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Market Performance: Week 31 (includes Monday)

It has been quite a week in the markets as the S&P 500 fell by -5.0%, the Nasdaq Composite by -6.7%, and the Dow Jones Industrial Average by -4.6%.

Let’s unpack what caused these significant declines:

Drivers of Performance

Rates Unchanged

The shift in sentiment started last week when the Federal Reserve kept interest rates unchanged, as expected.

While this decision was anticipated, the market was eager to hear more about the Fed’s rate outlook. Fed Chair Jerome Powell hinted that if inflation continues to moderate and economic growth remains stable, a rate cut could be on the table as soon as September.

This sparked some initial optimism early in the week, as lower interest rates make borrowing cheaper, which can stimulate economic activity and benefit the stock market.

Recession Fears

However, sentiment quickly soured starting Thursday when July’s Manufacturing Purchasing Managers’ Index (PMI) came in at 46.8%, down from 48.5% in June.

A PMI reading below 50% indicates a contraction in the manufacturing sector, suggesting that manufacturing activity is shrinking. This is concerning because a contracting manufacturing sector can signal a slowing economy.

The negative sentiment was compounded by weak labor data released on Friday. The US economy added only 114,000 jobs in July, significantly below the expected 175,000. Additionally, the unemployment rate rose from 4.1% to 4.3%.

This slowdown in job growth, combined with a decline in manufacturing activity, has investors worried that the US may be heading into a recession, a period of economic decline that can lead to reduced consumer and business spending.

Japan Increases Rates

The week’s crescendo occurred when Japan’s Nikkei Index plunged by approximately -13.4% yesterday, the most significant single-day drop since Black Monday in 1987.

This market move was triggered by the Bank of Japan’s decision to raise interest rates for only the second time since 2007, moving to 0.25%. After maintaining near-zero or negative rates for a long period, this shift spooked markets, exacerbated by concerns over the unwinding of the Yen Carry Trade.

A “Carry Trade” involves borrowing in low-interest currencies like the Yen to invest in higher-yielding assets, such as US stocks. As Japanese rates rise, the Yen rises and the attractiveness of this trade diminishes, causing investors to liquidate their US positions to cover Yen loans.

Manic Mr. Market

This past week serves as a reminder of how fickle the market can be.

Just a few weeks ago, everyone was optimistic, with indices reaching new highs. As expectations for interest rate cuts grew, investors shifted away from tech and semiconductor stocks into more interest rate-sensitive stocks such as utilities and real estate.

Now, panic is setting in as recession concerns rise and the realization that central bank actions around the globe can impact the US market. Sentiment is that the Fed has waited too long and needs to act fast to rectify the situation, or more pain will soon follow.

Closing Thoughts

These periods of market volatility are a great reminder of the importance of having an investment strategy and sticking to it regardless of market movements.

Understanding what you own, why you own it, and having a good grasp of the true value of your investments allows you to stay calm during market downturns. This knowledge helps prevent panic selling and enables you to make informed decisions while others may react out of fear.

Earnings Season

We are in the middle of earnings season. Below is a helpful resource to help you keep track of when companies report.

• Earnings Calendar

Don’t Focus On The Share Price

Investing in stocks makes it easy to get fixated on daily price changes. As the market noise around you grows you naturally start to wonder “Is now the time to buy now?” or “Is it time to sell?”

However, focusing only on the share price can be misleading.

Understanding that the share price is just a number and doesn’t tell the whole story is crucial. Instead, you should focus on the actual VALUE of the business behind the stock.

Share Price vs Company Value

Consider buying a house. You wouldn’t just look at the asking price but also consider the location, condition, and other aspects. Along with the asking price, these considerations give the house its value, and you can quickly tell when a property is under or overvalued.

The same goes for investing. The share price is merely what someone is willing to pay for a small piece of the company at a given moment, more important is what the underlying business is.

Focus on the Business, Not the Price

The true value of a company lies in its fundamentals.

For example, if you had invested in Apple before the 2008 market crash, you might have been tempted to sell because the market was in a tailspin. However, Apple’s robust business model, demand for its revolutionary products, and solid financial health were more important than short-term price drops.

Despite the market downturn, those who held onto their shares have seen substantial gains.

Similarly, during the DotCom Bubble in 2000, Amazon’s stock price fell by 90%. Yet, Amazon’s long-term potential wasn’t reflected in the share price at that time. People who focused on Amazon’s business model and future prospects saw significant returns as the company’s value became apparent over time.

When to Buy

If you’re considering investing in a company, think about it as if you were buying a house.

Create a checklist of what you want in a company:

• What is its business model?

• How does the company make money?

• Who are its competitors?

• How difficult is it for competitors to replicate what the company does?

Only invest in a company that matches your checklist. Once you’ve found a company that fits, THEN look at the share price to decide if it’s a good buy based on your valuation.

Let’s say you’ve researched a company and determined that its shares are worth $13 each based on your checklist. If the current share price is $12 or even $10 it is a decent time to buy.

What if the share price drops?

Well, if you believe it is worth $13 per share and due to pure market negatively, the share price drops from $12 to $8 per share, then isn’t it an even better opportunity to buy?

In other words - buy when it makes sense to you based on what you believe a company is worth.

When to Sell

There are several reasons to consider selling shares:

1. Finding a Better Investment: If a new opportunity looks more promising, you might want to sell your current shares to invest elsewhere.

2. Deterioration in Quality: If a company’s financial health or business model weakens, it may be time to sell.

3. Attractive Offers: If you get an offer that exceeds your valuation of the company, selling could be a smart move.

However, avoid selling just because of market noise or economic concerns like a possible recession or inflation fears.

Focus on the company’s performance and fundamentals rather than external factors.

In Summary

While share price is a consideration, it’s only one part of the investment puzzle.

By concentrating on a company’s value, financial health, and business fundamentals, you’ll be in a better position to make informed investment decisions when those around you are panicking

Investing is about finding valuable assets at good prices and maintaining a long-term perspective, rather than reacting to daily price movements.

This newsletter is here to help you become a better investor. If you have any topics you want to dive into or burning questions about investing, I want to hear from you!

What topics or questions are on your mind?

Simply reply to this email with your thoughts or questions, and let’s make our next newsletter even better together.

If you find value in these newsletters, please return the favor by spreading the word.

Simply click the Social Share button at the top of the newsletter.

Your support means the world to me—thank you!

How to Create Long-Term Wealth: Why Pick the Stock Market to Grow Your Wealth Effortlessly

Several close friends and community members have recently asked me how they should invest their money.

Given the frequency of this question and whether you have a lump sum or want to invest monthly, here’s a guide on how to grow your wealth over the long term.

Why Invest in the Stock Market?

The stock market, particularly the US market, has consistently proven to be one of the best places to grow wealth.

Over the last 50 years, the S&P 500 Index, representing the largest 500 US-listed companies, has outperformed other popular asset classes such as real estate (US housing prices), corporate bonds, and gold.

This is what a $1000 invested 50 years ago looks like today:

Summary of the graph above:

With an average annual return of around 11%, it’s easy to see why the US stock market is so attractive.

It didn’t involve any sorcery or a superior IQ. All you had to do was invest in the index and wait, regardless of the Fed’s next move, consumer sentiment, or the political landscape.

The Importance of Long-Term Investing

To receive the full benefit of the S&P 500’s returns, you must be invested long-term.

Compounding at 11% per year isn’t very useful over 6 months or even 1 year or two. $1000 earns you $110 in your first year, but in your 30th year, you earn over $2000 a year, more than double your original investment.

(Compounding is when your investment gains earn returns themselves, creating a snowball effect that grows your wealth exponentially over time.)

The key is to stay invested through market fluctuations and not try to time the market. Market crashes and corrections are natural, but history shows that the market recovers and grows over time. If the market crashes, do not panic and sell; if you can, try to invest more.

How to Invest: Index Tracking Funds

So we have now decided that investing in the market is the way to go, so now we need to discuss how.

Research shows that only 12% of professional money managers have outperformed the stock market in the last 15 years. You will unlikely do much better, given this isn’t your day job.

Therefore, rather than trying to outperform the market, the aim is to match the market’s performance with index tracking funds. These funds mimic the composition and performance of an index like the S&P 500, providing a simple and effective way to invest in the stock market.

For more details, read “Where I Would Invest My Money” newsletter from back in March.

Which Funds to Choose

There are many index track funds to choose from but here are three well-known S&P 500 index-tracking Exchange-Traded Funds (ETF):

These ETFs are popular due to their low fees and reliable performance. Low fees are crucial because high fees can significantly erode your earnings over time.

How to Buy an Index Tracking Fund

Buying the fund is straightforward:

Step 1: Open a Broker Account

Opening a stock broker account is the same as opening any ordinary bank account.

Look for brokers that are, first and foremost, reputable and well-established. Next, make sure they offer low trading fees, a user-friendly platform, and good customer service.

I would consider using the following based on where I live:

Step 2: Transfer Money

Next, you have to fund your account, which is as simple as transferring money from one bank account to another.

Step 3: Buy the Index Tracking Fund

Purchase your chosen index tracking ETF just like you would a stock:

1. Simply select the right Ticker (as per the table above),

2. Select how much $ you want to invest, and

3. Buy at the current price

Picking An Investment Strategy That Works For You

For simplicity there are two main strategies to consider when investing in an index-tracking fund.

1. Lump Sum

Lump Sum investing is exactly that - investing a lump sum in the market and leaving it there for as long as possible regardless of what the market does.

The advantage of a lump sum investment is that it will benefit from compounding more than monthly contributions, meaning it will grow more the longer you have it invested.

However, the risk is that you invest today, and the market crashes tomorrow. If history is any guide, it will recover and grow over time, so if the market does crash, DO NOT panic and sell; rather, if you can, try to invest more.

2. Monthly Contributions

Investing a small amount regularly, known as dollar-cost averaging, reduces the impact of market volatility. By investing consistently, you buy more shares of the ETF when prices are low and fewer when prices are high, averaging out the cost of your investments over time. This strategy is less risky short-term and helps build a disciplined investment habit.

Here are the returns of Lump Sum vs Monthly Contributions over the last 20 years.

As you can see, $24,000 invested in one lump sum far outperforms the same amount invested in $100 increments every month - but only if invested for the long term.

Summary

Investing in the stock market, particularly through S&P 500 index tracking funds, is a proven way to grow your wealth over the long term.

This approach is not sexy, and it’s not something your friends will be jealous of. But there is a high chance that in 10 years, your investments will outperform theirs, probably by a wide margin.

The key is to stay invested, allowing your money to benefit from compounding returns. Choose low-fee index funds, pick a reputable broker, and decide whether lump sum or monthly contributions suit your situation best.

If you have any questions or need further guidance, please reach out

Disclaimer: I am not a financial advisor and cannot give financial advice. However, I have researched the data presented below and wholeheartedly believe in the content. Still this newsletter is for information purposes only. It is vital you conduct your own research or seek out the advice of a financial advisor.

This newsletter is here to help you become a better investor. If you have any topics you want to dive into or burning questions about investing, I want to hear from you!

What topics or questions are on your mind?

Simply reply to this email with your thoughts or questions, and let’s make our next newsletter even better together.

If you find value in these newsletters, please return the favor by spreading the word.

Simply click the Social Share button at the top of the newsletter.

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When you become a member of My Portfolio you get to see exactly where I invest.

Membership costs $389 per year and is limited to 300 members to ensure a close-knit community of like-minded long-term investors.

To help you decide if this service is right for you, I offer a 14-day trial period. This way, you can experience all the benefits before committing.

Sign-up here!

As mentioned above, the community has more than doubled in just a few short months. Given our community’s growth, I thought summarizing the topics we’ve covered would be valuable.

• For newcomers, this will help you easily navigate to topics of particular interest.

• For our regular readers, this serves as a handy “table of contents” available on our website whenever you need it.

Summary of What We Have Discussed (Thus Far)

1. Don’t Try to Predict the Future: In this article, I discuss a common mistake among investors: trying to predict trends. I use the example of Tomi Environmental Solutions (TOMZ), a decontamination company I invested in, believing that disinfection would become a lasting trend post-pandemic. I was wrong, as the world quickly reverted to old habits.

2. Where To Invest Your Money: Only 12% of professional fund managers in the US have outperformed the market over the last 15 years. I show you how easy it is to outperform almost 90% of the pros by investing in index-tracking funds. I also explain why I don’t 🤫!

3. How to Find New Stocks to Invest In: For those not investing in index funds, I discuss using stock screeners, fund letters, 13F filings, forums, and insider buying to find new investment ideas.

4. Know When to Sell: One of the most common concerns in investing is knowing when to sell a stock. I outline the three scenarios that dictate when I sell a company, using Legacy Housing Corporation (LEGH) as an example.

5. Investing Risk: Investing in the stock market is often perceived as very risky, especially by those unfamiliar with investing. I discuss common misconceptions about investment risk and how I view and mitigate it.

6. 5 Steps to Analyzing a Company: Understanding risk is crucial, and knowing a company’s true value helps us reduce that risk. Here, I share my five-step approach to evaluating a business’s value.

7. Economic Moats: Finding companies with durable competitive advantages is considered the “Holy Grail” to investing success as it dramatically reduces our risk. I explain economic moats and why they matter and provide examples, including The St. Joe Company (JOE).

8. We Can Beat the Pros: Investing is a unique endeavor as it is one of the instances in which the individual has an advantage over professional money managers. In this newsletter, I explain why and provide a valuable resource to help individuals beat the market and outperform the pros.

9. Principles I Follow for Better Investing: I share five fundamental principles I look for in every business I invest in. Sticking to these principles has significantly increased my success in both my professional and personal investing.

10. How to Avoid Emotional Investing: If you want to be a great investor, you must learn to leave your emotions out of it. I believe the key to this is having realistic goals and expectations. Let’s discuss.

11. Liquidation Value of a Business: In a previous newsletter, we discussed the concept of a margin of safety. Here, we delve into the liquidation value of a business as a safety net—what it is and how to calculate it, using Legacy Housing Corp (LEGH) as a real-life example.

