Someone emailed me this question:
“I was wondering if you could break down the tools you use for investing and perhaps a step by step of your general process. For example, what brokerage do you recommend? What screener? Do you have various custom forms in Excel that you have developed (perhaps for sale)? Are there software packages that you utilize? Etc.”
Use whichever broker you want. Just use a broker as infrequently as possible. I use a full service broker. I like that he can buy stocks for me anywhere in the world given enough time, and, most importantly, I like that I have to call him up on the phone and talk to a real person to place a trade. This “inconvenience” has saved me more money than any discount broker ever could. If I could find a broker that would only buy for me if I flew across country to place my order in person, that would probably be the best broker for me. I’m joking, but, mathematically, I can actually see that my “joke” is probably not wrong here.
The price of a round-trip plane ticket to New York really could be worth it for me if it had slowed down my buying and selling activity over the last few years as much as I think it might have. Frequent trading has cost me more money in bad decisions than in broker commissions. The problem with online brokers is that they make you – the investor – into a trader. I don’t want to spend one more second than necessary thinking about the exact quantities of shares I’ll be buying, my limit price, etc. I want to focus 100% of my energy into finding the right stock to buy. What I’m buying matters. How I’m buying doesn’t matter.
My only advice as far as brokers go is that I’ve seen more investors “lose” money by “saving” on discount brokers, saving on taxes and saving themselves the hassle of opening a new account just to buy a certain stock. Focus on two things. One, buy the best stocks. Two, trade as infrequently as possible. If you do those two things, fees and taxes and such aren’t going to be important. Don’t focus on minimizing your expenses. Focus on maximizing the financial gain you get from your good ideas.
As far as screeners are concerned, I’ve never gotten many ideas off them. GuruFocus has a Buffett/Munger screen. It also has screens for predictable companies. Looking at predictable companies is a good idea, but the three stocks I own the most of – Frost (CFR), BWX Technologies (BWXT) and George Risk (RSKIA) – are all rated one star or less by GuruFocus in terms of predictability. The predictable companies screen is probably one of the best out there. At GuruFocus I’d use the Buffett/Munger screen, the undervalued predictable companies screen or just sort by predictability myself.
There are other web sites like Stockopedia, Morningstar and Portfolio123 that have screens. I’ve created screens of my own at all these sites, but, again, I’ve never found screens to be a good source of ideas. Technically, BWX Technologies (which was then Babcock & Wilcox [BW]) came from a screen, but it was a generic screen, and it was misleading that Babcock even made the cut. It’s just that Babcock hadn’t been public as an independent company for that long before it was planning a spinoff so I didn’t know the company well.
Generally, I get ideas from talking to people either offline or online or from reading blogs. Occasionally, I get ideas from “gurus” and “super investors” like Buffett, Mecham, Greenberg, etc., but there’s usually not much overlap between my style and their style – and most famous investors have big portfolios that can’t accommodate the best stocks out there. If I could find really great investors who manage $100 million instead of $10 billion – I’d pay more attention to them. The simplest screens are usually the best. Stocks that trade below 8x EBITDA have annualized returns in the stock for more than 10% per year for more than 15 years, have been profitable every year for the last 15 years and have reduced their share count every year for the last 15 (or whatever) years – are the kinds of stocks I find most useful. I get more out of looking at upcoming spinoffs than at screens.
I do have various custom Excel sheets I use. They aren’t very fancy. I usually gather 20 to 25 years or more of past financials. I am most focused on long-term returns (especially the harmonic mean), the median level of past returns on capital, margins, etc., and the coefficient of variation in margins. I’m often looking for predictable companies that will have higher margins, EPS, etc., in five years than they do today.
I bought Omnicom (NYSE:OMC) and Fair Isaac (NYSE:FICO) right after the 2008 financial crisis because their results in 2009-2010 were going to be cyclically bad but the companies had easy to predict profitability if you looked out to like 2014-2015. Similarly, I like Howden Joinery (LSE:HWDN) because you can predict roughly 8% annual growth in sales for the next five to six years and yet the stock trades at a normal price-earnings (P/E) of about 15. It shouldn’t have lower margins in five years than it does today. It might have higher margins. This also highlights gross profitability.
