The checklist will help you improve sell decisions. Knowing when to sell an investment is one of the most difficult decisions you have to make. Most sell decisions are based on judgment, feel, or instinct. The checklist helps you learn when to sell by helping you identify when the fundamentals of a business, such as the quality of the business or management team, begin to change.
How This Book Is Organized
The three most common investing mistakes relate to the price you pay, the management team you essentially join when you invest in a company, and your failure to understand the future economics of the business you’re considering investing in. The questions in this book can help you minimize these mistakes by helping you gain a deeper understanding of how a business operates:
Chapter 1 outlines a search strategy that will improve your odds of finding investment ideas that are worth researching further.
Chapter 2 helps you understand the basics of a business: What it does, how it earns money, how it evolved over time, and in what geographic locations it earns its money.
Chapter 3 demonstrates the importance of understanding the business from the customer’s perspective rather than your own. These insights will help you learn how important a business is to the customers it serves.
Chapter 4 helps you evaluate the strengths and weaknesses of a business. These are the questions that will help you evaluate whether or not a business has a sustainable competitive advantage, the competitive landscape, and the industry it operates in.
Chapter 5 helps you understand the operational and financial health of a business. You’ll look at key risks facing the business, how inflation affects it, and whether its balance sheet is weak or strong.
Chapter 6 looks at the distribution of earnings (cash flow) of a business. You’ll learn how to assess whether the company’s accounting practices are conservative or liberal (so you can avoid a company like, for example, the now-defunct Enron), the type of revenue it generates, whether the company makes money consistently or in cycles, and whether or not it’s resistant to recessions.
Chapter 7 is the first of three chapters that show you how to understand the quality of the management team. You’ll look at what type of manager they are, how they rose to lead the business, how they are compensated, and other background information.
Chapter 8 helps you gain insight into the competence of a company’s senior management. You’ll look at how they handle daily operations as well as long-term strategy, how they treat employees, and how they think about costs.
Chapter 9 helps you assess the management of a company by looking at their positive—and negative—traits: How they think, whether they’re self-promoting, and other critical factors. Remember, when you buy stock in a company, you’re essentially going into business with the managers who run that company, so you want to know as much about them as you can!
Chapter 10 demonstrates how you can evaluate the future growth opportunities of a business. You’ll look at whether it’s growing organically or by merging with or acquiring other companies, whether historical growth has been profitable, and how quickly it’s growing and whether management is growing in a disciplined way.
Finally, Chapter 11 looks specifically at mergers and acquisitions, to determine whether those completed in the past have been successful and how management makes the decision to merge with or acquire another company.
Each chapter offers countless examples of businesses I’ve researched, considered investing in, actually invested in, or decided not to invest in. These examples tell you in detail how my checklist helped me make investment decisions, and they’ll show you how you can make better investment decisions for your own portfolio. In addition, each chapter ends with “Key Points to Keep in Mind,” so you can zero in on the critical factors in each set of questions.
Now, let’s get started by learning how to generate investment ideas!
Acknowledgments
This book would not have been written without the encouragement and help of Judd Kahn and Bill Falloon who championed this book from the earliest proposal. No one deserves more thanks than my partner Ann Webb. Her willingness to make everything she touches a success is forever appreciated. Ruth Mills simplified the book-writing process for me and I can’t imagine finishing this book without her. Dr. Sandy Leeds was a true devil’s advocate. Those who have Sandy in their corner, both students and friends, are very fortunate. My friend Jeff “Falcon” Sokol helped ground the book and at the earliest stages attempted to convince me not to endeavor in this project. As such, all critics need to talk to Jeff about improving his powers of persuasion. I want to thank my mentor and intellectual coach John “Chico” Newman who always provides practical advice.
I would also like to thank the following for their contributions to the book: Bob Aylward, Ciccio Azzolini, Ron Baron, Peter Bevelin, Dr. Paul Bobrowski, Jean-Philippe Bouchard, Dr. John Delaney, Pat Dorsey, Matt Dreith, Ryan Floyd, Meg Freeborn, Ben Gaddis, Francesco Gagliardi, Dave and Sherry Gold, Bob Graham, Todd Green, David Hampton, Norman Hecht, Casey Hoffman, K.K., Paul Larson, Brad Leonard, Steve Lister, Chris Lozano, John Mackey, Denise Mayorga, Bob Miles, Vincent Nordhaus, Francois Rochon, Robert Silberman, Paul Sonkin, Jim Sud, Seng Hock Tan, Lee Valkenaar, and Matthew Weiss.
On a personal note, a heartfelt thank you to the most important people in my life. My parents have never wavered in their support of my ventures. Their patience allowed me to find my own path. Most of all I thank my wife for her steadfast love, support, and guidance. And I want to give a special dedication to my beautiful girls who have forever changed my life in the most wonderful way.