12. The Value of a Business: At its core, investing is about laying out money today with the expectation of receiving more in the future. Therefore, estimating a company’s future earnings rather than its past is essential. I use Innoviva (INVA) as a case study to illustrate how to do this.

13. Correlation Between Earnings and Share Price: We have discussed how a company’s value is its future earnings. In this newsletter, I give you proof showing how a company’s share price closely correlates to its future earnings growth and discuss why this is significant.

14. Please invest for the Long-term: Many people invest for the thrill of it, yet this is often a losing game. When done right, investing should be boring because it isn’t going to give you an adrenaline rush. This week, I will show you why long-term investing significantly increases your chances of increasing your wealth.

15. The Benefit of Spin-offs: I’ve shared resources to help you find your next great investment. Another potential investment strategy is looking at spin-offs. I discuss what they are and why they can be exciting opportunities, using Illumina’s (ILMN) spin-off of its cancer-detecting business, Grail (GRAL), as an example.

16. What Is The Best Way to Grow Your Wealth: In this newsletter, I discuss why you should consider the stock market for growing your wealth and provide practical steps about the best ways to maximize your returns when investing in shares.

This newsletter is here to help you become a better investor. If you have any topics you want to dive into or burning questions about investing, I want to hear from you!

What topics or questions are on your mind?

Simply reply to this email with your thoughts or questions, and let’s make our next newsletter even better together.

If you find value in these newsletters, please return the favor by spreading the word.

Simply click the Social Share button at the top of the newsletter.

Your support means the world to me—thank you!

A few months back, we discussed the advantages you and I have as individual investors compared to institutional money managers. Today, I want to dive deeper into one of these advantages using a real-life example.

Taking Advantage of Spin-Offs: A Real-Life Example

Unfortunately, before we can begin, we need to discuss some theory, but I promise to keep it short!😅 

What is a Spin-Off?

A spin-off occurs when a parent company separates a portion of its business or a subsidiary into a new independent company. This involves splitting out all the new entity’s assets, liabilities, and operations so it can operate independently from the parent company.

If the parent company is listed on a stock exchange, the new business will be listed as a separate entity.

Mechanics of a Listed Spin-Off

Shareholders of the parent company receive shares of the new entity. The distribution ratio (e.g., one share of the new company for every five shares of the parent company) is predetermined and announced during the spin-off process.

The new entity is then listed on the stock exchange and trades independently of the parent company.

Shareholding at a 1:5 ratio spin-off

Valuation of the Two Separate Companies

On the day the new entity is listed, the new entity’s value is determined by the market. So, the share price the new entity trades at is the value of the business the market believes accurately represents the company’s prospects.

The parent company’s value typically drops by an amount roughly equivalent to the market value of the new entity.

Initially, the new company’s share price might be quite volatile as existing shareholders sell the business if it doesn’t meet their investment criteria. And therein lies the opportunities for astute investors.

Index Tracking Fund (you’ll need this for later)

An index tracking fund is designed to replicate the performance of a specific market index, such as the S&P 500. These funds aim to mimic the returns of their chosen index by holding a portfolio of securities that mirrors the index composition.

If the index constituents change or the weighting within the index changes, the index tracking funds HAVE to adjust their fund accordingly.

Illumina and Its “Holy” Grail

With the theory out the way, let’s look at a real-life example!

Illumina, Inc. (ILMN): Illumina is a leading genomics company that develops and manufactures technology for genetic analysis. It is a listed company and is part of the S&P 500.

Grail (GRAL): Grail is a subsidiary of ILMN. It focuses on early cancer detection through blood tests.

The Backstory

In 2016, ILMN spun off GRAL to raise capital for the business and had notable early investors, including Jeff Bezos and Bill Gates.

In 2021, ILMN reacquired GRAL for $8 billion. However, the company did not follow due process, such as seeking EU approval for the acquisition. The EU launched an antitrust investigation, causing multiple years of headaches for ILMN and GRAL and ultimately leading to a fine.

This multi-year legal battle has resulted in GRAL being unable to reach its potential due to regulatory barriers. It has concluded with ILMN being forced to spin-off GRAL again.

Source: European Commission

For a complete history, read here.

Today, June 25, 2024, Grail will be listed as a separate entity under the ticker GRAL!

The Opportunity

ILMN doesn’t want to spin off GRAL, as it clearly sees potential in the business. Fortunately for ILMN, it will retain a 14.5% ownership stake.

Furthermore, GRAL has been unable to achieve its potential due to regulatory barriers. The spin-off should be the final catalyst for regulatory approval of its cancer tests.

Since ILMN is part of the S&P 500 index, funds tracking the index (told you you need this 😉 ) will have to sell GRAL shares, as it will likely have too small a market cap to be part of the S&P 500.

Vanguard owns 11.4% of Illumina, and BlackRock owns 8.4%. So, over 20% of Grail’s shares might be sold upon listing. This selling will be done regardless of GRAL’s share price, which could result in the company being oversold!

We don’t have these restrictions and can buy shares in GRAL regardless of size IF we believe it to be a good investment.

Risks

As always, there are risks involved, and the following are my two main concerns:

• Grail is not yet profitable and is burning through cash, estimated at around $250 million for 2024. However, ILMN is funding GRAL with almost $1 billion as part of the spin-off agreement, giving it about four years of operating cash.

• The potential for Grail’s cancer tests is significant, but commercial success is uncertain.

My Next Move

Despite the uncertainty, I believe it’s worth taking a small bet (a small position in my portfolio) IF GRAL’s shares are heavily sold down upon listing – It could take a few days to happen, so I am not in a rush.

The spin-off should clear the way for regulatory approval of its tests, unlocking value in the business. As things progress and if the company can improve its profitability, I may look to increase my investment.

Disclaimer: The information in this article is provided for informational purposes only and should not be construed as investment advice. It is important to conduct your own research and consider your financial situation, risk tolerance, and investment goals before making any investment decisions.

Given today’s Investing Chronicle is all about Spin-offs, I recommend reading “You Can Be a Stock Market Genius” by Joel Greenblatt.

I know the title is terrible, and I have mentioned the book before. Still, it details the potential opportunity spin-offs present as they tend to be overlooked and undervalued by the broader market.

Greenblatt highlights several reasons why spin-offs can be attractive:

1. Market Inefficiency: Spin-offs are often neglected by investors and analysts, leading to temporary mispricing. This inefficiency can allow investors to buy shares at a discounted price relative to their intrinsic value. (See “Reducing Risk When Buying Shares in a Company” for why this is important)

2. Focused Management: Newly spun-off companies typically benefit from a more focused management team incentivized to grow the business independently. This can lead to improved operational efficiency and better decision-making.

3. Special Situations: Spin-offs can create special situations where the new company’s stock might be under pressure due to forced selling by shareholders who received the shares but have no interest in holding them long-term. This selling pressure can artificially depress the stock price, presenting buying opportunities. (Sound familiar 😉)

4. Corporate Restructuring: Companies often spin-off divisions to streamline operations, unlock value, or facilitate growth in specific areas.

Greenblatt suggests that patient investors who understand these dynamics and are willing to wait for the value of a spin-off to unlock can do very well for themselves.

This newsletter is here to help you become a better investor. If you have any topics you want to dive into or burning questions about investing, I want to hear from you!

What topics or questions are on your mind?

Simply reply to this email with your thoughts or questions, and let’s make our next newsletter even better together.

The Importance of Having a Long-Term Mindset

Investing with a long-term perspective is crucial for success in the stock market. Focusing on long-term investments can yield better results than placing short-term bets on where the market, industry, or a specific stock might be in the next month or two.

Here’s why:

1. Increased Chance of Success

Predicting short-term market movements is incredibly challenging. Even the Federal Reserve’s experts struggle to foresee where the economy is headed.

For instance, in early 2020, few economists or market analysts predicted the rapid and severe impact of the COVID-19 pandemic on the global economy and stock markets. Many expected a prolonged downturn, but the market rebounded quickly, reaching new highs by the end of the year.

Another example is the recent inflation surge in 2021-2022. The Federal Reserve initially predicted that inflation would be “transitory” and not persist long-term. However, inflation has proved stubborn, leading to “higher for longer” interest rates.

While we can’t predict short-term trends, we do know that the U.S. economy tends to trend upward over the long term. High-quality companies see their revenues and profits grow, and as we’ve discussed in last week’s newsletters, as these financials improve, so do their share prices.

Need more proof?

Consider the S&P 500’s performance over the past 50 years. With dividends reinvested, it has returned an impressive 11.1% per annum. That means if you had invested just $1,000 fifty years ago, it would be worth approximately $193,000 today.

This growth hasn’t been a smooth ride—some years exceeded the 11% return, while others saw market declines. However, staying invested despite economic predictions, political events, and financial crises would have resulted in substantial gains.

If, instead, you had sold your investments during periods of uncertainty, waiting for the perfect time to reinvest, you would have surely missed out on the market’s gains and significantly underperformed the S&P 500.

2. Power of Compounding Returns

Compounding is often referred to as the eighth wonder of the world. It is an exponential force that accelerates the longer you allow it to work.

In the stock market, this means seeing your investment grow at an average of 11% per year. At this rate, your investment would double every seven years.

Investing for a year, withdrawing your money, and reinvesting later doesn’t have the same impact as a consistent, long-term investment strategy. Compounding is most effective when you remain invested over long periods, allowing your returns to generate more returns.

3. Benefitting From Exceptional Companies

Buffett compares investing in businesses to baseball, where you don’t need to swing at every pitch. Instead, you wait for the perfect pitch—the ideal business—and when you find it, you swing hard. Investing in companies you believe are truly exceptional, run by honest people, and holding them for long periods can make you very wealthy.

Buffett himself has only made a handful of exceptional investments, such as Coca-Cola, American Express, and Geico. These companies have been part of Buffett’s portfolio for decades and have been massive contributors to his compounding wealth. If he held them for only a few years, Buffett would not be the “Oracle” he is today.

In previous newsletters, I’ve discussed companies like the St. Joe Company and Innoviva. Both have fantastic potential, but it will take years to realize. I won’t benefit from their long-term growth if I only invest for a year or two. Instead, I must commit to being a shareholder for many years to reap the rewards.

Conclusion

Adopting a long-term mindset in investing is essential for achieving substantial returns and benefiting from the power of compounding. It also allows you to identify and invest in exceptional companies, setting you up for lasting financial success.

By staying the course and resisting the urge to make short-term moves, you can harness the full potential of your investments and build significant wealth over time.

Top Tools and Tips for Finding New Stocks to Invest In

I thought it would be beneficial to summarize some valuable resources to help you on your investment journey:

Stock Screeners

A stock screener is a tool that allows investors to filter and rank stocks based on specific criteria such as valuation, growth, and quality metrics.

Users can efficiently identify potential investment opportunities that meet their predefined investment strategy by defining parameters like market size and geographic location.

Here are three stock screening resources:

• Magic Formula Investing

• Finviz

• Yahoo Finance

Investing Forums

Engaging with investment forums allows individuals to exchange ideas, present investment theses, and receive constructive feedback regarding their research.

Here are two valuable resources:

• Value Investors Club

• Seeking Alpha

NB: Make sure the research presented and feedback is of the highest quality.

Insider Trading

No one knows more about a business than the people who run it, so we should take notice when we see directors or management buying shares in their own company. As the saying goes, management has many reasons to sell, but there is only one reason to buy: they believe the company is undervalued.

Here’s a helpful resource:

• Finviz’s Insider Trading

Word of Caution

While the resources mentioned above are great tools for finding potential ideas, remember they are for idea generation only. They are just the starting point of the investment process.

You are still responsible for doing the homework and detailed research to determine whether it is a good investment. Remember, investing without a well-defined thesis can lead to uncertainty when faced with adverse outcomes.

Here is your chance to ask those questions on your mind or share your insights with the Lockstep community.

Would you like to be featured in next week's newsletter?

Simply reply to this email.

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Simply click the Social Share button at the top of the newsletter.

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The statement above comes from a 1993 interview with Charlie Rose, which we discussed last week in “How to Value a Business Based on Future Earnings”

In essence, Lynch is saying that if a company’s earnings perform well over a sustained period, its share price will do as well, regardless of market and political noise.

That is a bold statement!

If true, it simplifies our approach as investors because it means all we have to focus on is the company and its fundamentals, leaving aside short-term share price performance and economic and market commentary.

But is this true? Let’s explore.

The Correlation Between Earnings and A Company’s Share Price

What is Correlation?

Correlation simply means there is a relationship between two or more variables. For example, egg prices are correlated with the supply of eggs—if there is a shortage of eggs, prices will increase.

How to Measure Correlation

Correlation is measured on a scale from -1.0 to 1.0:

• A correlation of 1 implies a perfect positive correlation, meaning both variables move perfectly together.

• A correlation of -1 implies a perfect negative correlation, meaning as one variable moves up, the other moves down.

• A correlation of 0 means there is no relationship between the two variables.

In our case, we are looking for a strong positive correlation. Anything above 0.9 is considered exceptionally strong.

You don’t need to worry about the mathematics behind it; I’ll do the calculations for you!

Correlation in Our Investing

Our goal is to see if there is a correlation between earnings and share prices. If a company’s earnings increase, does the share price also increase?

We’ll examine a company’s revenue, operating income (or Earnings Before Interest and Tax, EBIT), and net income growth vs. the share price and account for dividends, as they reduce the share price by the same amount.

Microsoft Case Study

Let’s start with the largest company by market cap in the S&P 500, Microsoft (MSFT). We will look at the company’s revenue per share, operating income per share, and net income per share from 2000 to 2023 and compare the growth to the company’s share price over the same period using the closing share price for its financial year-end.

As you can see from the graph, revenue, operating income (EBIT), and net income have all increased significantly from 2000 to 2023, while the share price has also increased, although it lagged slightly. This lag is expected as earnings are not released immediately, so the share price needs time to respond.

More importantly, the correlation coefficients are as follows:

• Revenue: 0.93

• Operating Income: 0.96

• Net Income: 0.96

Any correlation above 0.9 is incredibly strong, indicating that as Microsoft’s earnings increase, its share price follows almost perfectly.

Broader Analysis

We need more than one sample for a good study.

Here are the correlations for the top 6 stocks in the S&P 500:

All companies show a very high correlation between earnings metrics and share price.

