it’s hard to know everything about everything

In a world with complex industries and worldwide markets, it’s impossible, as a practical matter, to know everything about everything. My experience is that being a mile wide and an inch deep is a recipe for disaster. It’s much better to know a lot–at the very least, more than the average institutional investor–about a small number of things.

So a big question for all of us is to figure out where we think we are likely to have an edge over the rest of the market. For me it’s IT and Consumer Discretionary. For what it’s worth, I also think a systemic weakness of professional investors is that as the latter become more successful, many tend to be seduced by their affluence. They become experts on luxury goods but lose any ability they may have had to distinguish among Home Depot, Lowe’s and Tractor Supply.

don’t be too quick to run the numbers

Industry structure can sometimes be more important than overall growth rates.

–in retail, for example, there are many segments to consider. From high average purchases to low, my list is:

luxury goods–heavily dependent on China

department stores (ugh!}

specialty retail

Target/Walmart/Amazon

supermarkets/convenience stores

dollar stores

local, non publicly-traded retail.

A key feature of retail is that consumers shift down from the top of this list during recessions and shift up during recoveries. So holding specialty retail during a downturn is not the best move, nor is loading up on dollar stores during recovery–unless you have supreme faith in spreadsheets that say the opposite.

relative market share

This is important to consider in almost any distinct market segment–meaning where competition is pretty much head-to-head. A segment with three main rivals, each with a 30% market share, is likely to be much more strongly price competitive than one that’s 40%, 25%, 10%, 10%, 10%. Personally, I’d either be looking for one of the plucky 10%s with an innovative market strategy or to invest someplace else.

strength of company management

This is a hard thing to figure out, but it can be very important.

Many years ago, I met a fellow refuge from the academic world, a historian with a PhD who was working for a niche consulting company. His firm wrote corporate histories. The idea was that founders are typically revolutionary change agents, but as companies mature, they can easily turn into collections of inward-looking bureaucratic bean counters. A company history might be a way to shake things up and encourage calculated risk-taking.

GM, for example, once dominated the domestic auto market with a 50% share. Like any US-based car maker, it benefitted from decades of government protection against better-made foreign offering. Despite all this, GM still ended up in bankruptcy during the financial crisis, and is now a business school case of corporate dysfunction.

I’ve sometimes found it enlightening to call the investor relations department at a company, explain that I’m a shareholder and would like to ask some questions. Companies with a really terrible corporate culture–I’m thinking specifically of Intel pre-Gelsinger and Disney, pre-Iger–have told me that they don’t speak to shareholders and that I should essentially purchase company information from a stockbroker.

I firmly believe that attitudes like this come straight from the top of the company. Employees dress like the boss, talk like the boss and act like the boss. And I think that companies that have forgotten about their owners present a substantial investment risk.

Another example:

Through the 19990s, I owned Microsoft stock in the portfolios I managed (all my own money was in them, too). It had been a spectacular performer. In early 2000, I went to a MSFT analyst meeting in Seattle as I was trying to figure out whether to sell the stock, which, trading at about $50 a share, was at a very hefty 70x eps. Two relatively small things struck me. Someone asked Bill Gates a real softball question–what did he think was the most important thing he had done at MSFT (as the CEO office was transitioning to Steve Balmer). Gates replied that it was that he had created jobs for his friends. Questioned about MSFT’s dramatic slowdown in eps growth under his watch, Balmer said that the 5% growth the company was experiencing was a significant positive achievement, implying he–and we–shouldn’t expect more.

It seemed to me both that neither man felt any sense of duty to the owners of the company and, more than that, neither seemed to even have the faintest idea that shareholders should enter into their thinking at all. And, of course, 70x for 5% eps growth was a joke. I sold the stock immediately.

I bought it back in 2014 at around $40, as Balmer was finally being ousted. MSFT which was then regarded as a value stock, had been under pressure from corporate raiders to do so for several years. The stock, including reinvested dividends, is up about 16x since then, in a market that’s up around 4x.

I spent about eight years early in my Wall Street career during which a big part of my job was analyzing mining companies …including iron ore, but not steel-making, which was the job of the guy in the office just down the hall.

But that was also a long time ago. And I ultimately came to the conclusion that although this area had some Wild West appeal, I would be better off making a career in sectors like IT or the consumer, which had broader scope and were more important in a world that had plastics in it. For what it’s worth, though, here are what I see as the key issues for an analyst:

–centers of commodity trading, like Chicago, are significant sources of information about metals. In the eternal struggle between jocks and nerds, such places are hotbeds of short-term-thinking jock-ism. Still…

–government agencies take a nerdier view and may also have pertinent global data

—in some developing countries, mines are state-owned and are run to maintain national employment rather than to make profits. If such mines are significant for a given metal–think of copper, for example–overall prices may not be as high as one might think

–in my day, mining companies were very secretive about the extent of their reserves. I don’t see why that should have changed. The worries are that if governments understood the extent of the company’s holdings, they would increase taxes. Or a larger competitor might take the company over and fire all the executives.