CHAPTER 1
How to Generate Investment Ideas
There are many ways you can generate investment ideas, some qualitative, some quantitative. Quantitative methods include looking at specific financial or operating metrics, whereas qualitative methods rely on more subjective characteristics, such as management strength, corporate culture, or competitive advantages. Whether you are running a complicated stock screen or simply getting ideas from other investors, all methods have their own advantages, limitations, and risks. Ultimately, the best method of generating ideas for you is the one that gives you the largest number of opportunities.
This chapter explores why stocks become undervalued, how to generate investment ideas, how to filter these ideas, and how to keep track of them. These steps are critical to creating a pool of stock ideas.
How Investment Opportunities Are Created
You can’t manufacture investment opportunities. Instead, you need to be patient, and you have to be ready for the right opportunities. It is important to understand that good investment ideas are rare, and consistent success in the stock market is elusive. Those investors who believe that they can make money year after year in the stock market are setting themselves up for disappointment. Most investors are far too optimistic: They often think they’ve found great ideas when they haven’t.
In contrast, investors with the best long-term track records have made most of their money with just a handful of investment ideas. For example, Warren Buffett states that his investment success is due to fewer than 20 ideas, such as the Washington Post newspaper, Coca-Cola, and GEICO. In short, you need to mentally prepare yourself in advance with the idea that you will not have many outstanding investments in your lifetime. Most investments you make will produce mediocre results, but a few can provide outstanding results.
The best investment opportunities usually come in big waves, such as when entire markets decline. There have been several recent examples: the Asian financial crisis of 1997 to 1998, the Internet bubble ending in 2000, and the recession starting in 2007. There were many buying opportunities in 2008 when the S&P 500 dropped 36 percent. This was caused by forced selling. The market sell-off was exacerbated by the indiscriminate selling of stocks by money managers who were forced to sell stocks to fund client redemptions. Even if these money managers knew these stocks were undervalued, they had no ch
oice but to sell. This forced selling created artificially low prices—which created a rare opportunity for investors.
Other kinds of forced selling include situations when stocks are thrown out of an index because they no longer meet the minimum standards to remain in an index. Many investment managers who exclusively invest in stocks found in a particular index (such as the S&P 500) are forced to sell when the stock moves out of the index. Spin-offs (where a business divests a subsidiary) create a similar situation when the business that is spun off does not fit the investing criteria of an investment manager. Forced selling decreases prices—which creates opportunities.
Besides broad market sell-offs that create forced selling, the stock market has a way of magnifying different types of business and industry-wide risk that cause the stock prices of businesses to drop. To learn which area of the stock market is in greatest distress, look for those areas where capital is scarce. Scarcity of capital creates less competition for assets, which decreases prices. Ask yourself, what areas of the stock market are investors fleeing, and why?
You may want to begin by looking at the percentage change in prices of certain industries found in common indices such as the materials, energy, or financials subset of the S&P Composite 1500. For example, the price performance for components of the S&P Composite 1500 from April 23, 2010 to June 7, 2010 showed that:
Materials were down 18 percent
Energy was down 17 percent
Utilities were down 9 percent
With that information, you might start researching the materials industry, looking for stocks that have significantly dropped in price. Ideally, you want to identify those stocks where the baby has been thrown out with the bathwater—and then rescue that baby!
Most stock price drops are due to some type of uncertainty about the business, and there are many possible reasons:
Litigation fears
Accounting irregularities
Accusations of fraud
Health concerns (such as swine flu)
Execution problems due to a flawed strategy
Management concerns
Executive departures
Government intervention or regulation
Loss of a customer
Technological changes
Credit rating downgrades
Competitor announcements
Or a myriad of other reasons
In most of these cases, investors automatically assume the worst-case scenario and tend to sell stocks first and ask questions later. Once the reality starts to set in that the ultimate outcome will not be as bad as expected, then stock prices adjust and typically rise. Ideally, you want to identify those areas where the outlook is most pessimistic and identify whether the sources of pessimism are temporary or permanent. Let’s look at an example.
Case Study: Investors’ Pessimism about Heartland Payment Systems Proved Unfounded
In 2009, Heartland Payment Systems found itself in what appeared to be a disastrous scenario. Heartland helps small and mid-sized merchants with credit-card transactions, providing the physical card machine and payment-processing services that enable customers to use credit and debit cards in retail stores. In 2008, computer hackers installed spyware on Heartland’s network and had gained access to the systems that process Visa, MasterCard, Discover, and American Express transactions.
After discovering the problem, Heartland announced details concerning the breach, including the number of months the spyware might have gathered card numbers and the number of transactions that the company usually processed. Framing it as potentially the largest data breach in history, the New York Times noted that 600 million or more card accounts were vulnerable, and quoted a data security analyst who said that there could be as much as $500 million in losses and other expenses if you added it all up. Early estimates were that Heartland would have to pay $2 per card for MC/Visa to reissue each affected card. The result? Investors quickly sold the stock. The price plummeted from $18 per share before the breach was announced (on January 6, 2009) to as low as $3.78 per share on March 9, 2009.