This suggests that focusing on a company’s fundamentals is vital for long-term investment success. Most interestingly, operating income, on average, correlates with the share price the most, meaning it should be our main concern.

Conclusion

Peter Lynch was onto something when he emphasized focusing on a company’s earnings.

Investors should concentrate on the company’s economic growth rather than short-term market fluctuations, the broader economy or political landscapes. A company growing its revenue and maintaining high operating margins will likely see its share price follow.

If the share price doesn’t appreciate, it may indicate a buying opportunity, as the market may be missing out on an excellent investment.

Innoviva Update

Last week, we looked at the investment case of Innoviva (INVA). If you missed it, you can read it here.

Yesterday, the company gave a presentation at the Goldman Sachs Healthcare Conference. The presentation provided valuable information, so I highly recommend listening if you follow the company.

Here are the highlights that stood out for me from the presentation:

Royalties Revenue

• The CEO of INVA expects these royalties to be stable and durable for “years and years.”

Xacduro

• Expected to be a significant revenue generator.

• Zai-lab expects sales of over $500 million per year in their territories. Innoviva will earn royalties from Zai-lab’s sales similar to its other royalty revenue streams.

Zoliflodacin

• There are 1 million cases annually in the US and over 80 million globally – “This is just a huge opportunity.”

• “It could be a $500 million per year product in the US alone.”

NOTE: INVA only earns revenue from sales in US and other developed markets for this product.

Other Insights

The analyst interviewing INVA’s CEO remains skeptical about the company’s ability to commercialize its antibiotic products, as many other companies have failed to do so.

This is both a risk to the company and a reason for the opportunity - If Innoviva fails, it will only have its royalty stream to fall back on. However, the market is currently discounting the products on the Innoviva platform. If Innoviva succeeds, it should perform very well.

Conclusion

Last week, I provided a rough UPSIDE calculation of around $32.40 per share versus the current price of around $15.94. Based on the additional information from the presentation, it is easy to see a well-over $40 per share upside.

Disclaimer: The content in this newsletter is provided for informational purposes only. It is essential to conduct your own research before making any investment decisions.

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That was the last published comment I found from a reputable analysis on Innoviva (INVA).

That comment was from July 2022, when the analyst had a target price of $16.00 per share.

But this is what has happened to the company since then:

As you can see, INVA has been busy, yet with all that activity, its share price is still below Goldman’s target price of $16.00 per share.

WHY?

Because people aren’t paying attention!

Today, we look at the case study of Innoviva (INVA) and the importance of valuing a business based on its future earnings without the need for complex calculations.

How To Value a Business: The Innoviva Case Study

Investing is laying out money today with the expectation that you will get more back in the future. Therefore, it is essential not to value a business based on its past earnings in isolation but instead look to its potential to grow earnings going forward.

A Brief History of INVA

Innoviva (INVA) was founded in 1996 as Theravance Inc. Its main focus was discovering and developing drugs to combat several diseases, including respiratory.

In 2002, Theravance and GSK collaborated to develop and commercialize respiratory drugs, which led to the successful development of Relvar/Breo Ellipta, Anoro Ellipta and later, Trelegy Ellipta (FDA-approved in 2020). Under the agreement, Theravance received royalties for these products.

In 2014, Theravance split into two businesses, with one arm, Theravance Biopharma, focused on research and development, while the other, Theravance Inc., became the royalty management company, later changing its name to Innoviva in 2016.

The Problem With the Past

If, when I first analyzed INVA in 2022, I had based my decision purely on the company’s revenue, I would have quickly skipped over the business;

As mentioned, in 2022, INVA’s only revenue source was royalty fees from GSK. This revenue stream is about as simple as it gets to forecast because it is based on established products with a knowable lifespan.

Based on the company’s assumptions, analysts’ expectations the royalty business is worth around $1100 million after subtracting ALL the company’s operating expenses.

Source: Innoviva Company Presentation

Of course, we mustn’t forget that the company has liabilities, and we need to exclude those from the valuation of the business . See ”The Liquidation Value of a Company as a Margin of Safety“ for more details on why we do this.

INVA has roughly $520 million in debt but it also has $400 million in liquid assets. So, based on the royalty revenue alone, INVA should be worth approximately $1,000 million. INVA has a current market cap of $992 million, so we are not far off where it should be valued.

But INVA is so much more than a royalty business!

Enter Sarissa Capital

Activist investor Sarissa Capital Management first appeared on INVA’s shareholder registrar in 2017. The highly regarded Alex Denner, a former senior managing director at Carl Icahn’s activist fund Icahn Capital, owns Sarissa.

As things stand today, Sarissa is one of the largest shareholders of INVA with over 10% ownership, while Mr Pavel Raifeld, a former Sarissa employee, is the company’s current CEO. 

Sarissa’s involvement has resulted in a fundamental shift in the company and as a result, it is no longer just a royalty business.

The Opportunity

Royalty Business

The primary source of revenue remains the royalty business. Relvar and Anoro earned the company $238.8 million in revenue for the Financial Year (FY) 2023, and, as mentioned based on my analysis, I value this line of business between $550 million and $1100 million.

The actual value depends on the patent expiration and whether there is a market for the product when generic options become available. The CEO has commented on the difficulty of manufacturing these products and believes it has a longer shelf life past the patent expiration date.

So, it could be worth more than $1,100 million, but, as always, let’s be conservative.

Giapreza and Xerava

In 2022 INVA acquired La Jolla Pharmaceutical for around $210 million. La Jolla Pharmaceutical’s portfolio of products included Giapreza, a treatment to raise blood pressure for adults with septic and other distributive shocks, and Xerava, a therapy for complicated intra-abdominal infections.

Both these products generate revenue for the company, and sales are growing. Below is a breakdown of the revenue growth since INVA took ownership of Ja Jolla.

As you can see, these two products currently generate close to $17 million per quarter in sales, which will likely continue to grow. While it is difficult to predict the exact market size, we can safely value this business based on current revenue of approximately $80 million a year and apply a few simple assumptions.

The math looks like this:

So let’s value these two products between $80 million (1x current revenue) and $200 million.

Xacduro

Xacduro is an essential treatment as Acinetobacter infections result in high mortality rates and financial burdens on hospitals/patients, while up until Xacduro, there was no effective treatment. It was only made available in September 2023.

Given the current lack of effective treatment on the market, it is difficult to determine the exact market size. However, the US and Europe have up to 100,000 cases yearly, while less developed countries in Asia, South America and the Middle East have far higher cases.

Xacduro has just been approved in China, and in collaboration with Zai-Lab, it should start selling in the country in the coming month. China could be a much bigger market than the US; however, INVA will only earn royalties from sales, but we know how lucrative those royalties can be!

While challenging to value accurately, given that it is so new to the market, I have applied ultra-conservative assumptions. Xacduro could be worth between $100 million and $400 million, potentially significantly higher.

Zoliflodacin

Zoliflodacin is an oral treatment for uncomplicated gonorrhea that has recently completed successful phase 3 testing.

The current treatment for gonorrhea is an injection where one doesn’t want an injection. It is excruciating, and the current treatment is less effective as the bacteria builds resistance. Therefore, a less painful, less embarrassing and, most importantly, effective treatment is required—Zoliflodacin in that treatment.

Around 1 million cases are reported yearly in the US and far more globally. Unfortunately, I have no idea what this treatment could cost, but current treatments are around $20. For now, let’s be ultra-conservative and value the product at between $50 million and $200 million.

INVA will be filing for FDA approval early in 2025.

Other Investments

INVA has invested in many other businesses, including Armata Pharmaceuticals, Gate Neurosciences,  InCarda Therapeutics, ImaginAB and Nanolive. These are all clinic-stage companies and, therefore, don’t earn any money.

They are currently sitting on the balance sheet for over $220 million. There is a chance all these businesses will fail and be worth $0, but there is also the possibility that they will produce products with massive potential.

Being conservative again, let’s value these investments between $0 and $220 million.

The ISP Fund

Finally, there is the ISP Fund.

INVA invested $300 million in a fund which invests in listed pharmaceutical and biotech companies. Sarissa Capital manages this fund, and given Sarissa has to file quarterly holdings reports, we can see what the fund is invested in.

A competent team of investors runs Sarissa, so the ISP Fund should be in good hands. As of March 2024, it was valued at $287 million, and given it is invested in listed companies, it should be reasonably liquid.

So let’s value this asset between $200 million (30% discount to March 2024 value) and $287 million (March 2024 value). Of course, there is the possibility this fund will do well over time, but for now, let’s be conservative.

NOTE: This is the one negative about INVA – I don’t like that the main shareholder is paid a 1% annual fee to manage $300 million of the company’s assets to invest in other listed pharmaceuticals. The company should be able to do this themselves.

What is Innoviva Worth

We have been through its assets and their potential while it owns $520 million in liabilities.

So, let’s see what the business is worth:

Conclusion

Recall that INVA’s share price is currently $15.90 per share, implying a potential downside of -37.5% while the upside is over +100%.

I like those odds!

Especially since I know I have been very conservative in my valuation. I am likely overstating the downside while the upside potential is far greater.

But the real point I am trying to make here is that if you invest in INVA based on its past or current earnings, you would miss out on its true potential. As you can see from the exercise above, INVA is far more than a royalty business, so it is absurd that it is being valued as such.

The Lesson

When we invest in a business, we buy the sum of all its future cash flows so understand what the company is doing and its potential.

And…

Invest in that company when you have a high degree of confidence that it will be worth more in the future than it is today!

Given the length of today’s Investing Chronicles, let’s keep today’s lessons learned short.

Peter Lynch Interview

Here is a fantastic interview with Peter Lynch that cuts to the core of what we are trying to achieve as investors. I highly recommend watching.

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In previous newsletters we’ve discussed the importance of having a margin of safety to reduce investment risk. If you haven’t read it, please check out “Reducing Risk When Buying Shares in a Company” to better understand the margin of safety and its significance.

This week, let’s explore one of the greatest safety nets you can have when investing – the Liquidation Value of a business - using a real-life example to illustrate its potential.

Understanding the Liquidation Value as a Margin of Safety

What is Liquidation Value?

Liquidation value measures the minimum value of a company if it were forced to sell all its assets in a distressed situation, such as bankruptcy.

It represents the amount shareholders would receive after all the company’s assets were sold and the proceeds used to pay off the company’s debts and other obligations. Whatever remains is then distributed to shareholders.

How to Calculate Liquidation Value?

The calculation is straightforward on paper:

Liquidation Value = Total Assets less Total Liabilities

Steps to Calculate Liquidation Value:

1. Identify Total Assets: This includes everything the company owns that could be sold, such as cash, inventory, equipment, and property.

2. Estimate Sale Value: Determine how much money each asset could realistically bring in if sold quickly. This might be less than their book value, but sometimes it could be more.

3. Sum of Assets: Add up the estimated sale values of all the assets.

4. Identify Total Liabilities: This includes everything the company owes, like loans, bills, and other debts.

5. Subtract Liabilities from Assets: Finally, subtract the total liabilities from the sum of the assets to get the liquidation value.

While this theoretical application is straightforward, it is more challenging in reality, but therein lies the opportunity – most people don’t want to do the work.

But let’s look at a real-life scenario to see how this is done in reality!

The Liquidation Value of Legacy Housing Corp

Background

Legacy Housing Corp (LEGH) builds, sells, and finances manufactured homes and “tiny houses” distributed through a network of independent retailers and company-owned stores.

Established in 2005, LEGH is the sixth-largest producer of manufactured homes in the United States, primarily operating in the southern US. Over 50% of its sales come from Texas, 12% from Georgia, and 9% from Louisiana.

Targeting customers with household incomes below $75,000 per year, representing over 50% of all U.S. households, LEGH constructs homes in its three factories, sells them through independent retailers and company-owned outlets, and offers customized financing solutions.

How the Company Earns Its Money

LEGH generates revenue primarily from product sales (manufactured homes) and its financing business. As of Full-Year 2023, 76% of its revenue came from product sales, 20% from financing, and 4% from “other” sources.

Source: LEGH’s 10-K Reports

Trading at Liquidation Value

During the first quarter 2024 investor call, the CEO mentioned that after the poor Q4 2023 results, the company’s share price traded around its liquidation value.

What a comment!

It is pure gold to hear a CEO publicly state the company is trading at its liquidation value. Consequently, the board of directors implemented a share buyback program to take advantage.

But it is essential to conduct our own research. So, what is the liquidation value of the business?

Calculating LEGH’s Liquidation Value

1. Identify Total Assets:

We turn to the balance sheet to find the total assets:

Source: LEGH’s March 2024 10-Q

Don’t let the above intimidate you. We are going to work through this together!

Note: I have marked various assets on the balance sheet as these can be grouped to form a single line item as they are similar. All items marked in red are essentially “Loans” the company has made to buyers of their homes.

2. Estimate Sale Value:

While the balance sheet provides us with the book value, this might not be accurate because, in a distressed situation, the company might not be able to sell the item for that amount, while sometimes the item might be worth more than on the books.

Our job is to go through each item and estimate its actual value. Below, I have done just that and added my comments to show my thinking:

Property, Plant, and Equipment

As per note 8 of the March 2024 10-Q, we can see what the property, plant and equipment consist of: land, buildings, vehicles, etc.

Source: LEGH’s March 2024 10-Q

But here is where it gets interesting!

LEGH purchased raw land years ago, which it has been developing to sell to Mobile Home Park (MHP). The land is sitting on the books at cost - the price LEGH originally paid for it - but because it has developed the land and property prices in Texas have soared, that land is now worth considerably more.

From my conversations with the CEO, they have had independent valuations of up to $400 million for that land; however, the CEO and I believe that land could easily fetch $75 million if they had to sell it quickly.

Therefore, I valued the land at $75 million and the rest of the property, plant and equipment assets at 75% of their book value, for a total value of $115.5 million.

Loans

LEGH lends money to MHP owners and individuals to purchase homes. In a distressed situation these loans would likely go bad and be worth ZERO.

However,

LEGH has collateral on all the loans, and the collateral is the homes itself. Given these are manufactured homes, they can be transported and resold reasonably quickly. So they are definitely worth something!