I’m a little different from most investors in that I don’t pay that much attention to things like recent EPS growth. Instead, I am looking at the level of gross margins, gross profitability (gross profits/net tangible assets) and the predictability of that both at this company specifically and the industry generally. If you buy and hold a company with high and stable gross profits in an industry with high and stable gross profits – you’ll do fine for the long term. Most investors don’t care enough about consistency and they care too much about the operating number. For example, Amazon (NASDAQ:AMZN) rarely reports good results on the bottom line, but it’s actually been a predictable company higher up the income statement (like at the gross profit line) for a long time. Amazon isn’t a cheap stock, and I don’t own it, but it’s the kind of company that often doesn’t show up as a good business on a screen but clearly has excellent economics. GuruFocus’ formula knows this and so Amazon gets 4.5 stars for predictability.
The most important thing here is to keep it simple. That’s why I like things like Value Line and the web site quickfs.net. It’s simple. GuruFocus has a ton of data. And it’s all wonderful data that might be useful. If someone was asking me how to quickly find stocks to look at using GuruFocus – I’d say something like take the Predictability Score, multiply it by the F-Score and then multiply the product of those two figures by the Z-Score. If it’s really high (like 40), you might have found a good stock. If it’s really low (like 8), you may not want to spend much time on that. It’s harder to evaluate stocks with low predictability, low F-Scores and low Z-Score. I’m not saying it’s impossible, but it’s hard.
I’m being really misleading with all this talk of screens. Honestly, a “screen” for me is more like hearing a company is still controlled by the founder. If you look at which stocks I tend to be interested in, it’s stocks that have high and consistent gross profitability (that’s true), but more than that they are usually family controlled or founder controlled with long-term focused capital allocation. I did buy predictable, high ROE stocks like Omnicom, IMS Health (NYSE:IMS) and FICO right after the crisis, but I really bought those because they were great, cyclically cheap businesses that I felt were going to buy back their own stock.
If I was “trapped” in the stock while it went nowhere for five years, I’d actually get a steadily declining share count that would compound intrinsic value nicely. Without the capital allocation I expected at those companies, I might not have bought them. I’m not really interested in just a 10% free cash flow yield or something like that – I want a 10% free cash flow yield the company is using to buy back its own stock, make smart acquisitions, etc.
My mental screens – not screens I run online – are things like seeing a share count that always goes down, seeing a CEO who was been with the company forever, seeing a family or founder with a controlling stake and seeing a stock price that has done great things over the last 15 to 30 years. I have nothing against 52-week low lists and five-year low lists, but I’m more interested in a list of the stocks that have the best compound annual returns over the last 15 to 30 years because those stocks have – or had – the best businesses.
Unless something has changed dramatically, I usually don’t want to consider a stock that has returned less than 10% year over the very long term. If you can find a stock chart going really far back and when you plot the stock you’re interested in versus the Standard & Poor's 500, the S&P 500 wins – then, why would you want to buy the stock? This isn’t a rhetorical question. I mean it seriously. For instance, I picked Breeze-Eastern for the newsletter I wrote. It hadn’t performed well as a company. It had undergone a transition where it sold off worse businesses and kept a wonderful core business as the entirety of this newly emerged stock. Stripped of the dead weight and debt it had previously had – the stock was set to have a good next 15 years even if it had not had a good past 15 years.
The same is true at something like Interpublic (NYSE:IPG). It underperformed other ad agencies badly in the past, but I can see why it did, and I can see that it might not make those same mistakes in the future. By the way, Interpublic still outperformed the market over the last 40 years or so. It’s only the record from the 1990s on that looks shaky. Looking at the long-term stock record is always a good idea. It’s one of the best screens you can run.
For example, I was just talking about ATN International (ATNI) with someone, and he was going through the various business units and what he thought they were worth and so on. I stopped him to ask three questions: 1) Did he know the rate at which ATN had compounded book value over the last 15 years? 2) Did he know the rate at which ATN had compounded its stock price over the last 15 years? 3) Did he think ATN in 2032 (15 years from now) would look anything like ATN today? The answers were he knew a lot about the company as it existed today; he didn’t think that 15 years from now the company would look anything like it does now, and he didn’t really know the rate of intrinsic value growth at the company in the past, the history of deals the controlling family had done, etc.
