earnings. I am happy to short on valuation and ridiculously low FCF yields (or even negative low yields), even if the companies are actually fundamentally reasonable companies and I think they will continue to exist 10-15 years from now. E.g. I was short Deere even though it was not a bad company, in the classical sense of the world.

 

If you can make good profits by trading around, why don't you lever up on that and trade more?

[Guest Grey512]

The only circumstance in which I could possibly lever up is if I come across a massive correction e.g. total panic all around, S&P at 1200, JNJ crashes to something like $40 per share. I would take on debt and lever up to maybe 120% long or something. But even then, that's not a given. Probably because I am not that gutsy. I 'invest scared'. Levering up is just not my personality and not in my temperament.

[JayGatsby]

Thanks for the write-up/discussion. Some points in there that would have been a lot cheaper for me to learn if I'd read this earlier.  >:( ;)

4. Shorting. My gross short ratio has moved from 0% to 5% to 50% and back, meaning that my net long exposure moved from anywhere between 90% to 10% to 40%, depending on what I found in the market. Shorts have reduced volatility and have allowed me to come out of the volatility in 2015 YTD relatively unscathed. In my shorts, I simply look for the opposite of what I look for in long situations: companies are too highly regarded; analysts are too bullish; high valuation and cash burn. BTW: people say "don't short on valuation". I disagree. I do not have to find the smoking gun or evidence of accounting fraud. I do not even have to find evidence of earnings management - almost all companies out there manage earnings. I am happy to short on valuation and ridiculously low FCF yields (or even negative low yields), even if the companies are actually fundamentally reasonable companies and I think they will continue to exist 10-15 years from now. E.g. I was short Deere even though it was not a bad company, in the classical sense of the world.

I don't disagree, but I've had bad experiences shorting good businesses on valuation alone where I can't pinpoint something that will change that. For example, I think Netflix a great business with great leadership, but I think it's overvalued simply on economic terms. I expect the company to continue to perform well so I've avoided shorting it. Also, due to short-term taxes and unlimited downside I look for situations that have significant room for correction. Shorting helps me mentally manage short-term market swings. If you have the mental resilience to withstand those anyway, more power to you.

[Guest Grey512]

Agreed. It's just that when I identify bad businesses, the market often tends to pre-agree with me, resulting in high short-interest (i.e. crowded shorts). To limit my risk a little, I therefore move up on the quality curve but try to look out for other things such as excessively rosy analyst consensus estimates.