Again, based on conversations with the CEO, LEGH has 100% collateral on the loans, meaning they should be able to recover 100% of the loan value should the lender default.

Furthermore, in the case of MHP loans, they have third-party guarantors that would have to step in should the lender default and often the collateral is the entire park itself, meaning 1) the probability of these loans defaulting is very low and 2) if they did, often the collateral is more than what is on the balance sheet.

I am, therefore, confident they could recover the total $403 million in loans should all go bad, which is very unlikely.

3. Sum of Assets:

As per the table above - Estimated Liquidation Value of Assets = $538.8 million

EASY!

4. Identify Total Liabilities:

As with the assets, we now have to do the same thing on the liability side, calculating the actual value of the liability vs what is on the book.

Source: LEGH’s March 2024 10-Q

Fortunately, this is easy as we simplify assume LEGH pays off everything it owns (it can’t pay more), which is the value on the balance sheet.

5. Subtract Liabilities from Assets

Finally, subtract the total liabilities from the sum of the assets to get the liquidation value.

Liquidation Value = Total Assets less Total Liabilities

Liquidation Value = $538.8 million - $59.6 million

Estimated Liquidation Value = $479.2 million

So, after LEGH has paid off all its debt, there will be $479.2 million left to equity owners of the company.

Now, this is where one needs to be careful because that equity might not all be available to the company’s shareholders. If there are preferred shares or separate classes of shares, they might get paid before the common shareholder (you and me).

In LEGH’s case, however, these are no preferred shares or complex equity structures, so the entire $479.2 million would be distributed equally to all existing shareholders.

Liquidation Value per Share

To determine what we get paid, we still need to calculate the liquidation value per share.

As per the March 2024 10-Q there are 24,316,488 shares outstanding. So the $479.2 million would be distributed equally among these shares, meaning each shareholder would receive $19.71 per share.

Conclusion

The liquidation value gives us a fantastic safety net as it is the worst-case scenario. In LEGH’s case, we should expect to receive around $20 per share.

LEGH is currently valued at $23.61 per share (at the time of writing), so if you bought the share today, in a worst-case scenario, you should expect to lose -16.5% on your investment. That is not bad considering the potential of this business (see “When Should You Sell a Stock For Profit”)

That doesn’t mean the share price cannot go below $20 or even $17 or more. But it does mean that if the share price drops to $15 per share, there is a high probability that I will be buying a lot more of LEGH.

Disclaimer: This is not financial advice but for information purposes only. It is essential to do your own research.

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Last week, we discussed the journey we’re embarking on - searching for high-quality businesses where others are not looking. We laid out a set of principles to guide us. If you missed last week’s newsletter, “5 Fundamental Principles for Better Stock Analysis”. There will be exceptions to these principles, but sticking to these five guidelines will greatly increase our chances of long-term success.

But before we can begin, we need to discuss the most essential aspect of investing:

Managing Your Emotions When Investing

Investing is difficult because it involves our hard-earned money, and when it comes to our money, we are naturally emotionally involved. It is, therefore, imperative as investors to be aware of this and not allow these emotions to influence our decisions because this is a recipe for disaster.

One tool we have at our disposal is to manage our expectations.

My experience has taught me that emotions overtake our decision-making when our expectations are out of line with reality. It is akin to an amateur golfer who starts his round of golf with the expectation of playing as well as the professionals he watched on TV the night before. It is almost guaranteed to be a bad round of golf, with the golfer leaving frustrated.

Let’s not be that way when we invest!

Let’s not be that way when we invest! Instead, let’s set some expectations for investing before we even begin.

1. Finding Exceptional Companies is Challenging

If it were easy to find exceptional companies, everyone would do it. If everyone were doing it, these exceptional companies would all be valued at fair market prices, making our efforts futile.

So, our first expectation is that it will not be easy to find extremely high-quality businesses that we can hopefully hold for the rest of our lives. My goal is to find 10 such companies; for now, I believe I have discovered 2 after 2 years of searching. The point is that we won’t find these companies overnight, so we need to be patient.

Expectation 1: We must be patient in searching for exceptional companies.

2. Long-Term Potential Takes Time to Unfold

Just because we’ve found great businesses doesn’t mean we should expect immediate rewards.

Take the St. Joe Company (JOE), which I discussed in “Economic Moat Company Examples”. JOE’s value lies in its land, which sits at cost on its balance sheet. This land was purchased decades ago, so we know it’s significantly undervalued. Only once the land is developed will this value be unlocked.

The company owns 168,000 acres, so developing this land will take decades. I, therefore, expect that JOE will take many years to reach its potential. If I went into this investment expecting the market to realize the company’s true value overnight, I would get frustrated quickly.

Expectation 2: We must be patient when waiting for these businesses to return value.

3. We Won’t Be Right All the Time

Even legendary investors like Warren Buffett have made most of their wealth from just a handful of companies. Since we strive for similar success as the maestro, we must acknowledge then that he has made numerous investments that didn’t work out.

Mohnish Pabrai, one of Buffet’s disciples, aims for a 60% success rate; I’d be happy with 50%. Setting this expectation prevents us from putting all our eggs in one basket or taking too large a position in just one stock.

Fortunately, if we find quality businesses that can compound in value, then being right 50% of the time means we can still make a lot of money.

Expectation 3: Expect to be right only some of the time.

4. You Will Be Wrong

Expecting not to be right all the time prevents us from being overly aggressive when we buy into a company. Expecting to be wrong keeps us humble after we make the invest.

Even if we find what we believe to be outstanding businesses, we will make mistakes. Expecting to make mistakes helps us remain honest and humble so that we can acknowledge our mistakes.

It’s not easy to spend 40+ hours researching a company only to uncover information that disqualifies it as an investment – the instinct would be to dismiss this information and proceed. It’s even harder to research a business for 80+ hours, invest in it, and monitor it for 6 months, only to see your investment thesis fail to materialize.

You have to be able to let go when you realize your mistakes because if you fail to admit when you are wrong, you are going to lose a lot of money

Expectation 4: Expect to be wrong, so don’t lose money when you are.

Invest Only What You Don’t Need

To manage our expectations, it is essential, in my opinion, that you are in a position to invest for the long term.

There is no point in using your savings to invest in 10 exceptional businesses if you need those savings to fund your life. You will constantly have to sell without benefiting from the long-term compounding. It is also pointless to invest the money if you need it a year or two later to buy a house, a car, or whatever you are saving for.

Equally important is not to invest everything you have to the point you can’t sleep at night when your portfolio loses 10%, 20%, or even 30%.

The ideal scenario is investing money, which you can almost forget, allowing it to compound year after year, rather than sitting then anxiously watching every up and down tick of the share price.

Closing Thoughts

Investing isn’t easy because it involves our hard-earned money, resulting in us making decisions based on emotions.

But if we invest ONLY money that we are happy to leave for the next 10, 20, or 30+ years and ensure our expectations align with an investing reality, in that case, it will be far easier for us to control our emotions and, therefore, succeed.

So remember:

• Invest Only What You Don’t Need: Ensure you can afford to leave your investments to grow over the long term without needing to sell prematurely.

• Be Patient in Your Search for Exceptional Businesses: Recognize that finding high-quality companies takes time.

• Be Patient While Waiting for These Businesses’ Values to Unlock: Understand that it may take years for a company’s true value to be realized.

• Expect to Be Right Only Some of the Time: Accept that not all investments will be successful.

• Expect to Be Wrong, So Don’t Lose Money When You Are: Acknowledge mistakes and adjust your strategy to minimize losses.

This week, we discuss how managing emotions is crucial to long-term success. This aligns well with the wisdom shared by Charlie Munger in his famous speech, “The Psychology of Human Misjudgment” where he delves into the cognitive biases and psychological tendencies that can lead to poor decision-making.

Setting Expectations to Reduce Our Biases

Munger was a big believer in the power of incentives. In his speech, he highlights the profound impact of incentives on human behavior, known as the Reward and Punishment Super-Response Tendency. People respond intensely to incentives, often leading to irrational decisions.

This understanding is vital, as incentives impact market behavior, leading to distorted valuations of companies. We, therefore, cannot let the market’s irrationality dictate our decision-making.

The Liking/Loving Tendency and Disliking/Hating Tendency emphasize how personal biases can influence investment decisions.

We might become overly attached to a stock, especially when we have spent hours researching the company. Similarly, we might be critical based on our biases, so we avoid researching a company entirely. Recognizing this, we must strive for objectivity, ensuring our judgments are based on data rather than emotional attachments.

Munger also discusses the Doubt-Avoidance Tendency, where people make quick decisions to avoid uncertainty. This ties into our expectation that finding exceptional companies is challenging and time-consuming. We must resist the urge to make hasty decisions and be patient in our search.

The Inconsistency-Avoidance Tendency highlights our discomfort with conflicting information, which can lead us to ignore essential data that doesn’t fit our preconceived notions. As investors, we must embrace a holistic view, integrating all relevant information even if it challenges our initial thesis.

Social-Proof Tendency underscores the influence of others’ actions on our decisions, leading to herd behavior, where we might follow the crowd instead of conducting independent analysis.

By setting the expectation that we won’t find exceptional companies overnight and that once we find them, it will take time for our investments to play out, we can avoid the pitfalls of following market trends mindlessly.

Overoptimism Tendency and Excessive Self-Regard Tendency remind us of the dangers of overconfidence in our abilities and outcomes. Munger emphasizes the need for humility and realistic expectations, acknowledging that even legendary investors like Warren Buffett have made mistakes.

This ties into our expectation that we will be right only some of the time and our readiness to adjust when we realize we are wrong.

Finally, Munger’s discussion on Deprival-Super Reaction Tendency and Stress-Influence Tendency underscores how loss and stress can lead to poor decision-making.

By investing only money we don’t need for immediate expenses, we can better manage stress and avoid rash decisions driven by short-term market fluctuations.

In conclusion, Munger’s insights on human misjudgment allow us to better understand the psychological tendencies that can derail our decisions. By managing our emotions and setting realistic expectations, we can navigate the complex world of investing more effectively.

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Last weekend was “The Woodstock for Capitalists,” also known as “The Pilgrimage”—I’m referring to the Berkshire Hathaway Annual General Meeting, where shareholders from all over the world flock to Omaha to hear the words of wisdom from “The Oracle,” Warren Buffett.

In past meetings, Buffett commented on how his company has grown to a size that restricts his ability to find quality companies to invest in, similar to what we discussed in “Disadvantages of Institutional Investors”. However, he mentioned that he could guarantee shareholders a 50% annual return if he started fresh.

This year, a keen Berkshire shareholder asked how Buffett would make this 50% annual return if he had only $1 million to invest as of today. Buffett’s answer was simple: he would look at all the listed companies, searching for high-quality businesses that no one else is looking at.

You can watch the video here.

The timing of his comment coincided with the survey where you revealed that you want more company analysis and stock tips. Given my years hunting for and analyzing obscure businesses in Africa, I feel more than qualified to do just what Buffett suggested!

So, let’s do precisely that - Going forward I will spend my time sifting through listed US companies and dedicate the “Investing Chronicles” to discussing the process and revealing the companies I find.

I believe the benefits will be threefold:

1. You will see the process I follow for finding and researching companies I am interested in investing in.

2. We will learn many valuable investing lessons, which we can discuss as they unfold.

3. We will hopefully find some amazing companies worth investing in together.

Hopefully, this sounds as exciting to you as it does to me.

Before we begin, however, I need to discuss the principles I follow when researching a company. We have touched on this in the “Checklist for Fundamental Analysis of Stocks” newsletter, but I want to give you my “Must-Haves” for any company.

Principles I Follow When Researching a Company

1. Invest Within A Circle Of Competence

Our goal as investors is to value a business, but this becomes impossible if we don’t understand the company or how it makes money. So, I gravitate towards my circle of competence, and ideally, it is a business I find exciting because it is hard to thoroughly research a business I find boring.

Businesses I do not understand and tend to avoid:

• Mining and other commodity-type businesses

• Pharmaceutical companies

• Insurance companies

• Cryptocurrencies

Of course, there will be exceptions, but I am unlikely to invest in any of the above sectors.

2. Invest in High-Quality Businesses

Determining quality can be tricky, but there are two ways to do this: quantitatively and qualitatively. I tend to use a combination of both.

i) Quantitative Measures:

First, I look for a high Return on Capital (ROC). ROC measures the return a company can expect to earn for every dollar reinvested into the business.

Next up is revenue growth. We want to see a history of revenue growth and, more importantly, the potential for that growth trajectory to continue. After all, there’s no point in investing in a company that’s stuck in neutral.

Lastly, healthy operating margins are essential. A business that can convert a large portion of revenue into operating income will outperform a company with a similar revenue profile and a lower margin – that is just simple math.

Although not set in stone, this is my qualifying criteria:

ii) Qualitative Indicators:

Let’s discuss the softer side of assessing a business’s quality.

Not all businesses are created equal, and understanding various business models is critical to finding quality businesses. The more you know, the easier it is to distinguish between a gem and a dud. Check out my “Economic Moat Company Examples” newsletter for a deeper dive into this.

3. Invest in Healthy Businesses

How do you determine the health of a business?

i) Balance Sheet Analysis:

First, we delve into the company’s balance sheet—the financial snapshot revealing what it owns (assets) versus what it owes (liabilities).

What’s crucial here?

Well, a healthy business should own more than it owes. A business must be able to pay down its debts over time as it generates cash from its day-to-day operations, even better if it owes very little!

Together, we’ll sift through these balance sheets, learning what to look for and what are red flags.

ii) Cash Flow Statement:

As important as the balance sheet is the cash flow of the business.

You’ll be surprised how often investors ignore this, believing the cash will magically appear one day. A company’s ability to generate cash is its lifeblood. Without it, the business can’t survive, let alone thrive. We want a company that isn’t just paying its bills but also generating enough cash to fuel future growth.