This is the kind of stuff I am usually looking at as my “screens.” For example, someone mentioned Winmark (WINA) to me and asked if I knew the company. I said I didn’t know that much about what it looked like today. What I did know was what the chairman (John Morgan) and Winmark looked like years ago. Someone else mentioned MSG Networks (MSGN) to me. Now, yes, I do know MSG because I’m originally from New Jersey. MSG is one of the two important sports TV networks in the New York City area. The other is the YES network which broadcasts Yankees games. What I actually knew better was the Dolans (the family that controls MSG Networks).
I guess my process is much less quantitative than you might think. It’s pretty quantitative where it matters. I knew ATN’s compound annual growth rate, and I knew what kind of EBITDA multiples they’d paid for telecom assets they’d bought, etc. I also always know the coefficient of variation (standard deviation/arithmetic mean) in a company’s operating margin. That figure is probably one of the two things I always know that usually other people have never seen. I know a company’s gross profitability (gross profits/NTA) because I always know both gross margins and net tangible asset “turns.”
Three of the figures that are sort of like “screens” for me in that they help me make snap judgments about a company are:
- Gross profits/net tangible assets (higher is better).
- 15-year (ideally, as long as possible) coefficient of variation in the EBIT margin (lower is better).
- 15-year (ideally, as long as possible) compound annual growth rate in the stock (higher is better).
As a rule, if a company isn’t predictable, why would you buy it? If a business has historically had low gross profits relative to the net tangible assets it employs, why would you buy it? If the stock has underperformed over 15 or more years, why would you buy it? And then, if the company is now doing something different, has a different management team, etc., why would you buy it?
There are good answers to these questions. Maybe the new management team is better. Maybe the company has suddenly gained important economies of scale.
In my experience, companies that start life earning inadequate gross profits tend not to grow into companies that earn adequate gross profits. Likewise, stocks that have underperformed over the last 15 to 30 years rarely become stocks that will outperform over the next 15 to 30 years. I would say the main point of “good to great” is that it rarely happens. It does sometimes happen, but it often requires some sort of “re-founding” by an “outsider” type CEO who cuts out the bad stuff from a corporation, focuses on the good stuff and then thinks like a long-term shareholder.
The main feature of all the work I do on a company is that it’s historical. You’d be amazed how little time I spend looking at this year’s results. I’m often more interested in what the company has done over the last 15 years and what I think it’ll look like five years down the road.
I do use Excel. And if I have any “secrets” it is in those three numbers – gross profits divided by net tangible assets, the coefficient of variation in the EBIT margin and the long-term compound annual growth rate in the stock. These numbers became more important the more you trust management. I don’t really talk about myself as a “jockey” investor versus an investor who bets the “horse.” But, it’s true that the quickest way to get me to ignore a stock is to tell me it’s run by a fairly typical, fairly short-tenured professional manager. One reason I’ve rarely been able to invest in Japan outside of net-nets is that I’ve almost never been able to find a manager I like in Japan. I’ve found a couple, but it just hasn’t happened that the right Japanese manager has been at the right Japanese business at the right stock price (for me). By far the biggest reason I’ve invested more in the U.S. than any other country is that I’ve found it easier to get the kinds of managers I want running the kinds of businesses I want. I’ve found a few in Europe, but even my track record there is pretty American centric in the sense that my two favorite European companies are Luxottica (LUX) and Hunter Douglas (XAMS:HDG) – and they both focus on the U.S. market. I love the way both of those companies have been run. Again, that’s a historical thing. Without knowing the histories of Luxottica and Hunter Douglas, I doubt I could have picked either of them for the newsletter.
If I had to sum up my process in one word, it would be “historical.” I’m not sure all investors would benefit from adopting my historical approach. However, I am sure everyone reading this could benefit from my unorthodox ideas about brokers. The best broker is the one you’ll use the least.
Disclosure: Long Frost, BWX Technologies, George Risk.
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