However, other investors with a solid base of research on the company and industry knew several things that helped them take advantage of this situation:
First, they focused on Heartland’s transaction count of 100 million transactions per month, and they recognized that not all of those would be from unique accounts. People tend to go the same places more than once. Later, more conservative estimates of stolen cards emerged at about 140 million cards, instead of 600 million.
Second, there was publicly available information about a similar case involving retailers TJ Maxx and Marshalls that had been settled recently. In that case, the average settlement per account to the issuing banks to replace cards was about 70¢ per card.
In 2010, Heartland agreed to pay MasterCard, Visa, and American Express $105 million—not the $500 million that was originally estimated by news sources. This amount, which averaged 81¢ per card, was similar to the recent TJ Maxx and Marshalls case. More important for investors was the fact that this was a far cry from the first potential loss estimates. Investors who already held stock in Heartland shouldn’t have immediately sold the stock on the news. They would have been rewarded if they had purchased more of the stock to decrease their cost basis. Also, investors who didn’t already own Heartland stock should have bought at this time because this one-time event was nowhere near as devastating as the sources in the press made it out to be. After investors realized that the liability from the breach was lower than they anticipated, the stock price recovered to more than $13 per share several months later (by the end of 2010).
In sum, if you had purchased the stock after the breach was announced, you could have tripled your investment!
Be Wary of Exciting New Trends that Turn out to Be Fads
You must also learn to identify those areas of the stock market that are benefiting from abundant sources of capital, which drives up prices, so you can be careful investing in them. Wall Street is good at pitching stories, and investors tend to get excited by what they believe is an important new trend. However, many of these exciting major trends turn out to be fads that are based on speculation, rather than fundamentals. Let’s look at a couple of examples.
In the 1960s, investors bid up the stocks of conglomerates that were increasing their earnings through acquisitions. Businesses such as James Ling’s LTV (Ling-Temco-Vought), bought unrelated businesses to increase and diversify their revenue streams. Growing quickly, they used their high stock prices to purchase other businesses. LTV acquired company after company, growing from the 204th largest industrial company in 1965 to the 14th largest in 1969—only four years later!
Yet by 1970, under the pressure of enormous debt, antitrust threat, and a generally bearish market, LTV’s stock had plummeted, as did the stock of several of the other recently ballooned conglomerates. From a high in 1968 of $136 per share to a 1970s low of $7 per share, LTV ended up selling many of its acquisitions at clearance prices.1
The 1990s gave us another kind of speculative boom, what we now call the Internet bubble. Technology stocks provided rates of return that dwarfed their actual growth or profits (if they had any profit at all). For example, computer manufacturer and services company Sun Microsystems was once valued as high as 10 times revenues when its stock traded for $64 per share. CEO Scott McNealy recalls that heady period: “At 10 times revenues, to give you a 10-year payback, I have to pay you 100 percent of revenues for 10 straight years in dividends.” McNealy noted that his assumptions include a few major obstacles such as getting shareholder approval for such a plan and not paying any expenses or taxes. Furthermore, McNealy noted that Sun Microsystems would also have to maintain its revenue run rate without investing in any R&D. McNealy asked, “Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are?”2
How to Spot Investment Bubbles
To understand where current
bubbles exist, ask, “Where is a lot of money being made very quickly?” Look at the Forbes magazine list of billionaires. What industries are the new billionaires coming from? For example, in the early 1980s, the Forbes list was populated mainly by individuals in the oil and gas industry. Also, monitor initial public offerings (IPOs) coming to market. Are the IPOs that are quickly rising in price concentrated in a certain industry, as Internet stocks were during the technology boom of 1998 to 2000?
When capital is abundant, it searches for other similar businesses to duplicate success. The IPOs of technology businesses caused many other technology businesses to be formed and seek to go public. Here are a few signs of a bubble:
Lots of available capital
Higher levels of leverage
Decreased discipline from lenders as they try to get higher returns than through conventional lending guidelines
Decreased responsibility for the borrower, combining high leverage and looser lending terms
One of the lessons from the 1980s real estate boom/bust was that there was a grace period in which everybody had money in their pockets and they did not have to worry about whether tenants would occupy the buildings or whether the assumptions about future cash flows were going to be proven correct. Buildings were built on a speculative basis, as lenders were in essence throwing money at developers to build new projects and did not worry if the builders had tenants to occupy these buildings. Eventually, there was an oversupply of real estate, which caused prices for real estate to drop. Lenders and developers found themselves with many empty properties, and there were many bankruptcies during this period. This just goes to show that areas where there is an abundance of capital are usually poor hunting grounds for great investments. Investors who got caught up in the hype of the 1980s real estate boom or technology bubble of the late 1990s ultimately ended up losing most of their capital.
The Investment Checklist Page 2