4. Invest in Businesses Run by Honest People

This is probably the most challenging aspect of an analysis because it is difficult to know if someone is honest. There are things we can look for, however…

i) History of Management and Ownership:

My experience has taught me that dishonestly is a character flaw, meaning that a person will unlikely go from being a crook to a saint. Therefore, if a manager’s or owner’s history reveals skeletons in the closet, we can assume that the person continues to operate dishonestly.

ii) Management Compensation:

Next up, is examining how management is compensated. Is the CEO earning an exorbitant salary? Or is their compensation tied to meaningful metrics that align with shareholder interests?

According to Munger, this is the holy grail of how people are motivated, so we’re looking for leaders whose incentives are aligned with the long-term interest of the business and shareholder returns.

5. Invest In The Business Only When Decently Priced

Finally, we get to the easiest part - valuing the business.

In the newsletter about “Reducing Risk When Buying Shares in a Company” we discuss valuation in detail, introducing intrinsic value and the importance of maintaining a margin of safety. I strongly suggest reading through this if you haven’t in order to have a deeper understanding about valuing a business.

Our goal is not just to find great companies; it’s about acquiring them at a price that maximizes our potential return while minimizing our downside risk.

In Summary:

• Principle 1: Invest Within Your Circle of Competence

• Principle 2: Invest in High-Quality Businesses

• Principle 3: Invest in A Healthy Company

• Principle 4: Investing Businesses Run By Honest People

• Principle 5: Invest In The Business Only When Decently Priced

Over time, as we work through the 5 principles, we will better understand what to look for and what to avoid. If at any point you get lost or need more information, please don’t hesitate to get in touch with me. 

Also, if there is a specific company you want me to analyze, I am more than happy to include the analysis in our newsletter.

Closing Thoughts

I hope you are as excited about the journey we are about to embark on as I am.

While I am not guaranteeing 50% returns like Buffett, I can guarantee it will be an interesting learning experience for those who enjoy investing, especially those who love learning about new businesses.

And hopefully, we will find some truly exceptional businesses that are yet to be in the mainstream’s field of vision.

Universe of Stocks

Below is a link to a spreadsheet with over 7,000 companies trading on the US stock exchanges. I am going to be working through this list and updating the spreadsheet with comments as I go.

Feel free to use it as you wish or keep track of our progress:

Download spreadsheet here.

(Remember the spreadsheet will change weekly)

More resources to follow

When investing for yourself, it is essential to do things your way that suit your character and follow a research process that makes sense to you. So perhaps you don’t agree with my investing principles above, or maybe you want another opinion.

Enter Peter Lynch, one of the greatest investors of our time.

Peter Lynch’s Bio

Peter Lynch was the manager of Fidelity’s Magellan Fund, and he returned an impressive 29% per annum for 13 years! Under his leadership, the fund’s assets grew from $18 million to over $14 billion, making it one of the most successful mutual funds ever. So, he definitely knows what he is talking about.

In his best-seller, “One Up on Wall Street”, he shares his recipe for success and how individual investors can outperform the Wall Street experts.

One Up on Wall Street: 3 Key Takeaways

1. Invest in What You Know

Peter Lynch emphasizes the importance of leveraging your personal knowledge and experiences to identify potential investment opportunities. By investing in industries or products you’re familiar with, you can better understand a company’s prospects and make more informed investment decisions.

2. Do Your Own Research

Lynch advocates for thorough research and due diligence before making any investment. This involves analyzing a company’s financial health, understanding its business model, assessing its competitive position, and considering its growth potential.

His goal was to find businesses with high growth potential and purchase them when they are undervalued.

3. Stay Patient and Think Long-Term

One of Lynch’s core principles is the importance of patience and a long-term perspective. He advises against trying to time the market or reacting to short-term fluctuations. Instead, investors should focus on the long-term growth potential of their investments.

By holding onto high-quality stocks for extended periods, investors can benefit from the power of compounding and ride out market volatility.

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Investing is a fascinating place to play. It is one of the few professions where an individual investor, also known as a retail investor, who knows what they are doing, has an advantage over an institutional investor, also referred to as a professional money manager, such that you can outperform these pros in the long term.

It sounds unreal, but let’s delve into the reasons behind this claim:

The Disadvantages of Institutional Investors

Institutional money managers face several limitations that hinder their ability to perform optimally. The main shortcomings are:

A Short-Term Focus

Investment funds typically manage assets on behalf of clients, including pension funds, endowments, and Fund of Funds. These clients often expect regular updates on their investments, sometimes as frequently as quarterly or monthly. Consequently, if a fund manager experiences several months or quarters of poor performance, they will face scrutiny from their clients.

Given that a fund manager’s income is directly tied to the fees they charge clients for managing their investments, they naturally prioritize meeting client expectations. As a result, fund managers may unconsciously adopt a short-term mindset to avoid disappointing.

We know from previous discussions that focusing on short-term gains can hinder the long-term growth potential of investments. 

Restrictive Mandates

Naturally, clients are averse to money managers taking unnecessary risks, leading to the implementation of mandates which often limit the size of positions and the total exposure to industries or asset classes. Additionally, mandates usually require funds to be able to liquidate entire positions within a specified time frame.

Moreover, clients prefer managers to minimize cash holdings, as they would rather hold the cash themselves than remain idle in a fund charging them fees. So, even holding cash can be prohibited.

I have personally experienced this at my previous job. Our fund had an outstanding year, appreciating 66%. Because of the strong performance, we reduced our equity holdings as share prices increased, resulting in a cash allocation of over 30%. At this point, one of our largest clients questioned the high cash allocation, stating, “If we want to hold cash, we will hold it in our own bank account.”

Regrettably, we listened to them and reinvested in what we perceived as expensive investments at the time. Consequently, our performance was suboptimal in the following year.

So while these restrictions are reasonable from a risk management perspective, they inevitably constrain performance. 

Vulnerable to Client Behavior

Clients of funds exhibit the same emotional tendencies that drive all other investors.

There is a natural inclination to seek out fund managers who have recently outperformed, often assuming they are superior. However, this behaviour mirrors the “buying high” concept, which is flawed thinking. Rarely do these funds sustain their exceptional performance as they amass more capital.

When performance falters, clients begin to question their investment decisions and the competence of the fund manager, which, in turn, places significant pressure on the manager. If poor performance persists, clients may withdraw their investments often at the worst time, akin to “selling low.”

Moreover, market fluctuations can trigger panic among fund clients, prompting them to pull their investments hastily. These reactionary behaviors can undermine the fund’s stability, particularly if it leads to the forced sale of shares during unfavorable market conditions. 

Mimicking the Market

Due to the short-term focus, restrictive mandates, and fear of going out of business, managers often find themselves inadvertently copying the market so as not to disappoint. Consequently, the more they resemble the market, the less likely they are to outperform it.

The S&P SPIVA scorecard reveals that in 2023, only 40% of funds surpassed the S&P 500. However, over 10 years, a mere 12.6% of funds outperformed the S&P 500. It shows you just how challenging professional money management is, and part of the problem is due to the constraints.

While there are other shortcomings, these are natural hindrances that managers must deal with. Obviously, they are not issues you and I have; however, our real advantage over these managers stems from their size- the root cause of all three!

More Money, More Problems

Most money managers start with the noble intention of making money for their clients. They usually begin with a modest amount, and if they excel at their craft, they can outperform the market and their peers.

As their success grows, they attract more attention, and clients flock to them, hoping to capitalize on their expertise. Naturally, as professionals, managers accept more capital as it means higher fees and a more prosperous fund. It’s rare to find someone who turns down such offers.

However, a significant challenge arises as the fund’s size increases. With more assets under management (AUM), the fund’s investment opportunities diminish, leading to reduced performance. The larger the fund becomes, the fewer options it has.

For instance, while a $20 million fund can invest in almost any high-quality business,  a $20 billion fund faces limitations. It’s simply impractical for a $20 billion fund to purchase shares in a $200 million company as a 1% position means they own the entire $200 million business.

The larger the fund gets, the more it has to focus on larger, more established companies, and the more it starts to resemble the very thing it is trying to outperform – the index.

Advantage US!

Individual investors are not confined to the same restrictions as professional fund managers. We can invest in anything regardless of size. We can hold these for as long or as little as we want. If we choose not to invest, we can sit with the entire portfolio in cash without upsetting anyone.

But best of all, we can uncover high-quality businesses that institutional investors simply ignore. In the next section we’ll discuss how.

We’ve touched on how size gives you a significant edge over professionals. Let’s explore how to capitalize on that advantage. Enter my personal hero, Joel Greenblatt, and his book “You Can Be A Stock Genius”.

The Advantages of a Retail Investor

Despite its terrible title, “You Can Be A Stock Market Genius” is a gem of an investing book, which is easy to understand, regardless of your expertise in investing or accounting.

Mr Greenblatt eloquently elaborates, perhaps better than I have, on why individual investors possess an edge over Wall Street and introduces several techniques to leverage it. The book meticulously covers various corporate actions and explains how to seize the opportunity as an individual investor. This includes:

1.     Spinoffs

A spinoff is when a company decides to split off one of its divisions or subsidiaries into an independent entity by distributing shares of the new company to existing shareholders.

When this happens, Wall Street can ignore one of the entities purely because it is too small, which can lead to mispricing of that asset. Investors can benefit by owning the “forgotten” entity.

2.     Merger

A merger is the consolidating of two or more companies to form a new entity, aiming to achieve synergies, expand market presence, or diversify operations.

Mergers can lead to mispricing of either the company being acquired or the acquirer. Greenblatt shows you how to recognize the opportunity and capitalize.  

3.     Bankruptcies:

A bankruptcy occurs when a company can’t meet its financial obligations and seeks protection from creditors through legal proceedings.

The regulation around bankruptcies or liquidations can result in shareholders selling indiscriminately. We can benefit because distressed assets can become mispriced.

4.     Restructuring

Similar to bankruptcies, restructurings involve significant changes to a company’s organizational, operational, or financial structure to enhance efficiency, profitability, or competitiveness.

Individual investors can benefit as restructurings can lead to asset mispricing as institutions dump the stock.

5.     Rights Offering:

A rights offering is when a company want to raise additional equity, allowing existing shareholders to buy additional shares of a company’s stock at a discounted price, usually in proportion to their existing holdings.

Rights offerings are often harmful to existing shareholders as they dilute ownership. The astute investor can benefit by acquiring these rights at discount prices as others are “dumping” them. 

A Must Read

Joel Greenblatt managed a 40% return per year for over 20 years, which very few have matched. A large part of his success is because of the tools he teaches in this book. While it takes significant work to take advantage, those willing to put in the effort can become “a stock market genius.”

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Warren Buffett is credited with making moats the “holy grail” of investing. Essentially, it is about investing your money into companies with a sustainable competitive advantage over their peers, ensuring lasting success.

While this concept seems intuitive, I struggle with it. It’s not the concept that troubles me but rather its practical application. Finding these moats is just not easy!

This week, let’s discuss these moats…

What is a Moat?

To understand a moat, let’s borrow from Buffett’s analogy.

Picture a business as an economic castle under constant siege from competitors. These rivals aim to seize the castle, i.e. take market share. The moat serves as the protective barrier around this castle. It could take various forms: being a low-cost producer, holding a franchise that’s tough to replicate, facing high entry costs like establishing a power plant, or enjoying a monopoly such as a power distributor. The broader the moat, the more impenetrable the economic castle, making the business more appealing.

I probably haven’t done the description justice, so here is Buffett’s explanation:

Why is a Moat Important?

Businesses come and go, but some last much longer than others. Why is that?

Besides that, it offers a service or product that people want. It has a competitive advantage over its peers, allowing that business to survive during difficult economic times when most of its peers are forced to shut down and thrive during the good times.

Success is far from guaranteed when investing, and one sure way to lose is to invest in unsustainable businesses. The opposite also holds true: your success rate is far higher when you invest in a company that will do well during both good and bad times.

Buffett is so good at doing this, and what so many, including myself, try to replicate is finding companies with a competitive advantage that will outperform their competition over the long term.

Examples of Economic Moats

Despite the challenges in finding them, arming ourselves with knowledge is never a bad idea. So, let’s cover the various types of moats and look at examples for each.

Low-Cost Producer

A low-cost producer is a company that can manufacture or purchase goods or services at a lower cost than its competitors. This competitive advantage allows the company to offer products at lower prices, enabling it to gain market share.

Great examples are Costco and Walmart, whose sheer size enables them to procure goods at lower costs than their competitors and pass on these savings to customers. However, it’s worth noting that while this type of moat offers advantages, it’s vulnerable to disruption, as seen with Amazon’s ability to streamline operations and undercut traditional retailers.

Network Effect

The network effect occurs when the value of a product or service increases as more people use it. In other words, the more users a network has, the more valuable it becomes to each user.

It’s most commonly observed in social media platforms such as Facebook or WhatsApp, where the platform becomes more indispensable as more users join. Even Spotify has a network effect whereby its recommendation algorithm becomes more accurate with each additional user on the platform rating music.

The drawback is that switching costs can be low – it is effortless to use TikTok instead of Instagram, making it easy for users to migrate to a better alternative, as exemplified by the decline of MySpace.

High Barrier to Entry

In my view, industries characterized by high barriers to entry often possess some of the strongest moats. These barriers may be substantial capital requirements or intellectual property protections.

For instance, the semiconductor industry, which necessitates a high degree of expertise and substantial financial investments, presents formidable hurdles for new entrants. Not just anybody can set up a chip fabrication plant or design a world-class processor.

Similarly, the telecommunications sector demands significant startup capital, creating obstacles for potential competitors. However, it also faces challenges due to rapidly evolving technologies and the customer’s purchasing power, leading to ongoing capital expenditure at diminishing returns on investment.

Switching Costs

Switching costs represent another formidable competitive advantage. When it’s difficult or inconvenient for customers to switch from one provider to another because it requires significant time and resources and causes potential disruptions to operations, companies enjoy a captive customer base.

For example, Oracle customers hesitate to switch to alternatives because of the pain involved, regardless of whether better options are available. Similarly, companies like Microsoft and Apple create ecosystems that lock users into their products and services, making switching inconvenient.

Monopoly

A monopoly occurs when a single company has exclusive control over the supply of a particular product or service, effectively dominating the market and preventing meaningful competition. This control often arises from regulatory privileges, ownership of essential resources, or technological superiority. They benefit from pricing power as consumers have no alternative.