Say Company A is mining an orebody that geologists say is three miles long. The company has opened a mine that targets the first half-mile. Once that’s up and running, management clearly knows the profit potential there. It may also have done exploratory drilling over the next half mile and therefore have a very good guess about that area’s potential. Experienced geologists say the other two miles are most likely at least that good. Arguably, the company has no obligation to disclose to shareholders either the drilling results or its geologists’ analysis.

In contrast, Company B’s similar orebody is a half mile and nothing more. People who work in the industry may have some idea of the difference, but it’s much harder for you and me.

Two consequences: there’s probably more total supply of the metals in Company A’s mine than more people realize; and for you and me there’s a significant roll-of-the-dice factor in deciding whether to hold A or B.

–grade management. Any mining company focused solely on profits (meaning not a state-owned company with different objectives) will plan to extract the highest amount of valuable stuff from a given mine over its lifetime. This means that as prices rise, it shifts to mining lower-grade ore and reverses the process if they start to fall. This is the optimal strategy for miners, but arguably causes spot prices of metals to be more volatile than they might be otherwise.

–byproducts. A base-metals mine, say a copper mine, can easily have ore that contains (usually, small) amounts of gold or silver. These are generally not regarded as a source of profits but as a reduction in the cost of mining the primary metal. Of today’s hot EV-related metals, cobalt occurs as a byproduct, but not lithium.

A short while ago, I got an email from my friend Matt, with general questions about stock market investing. I figured I’d answer him with a series of posts. This is the first.

To be clear at the outset, I’m a growth stock investor. This is one of the two main schools of thought (the other being value) guiding professional investors in the US. The mindset for me is to be more concerned about possible upside, with less worry about downside protection. In contrast, the more important thing for my value counterparts is protecting the downside. So we tend to work in different parts of the market.

I got my first job, a lucky accident, at Value Line in New York in 1978. The essence of the “value line” on the company’s stock charts (which led to the name of the firm) was the thought, back in 1931, that price/cash flow is a better indicator of a stock’s worth than price/earnings. What brought the company real fame wasn’t this, however, but instead the computer ranking system devised by Sam Eisenstadt in the 1960s. His stock picks trounced the market returns year after year for well over a decade, to the chagrin of academics whose (wacky) efficient market theories maintained this was impossible. Sam’s basic idea was GARP–growth at a reasonable price–with “reasonable” being an amalgam of the relative standing of a given stock’s current earnings vs. its history plus a comparison of where this position stands vs. the positioning of the 1500 or so other stocks in the VL universe. The system gradually lost its edge by the 1980s, though, as (among other things) the price of computing power plunged, spawning a host of imitators.

The people who trained me as an analyst were almost all value investors of one type or another. I spent the six years after I left in 1984 working in Pacific Basin markets, where the cheapest stocks were also the fastest growing. By the time I joined a domestic deep value house in 1990 I realized I was no longer a value/GARP investor. I’d become a growth advocate. Still, I worked with, and learned from, value colleagues for the next ten, very interesting, years. I ended my working career with six years in a heavily tech-oriented growth shop.

All this is to say that while I’m not a value investor, I do know something about value techniques, and have been able to watch, and swap ideas with, value managers of various stripes from the inside for 16+ years..

value investing

The essence of growth investing is to locate companies whose future earnings you think will be higher than the market has factored into today’s price. The best case is when the market also mistakenly judges that any period of superior earnings performance will be much shorter than will end up being the case.

Value investing, as I see it, is about finding companies that are rich in potential but poor in current operating performance. They may, say, be in a growing industry, or have lots of cash, or have brand names, or software, or valuable intellectual property, or prime store locations, or maybe the company HQ is on top of a gigantic soon-to-be-developed gold mine …but are not making anywhere close to the money they should be.

Benjamin Graham, the father of securities analysis as well as of modern value investing, began teaching and writing during the Great Depression of the 1930s. One of his early formulations was to look for firms where, if they were to turn all their working capital into cash and repay all long-term debt, the money that would be left over would be greater than the total market value of the company’s stock. If so, you essentially get the longer-term company operations for free. Maybe business will get better all by itself, but even in the worst situation–where someone new gains control in order to shut down operations and liquidate–anyone who buys stock now should turn a profit. It’s hard to see the stock going down. In addition, the worst may not happen. The business might revive, with or without the help of newcomers, creating a bonanza for current shareholders.

There were a lot of these back then, while the world economy was flat on its back, so there was no reason to take the risk of doing anything else.

Since then, other than for a short time in 1974, or maybe in 2008 (?), you’d be hard-pressed to find anything to buy if you followed this ultra-stringent rule. But if nothing else investors are pragmatists. So that early Graham rule is long since out the window.

Today’s value investors retain the general cheaper-than-dirt Graham attitude of buying assets they perceive as deeply cheap, though, and they tend to fall into two camps:

–investors who won’t buy until they see a catalyst for change in an underperforming company and

–“deep” value investors who are willing to commit before there’s any evidence of change to come.