A good example is a power distributor licensed by local or national governments to distribute power through the region. It makes little sense to have two distributors in the same geophagy, and since we all need electricity, there is little we can do regarding their pricing power.

Of course, even power distributors can lose their moat with a simple change in regulation or innovation, such as home solar becoming more affordable.

Brand Loyalty

Brand loyalty, Buffett’s favorite moat, is perhaps the most challenging to quantify. Strong branding creates emotional connections with consumers, fostering loyalty that transcends product features.

For instance, I read a study on Apple vs Samsung’s branding power a few years back.

According to the study, loyal Apple customers showed the same emotional connection to the Apple brand as they did with their relatives (the ones they liked anyway 😆 ). In contrast, Samsung generally showed a shallow emotional connection to the Samsung brand and an adverse reaction to Apple, suggesting they didn’t like Samsung but rather hated Apple.

That is a powerful brand and perhaps why Buffett bought Apple shares in 2016.

Finding a Moat Isn’t Easy

While understanding the concept of a moat is relatively straightforward and widely touted as the ultimate investing strategy, I’ve personally struggled with it, and I believe many others do, too.

People often cite examples like Google, Amazon, or Netflix to illustrate moats due to their industry dominance. I agree they are fantastic companies with wide moats, but it is easy to recognize them in hindsight. What value does that bring to an investor after the fact, especially when competitors are already breaching the castle walls?

The actual skill lies in discovering a moat before others do. In the next section, we’ll look at a real-life example of a company I believe has a significant moat.

Let us continue our discussion on competitive advantages.

I thought it would be valuable to share with you a company I believe has a wide and sustainable moat - The St. Joe Company

How is this about learning from the experts?

As discussed below, the largest shareholder is a very well-respected value investor, Bruce Berkowitz. I learned about JOE by reading the company’s annual reports, listening to annual shareholder meetings, reading Berkowitz’s commentary about the company, and watching interviews with him. Therefore, he taught me about the company, and I want to pass it on to you!

I hope you enjoy it!

The St. Joe Company: An Economic Castle with a Wide Moat

Company Description

The St. Joe Company (JOE) is a property company with 168,000 acres of land in Northwest Florida with development rights. Rumor has it that Walt Disney originally wanted to build his Disney World theme park on this land but was rejected by the company’s CEO at the time.

JOE is in the process of developing this land, but what makes it stand out from other property developers is that it has an owner-oriented mindset, meaning it develops residential communities, hospitality and commercial projects with the idea of owning as much of these developments as possible while getting a third party to manage the day to day operations.

This business strategy does two things:

1. It sets up a lifetime of recurring revenue stream from land it develops – The more it builds, the larger the revenue stream becomes, and JOE has only developed 2% of the 168,000 acres!

2. As the area’s densification increases, the land will increase in value, and JOE benefits from that appreciation - the land is held at cost on the company’s balance sheet, meaning it is significantly undervalued.

Owned by a Respected Investor

JOE’s largest shareholder is Fairholme Capital Management, led by respected investor Bruce Berkowitz, who is also the Chairman of JOE. Fairholme owns over 38% of the company, but more importantly, JOE counts for almost 90% of Fairholme’s fund, so you can be assured that the Chair will protect the interest of the shareholders.  

The Moat - No Competition

Because of the size of the land JOE owns, it can develop without risk of competition, giving it a monopolistic feature. 

As discussed in the Investing Chronicles, a monopoly can be a powerful moat; however, regulatory risk can be a threat. In JOE’s case, it owns the land and has been granted development rights. The risk of the rights being taken away is low, and since JOE owns the land, the risk of Florida allowing competition into the area is even lower.

Therefore, JOE has a powerful monopoly in the area and, consequently, a wide moat. Just take a look at what they are building…

The Pandemic: The Catalyst it Needed

For JOE to reach its true potential, the majority owner in 2017 stated the company needed a catalyst. In 2020, it appears that that catalyst occurred.

Lockdown across the United States resulted in the migration of people away from urban areas the the coast in the South of the country. “If I don’t have to go to the office, I ain’t going to live in New York” became the mentality as people left the cities.

Northwest Florida became one of the fastest-growing areas in the country because of this migration—this growth continues to this day. As more people flocked to the area to buy homes, the need for services such as hospitals, schools, hotels, and shopping centers increased, and Northwest Florida reached critical mass.

JOE has, therefore, been building homes, clubhouses, hotels, office parks, retail outlets, hospitals, schools, etc. Most exciting is that the company has only developed 2% of its land thus far, so the growth should continue for years to come.

At least, that is the plan!

So, while I believe JOE has a moat, I cannot say anything with 100% certainty because things may go wrong. People could stop moving to the area, or perhaps development rights are taken away, but until that happens, I will own shares in the company, continue to monitor the business as it develops and hopefully will be a shareholder of what appears to be an impenetrable castle for many, many years.

Resources

• Bruce Berkowitz - 2017 Bloomberg Interview: See from 37:31

• Bruce Berkowitz - 2023 Wealthtrack Interview: See from 19:10

• Bruce Berkowitz - 2024 Richer Wiser Happier Podcast: See from 34:47

• The St Joe Company Annual Reports

• The St Joe Company Presentations

• The St Joe Company Project Updates

This week, I want to share my investing process and how I use a checklist to invest better. While it doesn't guarantee success, it improves my odds.

If anything is confusing or you would like more details on one of the steps, please email me, and we'll go into more detail in the next newsletters.

5 Steps for Better Fundamental Analysis of a Company

1. Searching for New Investments

The first step in investing is finding new investment ideas. This is not easy, but it can be fun, like searching for treasure. I have covered the topic in "How to Find Your Next Great Investment," so check it out for more details.

For simplicity, here is a summary of a few options available:

• Stock Screening: Rank companies based on fundamental metrics such as growth or value metrics.

• Fund Letters: Professional money managers often write about their best investment ideas as a form of marketing in their quarterly or annual newsletter to investors.

• 13F Filings: Any fund investing over $100 million in US-listed companies has to report their holdings quarterly. It is a great place to see what they are buying and selling.

• Investing Forums: Forums are a great place to read other investors' investment ideas and theses, but ensure you read quality research.

• Insider Buying: Managers and large owners of US-listed companies must disclose when they buy or sell shares via an SEC Form 4 filing. It is a great place to look for potential ideas.

2. Company's Economic History

So you have found a company that looks interesting, so now what?

It's now time for a deeper dive, which involves understanding the business, how it makes money and its history. If you don't know what makes a company successful, you can't expect your investment to be a success.

Where do we find all these details? The company's annual report or 10-K.

As it might feel like a daunting process, especially for newcomers, let me walk you through an example of one of my investments…

The Buckle (BKE) Case Study

I first noticed BKE in 2020 when it screened on the Magic Formula Investing Website. After a few quick calculations, I found it to be a high-quality business (high ROC) and valued very attractively (high Earnings Yield). It was time for a deeper analysis:

i) What does the company do?

As per the 2023 annual report (page 4), BKE is a retailer of medium to better-priced apparel, footwear, and accessories for young men and women. As of January 2023, the company operated 441 retail stores across 42 states in the US. The company primarily markets brand-name apparel, including its own in-house brand.

ii) How does it make money?

As per page 5 of the report, the company breaks down where its sales come from:

As you can see, most of the company's sales come from Denims followed by tops. This trend has been consistent for the last 3 years.

So, we know how the company makes money, but we need to see if it has consistently made money.

Simple enough!

iii) Historical Performance

Next, we work through as many annual reports as we can get our hands on and summarize the business's financials. While the list is not exhaustive, I am looking for the historical trends of metrics that are important to me, including:

• Revenue growth

• Operating Income (EBIT) margins

• Cash Flow Yield

• Dividend Yield

• Earnings Yield

• Net Debt

• Return on Capital: See the article on "Magic Formula Investing"

• Growth in book value per share

My metrics might differ from what you are looking for. If you want dividend-paying stock, then dividends are essential. If you want a high-growth stock, revenue growth is obviously key.

You need to decide what matters to you.

But let's get back to BKE:

As you can see from the chart above, revenue has been growing over the years; however, there is a period from 2016 to 2022 where revenue retreated, and while margins have been healthy, they too compressed as revenue declined.

While the negative revenue growth from 2016 to 2022 is disappointing, it gives us a fantastic opportunity to learn more about the business and the risks involved. Please don't skip digging into what went wrong because it will help you when the company faces other headwinds.

Other Metrics

As with revenue growth and margins, I look at the other metrics in a similar manner, and have summarized my findings for simplicity:

Each company will have different findings from the analysis of the financial statements. In BKE's case, what stood out was the excellent cash generation of the business, as evidenced by the high margins and cash flow yield, which the company returns to shareholders in the form of a dividend.

(FYI…negative net debt = net cash which is excellent!)

Looking deeper, BKE has consistently paid a special dividend each year without exception for the last 20 years, resulting in a high dividend yield. The negative is the low revenue growth, meaning I can't expect that dividend to grow over time.

HOWEVER

When I analyzed the company, the share price was at $19.00 per share vs. the $37.00 per share today. This meant that I could buy a much higher dividend yield at $19.00, and I was locking in the high dividend because of the sustainability of the dividend payout.

I was now very interested in BKE, providing the rest of the analysis worked out.

Summary of BKE's Historical Analysis

While revenue growth was poor, the company has consistently had high operating margins, it has never made a loss going back to 1993, and it has paid a dividend with the cash it has generated since 2003.Therefore, there was a high probability that the company would continue to produce cash and return the money to shareholders.

Because of the depressed share price due to the pandemic, I could lock in a very high dividend yield by buying shares at $19.00 per share.

3. Who is the competition, and how are they doing?

Understanding who the competition is, how they perform, and how they have done over time is essential.

What if your company has the lowest growth, the worst margins, and is the most expensive in the industry? You will only know this if you analyze the company’s peers!

PLUS

The more you learn about the competition, the more you learn about the industry, increasing your certainty, remembering…

Lower Uncertainty = Lower Risk

How to Analyze Peers

Just like you have done with the company's financials you are analyzing, you want to examine the competition and see how they have performed over time.

In Buckle's case, the peers were other apparel companies, especially those specializing in denim, given that BKE made most of its revenue.

I therefore analyzed companies such as Levi Strauss (LEVI), Express (EXPR), Abercrombie & Fitch (ANF), and several others. What stood out was that BKE had far superior margins to the competition yet had a much higher earnings yield. This is unusual, so I needed to find out why.

A deeper dive - including talking with management of BKE - revealed that BKE had strategically chosen slower growth, as evidenced by the low revenue growth, for better cost control, evident from the higher margins.

BKE therefore, stood out among its peers as it operated more efficiently, while slow revenue growth explained why it was the cheapest apparel business at the time. The high dividend made up for this however especially at the depressed price of $19.00 per share.

4. Who owns and manages the company

The next step in the analysis process is understanding who owns and operates the business.

Again, most of the information can be found in the 10K and the company's Annual Shareholder Meeting filing, known as the Proxy Statement. Here, you can see who the principal shareholders are, who runs the company and, most importantly, how management is rewarded or incentivized.

According to Munger, incentivization is everything, and it is our duty as investors to know the motivation of management. If a manager is paid a fat salary regardless of the job he has done, then there is little to motivate him other than making sure he keeps his job.

But suppose a manager's base salary is low and her bonus is linked to the company's long-term performance. In that case, she is motivated to act in the company's long-term interest and, therefore, our interest as shareholders.

In The Buckle's case, the company's largest shareholder is the founder of the business, while the CEO has been with the business since 1973 and owns a significant portion of shares.

This ownership structure is excellent news for shareholders because it is doubtful that the chairman will do anything to compromise shareholder value, as it will impact him more than anyone. The chairman also receives no compensation for heading up the company’s board of directors. It is, therefore, unlikely the dividend policy will change soon.

5. To Invest or Not

After all your hard work, it is time to decide: is this a business you want to own for the long term or not?

The time it takes from the start of the process varies depending on the company and the situation’s complexity. In BKE’s case, it was reasonably easy to decide after I saw the dividend yield and how sustainable it was, especially after I realized the chairman was incentivized to keep paying this high dividend for as long as possible.

Remember to be honest during this final step!

Just because you have invested 50+ hours in analyzing a business doesn’t mean you need to invest.

Whether or not you invest, remember that you have gained much more than monetary returns. During the process, you would have learned so much about the company and the industry, and that knowledge compounds and transfers to when you analyze your next apparel business.

Checklist For Fundamental Analysis of Stocks

1. Search for New Investments

• Utilize stock screening to rank companies based on fundamental metrics.

• Review fund letters from professional money managers for investment ideas.

• Analyze 13F filings to observe the buying and selling activities of institutional investors.

• Participate in investing forums to gather insights from other investors.

• Monitor insider buying activities disclosed through SEC Form 4 filings.

2. Company’s Economic History

• Obtain the company’s annual report or 10-K to understand its business model and history.

• Analyze revenue sources and major product lines to comprehend how the company generates income.

• Examine historical financial performance, including revenue growth, operating margins, cash flow yield, dividend yield, and return on capital.

• Look for years of strong and weak performance to learn more about potential risks

3. Competitive Analysis

• Identify key competitors in the industry and assess their financial performance and market positioning.

• Analyze industry dynamics to understand the overall market environment and potential challenges or opportunities.

• Compare your company’s performance with its peers to gauge its competitive advantages and weaknesses.

4. Ownership and Management

• Review the company’s major shareholders and their level of ownership and influence.

• Examine the background and tenure of key executives, including the CEO and Chairman

• Evaluate management incentives and compensation structures to assess alignment with shareholder interests.

• Consider the impact of management decisions on long-term shareholder value and corporate governance practices.

5. Investment Decision

• Synthesize all gathered information to make an informed investment decision.

How To Learn Basic Accounting

As we delve deeper into financial analysis this week, it’s essential to discuss the language of business - Accounting.

Whether you’re an entrepreneur or an investor, a solid grasp of accounting principles is indispensable. While you don’t need to become a certified accountant, a fundamental understanding is crucial for success in business and investing.

I’ve compiled a list of resources tailored to beginners to facilitate your journey. Remember, learning is a gradual process, and the beauty of investing lies in compounding both wealth and knowledge, so take your time and enjoy it!

Accounting Books, Videos and Online Courses

Books

• Accounting Made Simple by Mike Piper: Take away the technical jargon of accounting and learn the accountant equation, how to read and prepare financial statements and how to calculate and interpret important financial ratios.

• Accounting for Non-Accountants by Wayne Label: This easy-to-read book demystifies accounting fundamentals using a fictitious company as a learning aid. It covers essential topics such as balance sheets, income statements, and cash flow statements.

• The Little Book of Valuation by Aswath Damodaran: Authored by esteemed professor Aswath Damodaran from the Stern Business School at NYU, this book offers insights into valuing businesses, a critical skill for investors.

Online Courses

• AccountingCoach: Harold Averkamp, an experienced accountant, founded Accounting Coach LLC, offering free online courses from beginner accounting to more advanced concepts.  

•  Accounting Essentials by Imperial College London: If you want to follow a formal track, perhaps this six-week course is more your style. It provides learners a comprehensive understanding of accounting basics, including income statements, balance sheets, and cash flow statements. No prior accounting knowledge is required, only basic math skills.

Video Courses

• Accounting Stuff: If you prefer learning visually, you’ll like this YouTube channel, dedicated to helping beginners grasp accounting concepts through informative videos.

The list above is not exhaustive so if you have other recommendations I am sure the Lockstep community would love to know.

Happy Learning!

How can I manage risk when investing? Can risk be controlled by an investor? What are ways I can reduce risk in my investments? These are questions that might be at the back of your mind.

I want to share my perspective on risk, which, while not unique, diverges from conventional thinking and is, more importantly, NOT intuitive.

Understanding and Reducing Risk When Investing

What Risk Isn’t

In its purely theoretical form, risk is the volatility of a share price. The more a share price fluctuates, the riskier it is perceived to be.

I disagree with this concept!

Share price volatility is more a measure of emotional stimulus than risk – we become depressed and anxious when the share price moves significantly below our purchase price and exuberant when the share price rises above. But mood swings are not risk!

How I Perceive Risk

In investing, the risk is that we lose money; we lose money when we are forced to sell our investment at substantial losses.

Therefore, to better understand risk, we need to understand what it is we are trying to do so that we can reduce making big mistakes;

What is Investing Actually

In its essence, investing is laying out cash today with the expectation of getting more back sometime in the future. We are, therefore, occupied with trying to answer 3 fundamental questions:

1. How much cash will I get back?

2. When will I get it back?

3. How CERTAIN am I of getting it back?

The better I can answer these questions, the greater the probability of a successful outcome and the less RISK I have of losing money. But the opposite holds too in that:

LESS certainty = MORE risk

Intrinsic value: What is it?

To answer the questions above let’s work an example together:

We are considering purchasing a company, The Once-ler Company, which manufacturers Thneeds (borrowed from The Lorax 😉). We are fortunate to have a crystal ball to know that Thneeds will be in fashion for exactly 10 more years before no one buys one ever again. Furthermore, our crystal ball gives us perfect foresight regarding the company’s future cash generation:

Thanks to this foresight, we know that Once-ler will generate $1000 in cash over its remaining lifespan. However, as cash received tomorrow is worth less than cash in hand today, we discount these future cash flows back to their present value—let’s use a 5% discount rate for simplicity:

So we now know that Once-ler will produce $1000 in the future, equivalent to $803 in the bank today (based on our 5% discount assumption).

The $803 is the company’s intrinsic value and is what we are trying to calculate when we invest. If someone offered to sell you the business for $850, you would turn it down, knowing you would lose money, but if offered $750, you would happily buy it, knowing you were earning a $53 profit.

Intrinsic Value and the Real World

Unfortunately, in reality investing isn’t that simple. I do not know what the cash flow of The Once-ler Company will be. I don’t know how long it will remain in business. I don’t know how competent management is or what the competition will do. I have to, therefore, estimate what I believe intrinsic value to be based on certain assumptions.

Of course, the more assumptions I have to make, the more my uncertainty increases, and we know from above uncertainty = RISK.

Unfortunately, even if we do all our homework, there will still be much we don’t know.

So, how do I reduce risk?

Intrinsic Value is Not a Number but a Range

We can reduce our risk by increasing the expectations of the possible outcomes for intrinsic value.

Instead of trying to guess a single number and declare the Once-ler company is worth $803, we can look at our assumptions and apply best and worst-case scenarios to our estimates.

The best-case scenario is when we factor everything runs perfectly, and the company is worth $850. The worst case is the opposite, and Once-ler experiences nothing but headwinds, producing only $750 worth of cash in present-value terms. So, instead of saying the company is worth $803, we estimate it to be worth anything from $750 to $850.

But we can reduce risk further still.

Risk and the Margin of Safety

Let’s delve into the concept of the margin of safety, a term often encountered in investment discussions. While I’ve touched upon it briefly in a previous newsletter, let’s explore it more deeply here;

Returning to the Once-ler company - after all our hard work and analysis, we estimate it is worth between $750 and $850.

So, would I actually buy it for $750? Probably not, because what if my calculations are wrong (and they definitely will be no matter how good an analyst I am) and I have overstated the value? It might only be worth $700; I would have lost money.

But what happens if the market panics, for whatever reason, and someone is offering to sell me Once-ler for $500? I would now have a safety net if my calculations were wrong and the company only produced $700 or even $600 worth of cash.

The larger the safety net, the wider my Margin of Safety and the LOWER THE RISK.

(Companies can actually be offered at massively discounted prices; just look at when Meta Platforms (META) traded at under $100 per share because the market panicked .)

Risk and the Share Price

You might have noticed that in our discussion thus far, we have not mentioned the share price. That is because, if you agree with my concept of risk above, it has little to do with the company’s share price.

The share price is simply the price of the most recent transaction between the buyer and the seller of a share. It has nothing to do with what a company is worth – the seller believes the company is worth less, or they wouldn’t sell, and the buyer thinks it to be worth more – but just because they believe it doesn’t make it so.

But we know better and can take advantage of this!

We now know that a falling share price implies our Margin of Safety is increasing, and therefore our risk is REDUCING. Conversely, a rising share price means my risk is INCREASING because my margin of safety is diminishing.

Summary

My task as an investor is to figure out:

1. How much cash I expect to get back in the future,

2. When I expect to get it back, and

3. My level of confidence it will happen.  

I cannot accurately calculate how much cash I will get back, so I estimate a range of the intrinsic value using differing scenarios.

To provide an additional safety net, I invest when the share price is lower than that range.

Therefore:

• When the share price retreats, my margin of safety increases, so my willingness to buy more shares increases.

• When the share price appreciates, my margin of safety diminishes, and I become more inclined to sell.

Hopefully that gives you a better understand of risk, at least how I perceive it. And perhaps you even agree!

I want to introduce you to the well-regarded value investor, Mohnish Pabrai and his book “The Dhando Investor: The Low-Risk Value Method of High Returns”.

Mohnish’s Background

Mohnish Pabrai is a seasoned investor and the founder of Pabrai Investment Funds, which he started in 1999 after a career as a software engineer. Although I cannot find published returns, sources report his fund has returned over 20% per year.

While it is challenging to verify these returns, his fame as an investor and his proximity to Warren Buffett and his idol, the late Charlie Munger, suggest he knows what he is talking about.

Dhando Investing and Risk

While the book about Dhando investing covers several topics around value investing, what stood out for me, and in line with today’s Investing Chronicle, is Pabrai’s approach to risk:

This beautifully articulated phrase encapsulates the core principle of managing risk – make sure your downside is limited so that you don’t lose the shirt off your back if you are wrong. But if you are right, you can do very well for yourself.

You Won’t Always Be Right

Pabrai also clarifies that he doesn’t expect to be right all the time. In fact, he believes his success rate is only around 60%. If this seasoned pro only expects 6 out of 10 of his investments to go his way, then we shouldn’t expect to do much better.

But you don’t need to always be right, but it is so crucial that our downside is limited because, for the 40% or more we are wrong, we need to ensure our losses are limited such that we “don’t lose much”.

How do we do that?

Central to Pabrai’s philosophy is the concept of a margin of safety, which you are now acquainted with. His approach is to buy stocks at a significant discount to their intrinsic value, providing a buffer against potential losses. Sound familiar!

The good news is that you now know how to do that!

Conclusion

Whether you’re a seasoned investor or a novice seeking to build wealth, “The Dhandho Investor” is a great read. It presents the concepts of value investing in a very easy-to-understand format, leaving you with more confidence in your ability to be a successful investor.

He also has regular blog posts or perhaps you would prefer his interviews.

Several longstanding Lockstep Community members recently contacted me concerning Legacy Housing Corp (LEGH), a company that has been a part of my portfolio since its inception, following its disappointing fourth-quarter (Q4) 2023 results. Understandably, these members wanted to know if it was time to sell LEGH.

By addressing their concerns, I aim to provide a response that will benefit you as well by tackling one of the most challenging aspects of investing - Knowing when to sell a stock.

When to Sell a Stock for a Profit: A Legacy Housing Case Study

Company Description

Established in 2005, LEGH is the sixth-largest producer of manufactured homes in the United States. Specialising in the construction, sale, and financing of these homes, the company primarily operates in the southern United States, with over 50% of its sales originating from Texas, 12% from Georgia, and 9% from Louisiana.

Targeting customers with household incomes below $75,000 per year, representing over 50% of all US households, LEGH constructs homes in its three factories, sells them through independent retailers and company-owned outlets, and offers customised financing solutions.

How the Company Earns Its Money

LEGH generates revenue primarily from product sales (manufactured homes) and its financing business. As of Full Year (FY) 2023, 76% of its revenue stemmed from product sales, 20% from financing, and 4% from “other” sources.

LEGH’s revenue more than doubled from 2016 to 2022, meaning it has been growing at roughly 15% per year, which is not bad!

A Terrible Fourth Quarter (Q4)

In 2023, LEGH experienced a significant decline in revenue, down over -26% Year-on-Year (YoY), with Q4 2023 revenue dropping over -50% compared to Q4 2022. The poor Q4 results are due to 1) lower housing demand caused by higher interest rates and 2) a significant one-off gain in Q4 2022 due to a change in revenue recognition.

Consequently, the company’s share price fell from over $25 to under $20 per share, prompting concerns. I bought LEGH at $16.51 per share, and given the bad Q4 2023 results, is it time to sell the stock, secure my gains, and deem it a victory (albeit a minor one)?

When to Sell an Investment

I believe there are only three valid reasons to sell a stock:

1. Overvaluation: When the share price appreciates to a level where the company is significantly overvalued.

2. Opportunity Cost: When better investment opportunities are available elsewhere.

3. Change in Investment Thesis: When the original reason for investing no longer holds true.

Let’s have a look at each and see if any apply to LEGH:

1. Overvaluation

I was initially attracted to LEGH because it was significantly undervalued relative to its peers. Besides being a relatively small, unknown business, the company had issues with late filings of its financial reports, which the market punished by selling its shares down! After some digging, it was clear the late filings were due to non-material issues, and the market overreacted, providing an opportunity to invest.

Over time, management resolved the financial reporting issues. As a result, the share price appreciated, from my initial purchase price of $16.51 per share to a high of $26.50. Even with this significant gain in value, LEGH was still only worth 12x operating profit while profit had been growing.

Therefore, I should NOT sell because it is overvalued.

3. Opportunity Cost

Another reason for selling is that better investments are available than the one you are currently in.

For a while now, I have held almost 5% of my portfolio in cash, and with the indices at all-time highs, I am not overly confident that now is the time to look for new investments.

Therefore, I am NOT selling because I need the money to invest in better opportunities elsewhere.

3. Change in Investment Thesis

This brings us to the final reason for selling - Perhaps the investment thesis is no longer valid.

Why Do You Need an Investment Thesis?

For those acquainted with my investment approach, I emphasise the importance of having a clear reason for investing before purchasing shares. This planning becomes crucial when faced with inevitable setbacks, enabling you to steer clear of emotionally driven decisions – a pitfall in investing.

Each investment carries its unique thesis, and while LEGH’s financial reporting issues presented an opportunity, they were not the sole reason for my investment.

LEGH’s Investment Thesis – The US Housing Deficit

The United States currently grapples with a significant housing shortage.

Since the 2008 housing crisis, the pace of new home construction has lagged far behind the demand. Estimates suggest a deficit ranging from 1.5 to 6 million homes nationwide, depending on the source. Moreover, Texas - LEGH’s primary source of income - has one of the most significant deficits in the country.

Data Source: FRED Economic Data

As housing prices continue to increase due to supply constraints, more households are priced out of traditional housing and are turning to manufactured homes like LEGH’s. Consequently, companies like LEGH should benefit from a multi-year tailwind driven by sustained demand for homes and manufactured housing in its region.

Is the Thesis Broken?

Despite the disappointing Q4 2023 results, growth doesn’t happen in a straight line, and there will always be obstacles to overcome, such as the current high-interest rate environment. But thanks to my investment thesis, I do not have to act on impulse. Instead, I stepped back, removed emotions from the equation, and comprehensively reassessed my investment.

After meticulously examining the annual report, thoroughly analysing competitors’ recent performances and even talking with the company’s CEO just last week, one thing has become abundantly clear – there’s no need to panic.

The US housing shortage persists, and people will always want homes. Interest rates will come down, and when they do, LEGH should be well-positioned to capitalise on that demand pickup.

My Next Move

Experiencing a decline in the value of your investment is always painful, but such decreases can present opportunities. After doing my homework, I feel confident in my work and believe LEGH is a high-quality company in an industry with a significant tailwind behind it.

Therefore, instead of selling, I am looking to increase my investment in LEGH and will likely buy more shares if the share price retreats to $20 per share or below.

Interestingly, I’m not alone in this sentiment, as directors, and per my conversation with the CEO last week, the company itself is also buying shares.

Summary

Investing is inherently emotional because it involves our money!

Buying is easy, but as soon as we do, our emotions take over, making selling one of the more challenging aspects of investing. It is critical to have a game plan for selling to minimise reacting from a place of emotion and instead act with logical reasoning.