In the latter case, the value buyer argues that sooner or later change must come to an underperforming firm, so long as it has revenues. Either the board of directors will throw out the old, bungling, management or a third party will launch a hostile takeover and do the work the board should have been doing, heaving them out along with the CEO. This gets you in at an ultra-low price.

Two worries with the before approach: unless your clients understand what you’re doing and have deep faith, you risk being fired yourself before your stocks begin to pay off; and the technique may not travel well outside the US. Two decades+ of heartbreak by foreigners dabbling in Japan is probably the prime instance of this.

example

Singer, the sewing machine people, was one of the first companies I was assigned to cover at Value Line. It was a train wreck. Demand for home sewing machines in the US peaked shortly after Benjamin Graham got out of college and had been in secular decline since. There was reasonable demand in emerging markets, but even there Singer was bleeding market share to more advanced, reliable and less expensive machines made in Asia. The stock price at the time was $7.

Overall, the company was cash flow positive but unprofitable. In the plus side, it had accumulated tax losses worth about $25 a share if they could be used all at once (which they couldn’t). Singer was also the world’s chief maker of aircraft pilot training machines (also used in horrible virtual rollercoaster rides in amusement parks). It made power tools and had an assortment of other manufacturing subs. It owned a lot of real estate, as well. And it had just replaced its CEO.

I was too dumb at the time to realize what was about to happen. But the new CEO began to reorganize, to cut costs–like closing the sewing machine plant in New Jersey and relocating to Southeast Asia–and to sell off businesses that couldn’t scale. Within two years or so the stock was around $50.

If you want a counterexample to the turnaround idea, look at GM. It had something like half the US auto market a generation ago but ended up in bankruptcy in 2008 despite continuous government protection against foreign competition. It trades at about 5x earnings.

Every investor should have a strategy. It may be very simple, like don’t do crazy stuff. Or it could be to hold index funds, accept the market return and focus all your physical and intellectual efforts on excelling at something else.

Most brokerage houses, financial publications and investment managers have people whose job title is strategist and do this full-time. Most often, in my experience, strategists are not investment stars. Rather, they have either never managed investment portfolios at all, or haven’t been particularly good at doing so. They’re part of a firm’s sales effort. They visit clients to explain how their firm is constructing its portfolios and why.

I’m writing this today because I’ve just read one of the oddest strategy pieces I can ever recall seeing. It came from a big brokerage firm. Its conclusion was that the stock market will continue to rise over the next year. But the market will be led by Utilities, Consumer Staples, Healthcare and other defensive market sectors–which typically outperform only in down markets.

The weird part is that there was no explanation of this paradoxical forecast.

Essentially, it calls for a bull market that rises without help from big, typically up-market outperforming, sectors like Consumer Discretionary or Tech. The idea may be that last year’s stars will underperform as the market rotates, based on valuation, to last year’s losers. But the situation is more complicated than this. The forecast would seem to imply that last year contained little bounceback from the pummeling dealt to up-market sectors in 2022–or, put a different way, that the beating IT and Consumer Discretionary took when they were the two worst sectors of 2022 didn’t make them undervalued: it just restored fair value post-pandemic.

Maybe so, but not something I’d take for granted.

This is about liquidity risk. It may not be a practical concern for you and me as individual investors, unless we either dabble in ultra-small cap stocks or in mutual funds/ETFs that do so and where we and the fund end up holding significant chunks of a given stock’s float (the shares available for public trading). But it is a risk for institutions.

Early in my career, I managed a portfolio of Asia ex Japan stocks, a time when Australia was the largest component . In fact, the Kuwaiti Investment Office and I were the two biggest foreigners in the Australian market back then. After I ‘d been doing this for a bit over a year, I got an offer to manage a global equity portfolio for an obscure mutual fund complex whose global fund had a woeful record under a just-fired manager. My boss had begun to tinker with my Australian holdings after liquid lunches with Australian brokers, adding clunkers like “the Apple of Sweden,” which I would end up taking the blame for. So I left.

When I arrived at my new home, I looked more carefully at the portfolio I’d inherited–and found a gigantic area of risk that I just haden’t understood. The portfolio, which was having heavy redemptions, was chock full of illiquid stocks. The worst was Ampol America Israel, a subsidiary of Bank Hapoalim. As a company, Ampol AI was a gigantic mess. Worse for me, though, was the size of my position vs. trading volume. Assuming I could be 10% of the daily trade without anyone realizing that the largest US holder (i.e., my fund) was beginning to sell, it would be 27 years before I’d gotten rid of the last shares. Yes, there are normally things you can do as an institutional investor to disguise your intentions, but not a minnow like I was. I could have kept the secret for maybe a week before someone would begin to short the stock.

Not a pretty picture. Luckily for my shareholders, and for me, a corporate raider launched a takeover campaign, during which Bank Hapoalim bought my stock.

The first year was awful. The following five were just the opposite, though.

My point: the illiquid stocks were all close to zero volatility even though they were extremely risky.