My approach to selling involves the following:

1. Sell when a company becomes significantly overvalued.

2. Sell when better investment opportunities are available.

   OR

3. Sell when the original investment thesis is no longer valid.

Last week, Daniel Kahneman, a luminary whose profound contributions to behavioural economics earned him the 2002 Nobel Memorial Prize in Economic Sciences, passed away. Among his many works, “Thinking, Fast and Slow” is an invaluable resource for enhancing critical thinking skills.

Although not the easiest to read, it’s a book I hold in high regard, with the conviction that it can elevate anyone’s cognitive prowess.

Given this week’s discussion on the best time to sell an investment, it’s fitting to delve into one of Kahneman’s and his colleagues, Amos Tversky’s notable theories: Loss Aversion.

Loss Aversion – Pain is more acute than pleasure

Individuals experience the sting of losses more intensely than the pleasure derived from an equivalent gain. According to Kahneman and Tversky, the pain of a loss can be twice as potent as the joy from a comparable gain.

This phenomenon helps explain our actions when investing. Investors, including myself, tend to hold onto losing positions much longer than we know we should because of the fear of experiencing a painful loss. In contrast, we often sell out of our winners to lock in gains to avoid future losses.

Our discussion on Legacy Housing in today’s Investing Chronicles is a fantastic real-world example. LEGH’s share price has increased from where I bought it, and because of a bump in the road and the share price retreating, the instinct is to sell, lock in the gains remaining, and call it a victory in fear of losing more.

This is the wrong way to act!

Instead of a knee-jerk reaction, we need to step back, analyse the situation and make better decisions based on research rather than emotion. At the risk of sounding like a broken record, hopefully, it is clearer why having an investment thesis is so important.

Closing Thought

Unfortunately, biases cannot be totally overcome, but we can arm ourselves with tools to help reduce their impact, and knowing they exist is the first step. “Thinking, Fast and Slow” introduces us to our behavioural biases and is a step toward becoming better investors.

How to Find New Stocks to Invest In

Finding the right investment opportunities can be one of the most challenging aspects of investing, but it is fun (at least I think it is 😉).

Allow me to share a few options that might help improve your treasure hunting:

Stock Screening

My preferred method is to use a stock screener, which allows me to rank companies based on predefined criteria such as valuation, quality, and growth metrics. You also get to define your stock universe; perhaps you are looking for companies listed only in the US or of a specific size—the screening options are numerous.

There are several excellent stock screeners available online, including:

• Finviz

• Yahoo Finance

• TradingView

The disadvantage is that good companies don’t always appear on the screener, so you need other tools in your arsenal when looking for your next investment. We’ll cover those options below.

Fund Letters

Professional firms often publish letters to their clients discussing their performance and recent investment decisions. These letters provide insights into potential new investments and the rationale behind them. Seeking Alpha is an excellent source for fund letters.

It is critical to be aware that reading someone else’s investment thesis on a specific stock, especially the opinion of a professional money manager, will sway your thinking, and when it comes to investing, it is critical to have your own convictions.

13F Filings

Institutional investment managers with over $100 million of assets under managers and significant US holdings must file quarterly reports disclosing their US equity holdings. These 13F filings can be valuable sources for finding new investments.

Platforms like WhaleWisdom provide detailed analyses of these reports, summarising when managers buy and sell positions for their portfolios.

Investing Forums

Engaging with investment forums allows individuals to exchange ideas, present investment theses, and receive constructive feedback regarding their research.

Value Investors Club is a fantastic forum for value investors; however, access to the latest research is for members only, and you must submit a piece of research to qualify for membership. The demand for the club is very high, and your research needs to be exceptional. The advantage of being a member is that the quality of members is guaranteed to be of the highest standard.   

Seeking Alpha is another fantastic forum with a community aspect, allowing you to follow investors you like. The difficulty with this platform is that not all research is created equal, and you need to be able to sieve through the good and the bad to find the gems.

Insider Buying

No one knows more about a business than the people who run it, so we should sit up and notice when we see directors or management buying shares in their own company. As the saying goes, management has many reasons to sell, but there is only one reason to buy: they believe the company is undervalued.

Managers, directors and large shareholders must disclose when they buy or sell shares by filing a Form 4 with the SEC. Platforms like Finviz’s Insider Trading offer great summaries in this regard.

Word of Caution

While the resources mentioned above are great tools for finding potential ideas, remember they are for idea generation only. They are just the starting point of the investment process.

You are still responsible for doing the homework and detailed research to determine whether it is a good investment. Remember, investing without a well-defined thesis can lead to uncertainty when faced with adverse outcomes.

Happy hunting!

The Investing Chronicle above explores techniques for discovering new investment opportunities. Among these methods, my favourite is the screening process, and due to my love for mathematics, I prefer to conduct my own screenings.

One particularly powerful screening technique is Joel Greenblatt’s Magic Formula. In his book, “The Little Book That Beats the Market,” Greenblatt argues that amateur investors can outperform the market by investing in a portfolio of stocks selected using his “Magic Formula”, which ranks companies based on quality and value metrics.

Let’s delve into the process:

Warning: Some maths is involved, but it’s nothing you can’t handle

The Magic Formula

1. Define Your Universe of Stocks

Begin by defining the universe of stocks from which you’ll construct your portfolio. Currently, my universe comprises all US-listed companies, but you can define your own. You may choose to invest only in companies with a minimum market cap or stocks that trade a minimum daily volume, or perhaps you prefer UK-listed companies. The choice is yours.

Below I walk you through a simple example of how how the Magic Formula ranking process works using all the consituents of the S&P 500. For each company I have populated the necessary metrics and rank them showing you the top 5 for each step below.

2. Rank According to Quality

Next, rank each business in your universe based on quality. Greenblatt’s formula uses a metric called Return on Capital (ROC), which measures the amount a company earns per dollar it invests. A higher ROC indicates a stronger incentive for the company to reinvest back into the business.

ROC is calculated as follows:

ROC = EBIT / (Fixed Assets + Net Working Capital)

Once you have each company’s ROC, rank them from highest to lowest as per the example below:

The table above represents the 5 companies in the S&P 500 with the highest ROC. It is for illustrative purposes only, and data should not be relied upon

3. Measure for Value

Greenblatt advocates using the Earnings Yield as a measure of value. This metric reflects a company’s earnings from an operating perspective and is less prone to manipulation than net income. Think of earnings yield as similar to an interest rate, and is calculated as follows:

Earnings Yield = EBIT / Enterprise Value

Once you have each company’s yield, rank the companies from highest to lowest based on this metric.

The table above represents the 5 companies in the S&P 500 with the highest Earnings Yield. It is for illustrative purposes only, and data should not be relied upon

4. Building the Portfolio

Once you have completed the initial rankings, it’s time to construct your portfolio. Combine the ROC and Earnings Yield rankings to create a Total Ranking. Order the Total Ranking from lowest to highest

The next step is to purchase the 20 - 30 companies with the LOWEST  Total Ranking and hold them for exactly one year in equal proportions. Based on our example, the portfolio has the following 5 companies:

The table above represents the 5 companies in the S&P 500 with the highest Total Ranking. It is for illustrative purposes only, and data should not be relied upon

At the end of the year, you repeat the process above and adjust your portfolio accordingly. It’s that simple.

Of course, there will be years of underperformance, but consistency is key. If followed diligently, Greenblatt’s evidence suggests you will outperform the relevant benchmark, e.g. if you are investing in US stocks, you will outperform the S&P 500 over the long term.

Word of Warning

Data quality is crucial. The better the quality of the data used to calculate your metrics, the better the outcome of your performance. I prefer using the company’s financial statements directly, but some service providers summarise the data for you. Greenblatt’s Magic Formula Investing website does all the work for you, making the process even easier.

NB! READ The Book Before Starting

If you’re interested in screening for new investments, I recommend Joel Greenblatt’s Magic Formula. If you choose to follow this method, I strongly suggest reading his book, which provides a comprehensive overview of the abovementioned technique.

The stock market has experienced a strong rally of late, with the S&P 500 up over 30% in the previous 12 months and the Nasdaq Composite doing even better, up over 40% over the same period.

Naturally, this strong performance has caused people to be concerned that the stock market is overvalued and is due for a correction. A few community members are concerned the market might even be in a bubble, especially with the strong performance of the technology sector exposed to artificial intelligence.

Market Correction or Crash?

Before addressing a few of our members’ concerns about where the market might be heading, let’s first define a market bubble.

What is a Market Bubble?

A market bubble typically manifests as a rapid escalation in asset prices, driven by irrational behaviour, leading to assets being traded well above their intrinsic value. This bubble inevitably bursts when investors realise that valuations significantly exceed actual worth, triggering a swift sell-off or crash.

The Dot-com bubble is a fantastic example as anything to do with the internet was in vogue and traded at crazy valuations. The Nasdaq Composite rose 5x over a few years, reaching 5,048 on the 10^th of March 2000, only to come tumbling down 78% to 1,114 by October 2002.

Are we in a bubble now?

To answer that question, we need to look closely at valuations, and the most common and straightforward metric used is the Price to Earnings Ratio (P/E), which measures a company’s price relative to its earnings.

Since we are looking at the market as a whole, we will examine the S&P 500 price relative to the earnings of the 500 largest listed US companies that make up the index.

Is The US Stock Market Overvalued?

The S&P 500 has a current P/E of approximately 28.0. Compare this to the 50 year average P/E for the index of 20.5, and it most certainly does seem expensive; however, it doesn’t appear to be a bubble when compared to previous examples:

That said, it doesn’t mean prices cannot go down from here, especially if we look at the P/E of the largest companies making up the S&P 500.

The 6 largest companies on the S&P 500 have an average P/E of 43.1, which is scary compared to the index’s average valuation. It also means that the remaining 494 companies in the index have a P/E of 25.8, still above the average. Therefore, I can argue that the market is expensive, but it is difficult to suggest the market is in a bubble and due for a crash.

Navigating the Current Landscape

Moving forward, I am have two strategic options if I want to invest today:

1. Buy the Index for the long term:

As per last week’s discussion, I can always buy the S&P 500 index and hold it for the long term. If we believe in the reversion to the mean, then the market might go down in the near term, but over the long term, I continue to expect to earn around 11% per annum.

2. Buy QUALITY businesses with P/E values below the 50-year average:

Alternatively, I can invest in businesses with P/E ratios below the 50-year average of 20.5. However, I must exercise caution and conduct thorough due diligence to ensure the selected companies are indeed high-quality investments and not “undervalued” for a reason.

This week, I feel compelled to acquaint those unfamiliar with the cornerstone figure of value investing, Benjamin Graham. Regarded as the “Father” of this discipline, his seminal works, Security Analysis and The Intelligent Investor, serve as indispensable guides for investors. Graham’s principles laid the groundwork for the legends of Warren Buffett and Charlie Munger and continue to inspire legions of aspiring investors.

The Teachings of Benjamin Graham

Graham imparted numerous invaluable lessons, but today, I wish to highlight three that I consider pivotal for enhancing one’s investment acumen:

1.      Invest in the company, not the share price

When we purchase just one stock of a listed company, it is no different from buying the entire business. That one share gives us ownership rights of the company, including a proportionate share of the company’s profits. So we are NOT buying a share but rather a company.

It may seem like I am stating the obvious. Yet, even today, people trade stocks because of their volatility rather than the underlying fundamentals of that business, and even “investors” quickly overlook the basics of a company because they don’t want to miss out on the latest trend.

While there are stories of success trading stock and people retiring early because of  “the next big thing,” there are far more stories of going broke due to the same strategies. Unfortunately, those stories are seldom in the media, posted on social media or spoken about over the dinner table.

If we want to be successful investors, we must understand the company we are buying, how it generates revenue, the costs to run it, and the risks involved. The more we know, the more confident we will be when we invest, and although that doesn’t guarantee success, it dramatically improves it.

2.      Invest at less than it is worth.

Graham, being an investor during the Great Depression, was always acutely aware of the risks of investing in the stock market and how easily fortunes could be lost. Therefore, he believed in investing with a Margin of Safety, which means buying shares in a company at a discount to its true worth or intrinsic value.

In Investing Chronicles above, we discussed the historical average P/E of the S&P 500, which is around 20.5, meaning that, on average, the price of the S&P 500 is roughly 20x the combined earnings of its constituents. If we assume this is the fair value of the index, then whenever the index is trading below 20x earnings, we have a margin of safety. The lower the P/E, the greater the margin of safety.   

Similarly, for a company, once we have analysed the business and its economic drivers, we should be in a decent position to derive an estimate of its intrinsic value. If we believe the company to be worth $100 million and the market currently values it at $150 million, why would we purchase shares?

However, the opportunity is evident if that company has a current value (market cap) of $75 million. More importantly, buying it at $75 million provides us with a safety net because our calculations might be off (almost guaranteed they are), and the company’s actual value could be $80 million. Of course, the actual value could be $120 million, but you get the point!  

3. Let the Market Come to You

Besides “ Margin of Safety”, Graham is also famous for coining the term “Mr Market”, referring to the bipolar nature of the stock market.

In the stock exchange, as with all things involving human beings, emotions get involved, and one could argue that when money is involved, we get highly emotional. The higher the emotional charge, the higher the capacity to act irrationally.

Euphoria will likely occur when share prices appreciate and money is made. Market participants throw caution to the wind during these times, feeling nothing can go wrong. As a result, investors overpay for assets. We can see this currently, at least in my opinion, as certain tech stocks are valued as though the stars have aligned

Of course, the opposite is true too, when fear takes grip. During these times, irrational, pessimistic market participants convince themselves that they will lose all their money and sell while running for the hills, screaming, “The sky is falling”. During these times, valuations can plummet to illogical lows.

Our goal is to remove our emotions when investing.

Investing in the long term is a fantastic strategy because it allows us to ignore short-term market noise and fluctuations, especially if we understand what we have bought. We are in a hugely advantageous position to take advantage of Mr Market, buying when fear is at its peak and selling to the overzealous buyer.

Summary

So be more like the Father of Investing:

1. Know what you are buying,

2. Know what it is worth, and

3. Only buy it when you can get a substantial discount.

If you can master the above, you are well on your way to being better than most.