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What to Do When Good Stocks Aren’t Cheap
Posted by: Geoff Gannon (IP Logged)
Date: November 14, 2012 05:07PM

You have to look for a margin of safety in every stock you buy. If you can’t find a margin of safety – you have to hold cash.

Two people who read my articles []sent me these emails[/url]:

Hi Geoff,

My question is what strategy should an investor adopt when the market is rising (generally good stocks are not available at reasonable prices in such circumstances)? Should an investor just wait on the sidelines when the market continues to rise?

And the second email:

In general, how do you approach the macro investor problem: When markets are down, value investors pile in, but when markets are up, what should value investors do? Underperform?

That’s what I’m doing now. I have 75% of my portfolio in cash. And I am underperforming. I am up 5% in 2012. The S&P 500 is up 11%. It is no fun making 5% a year. And it is no fun being beat by the S&P 500.

But when you keep 75% of your assets in cash – you know that has to happen. I would love to be 100% invested. I would always love to be 100% invested. But when I can’t find stocks I like with a margin of safety – I stay in cash.

It’s odd for me to have 75% in cash. I can’t think of any time in recent years where I kept more than 50% of my portfolio in cash for more than a month or so. It just never happens. But it’s happening now. It’s been happening for most of 2012.


We all have rules. We all have habits. We all have ways we like to invest. Most investors diversify more than I do. I have low standards when it comes to diversification. I have high standards when it comes to stock selection.

Like I said in a recent article – my required rate of return is 10%. If I don’t think I can make 10% a year in a stock – I don’t buy that stock.

So I have a rate of return hurdle. I also have a value hurdle. I need to know the stock I am buying is – conservatively calculated – worth more than what I am paying. I need clear and convincing evidence of that.

I also have a safety hurdle. We’ll call it a comfort hurdle. I need to be comfortable with the industry, the organization, the management, the balance sheet, etc. There needs to be a low risk of catastrophic loss.

I don’t like looking at stocks where I think there is a real chance of losing 50% of my investment.

I don’t own banks. Over the last few years – there were many cheap banks. There still are some. Many of them have a real risk of catastrophic loss. You could lose 50% of your money if the world goes against you.

That is not true in Kimberly Clark (KMB). That is not true in Waste Management (WM). That is not true in Carnival (CCL). Or in Omnicom (OMC).

Those are companies in industries with solid demand. They are businesses with solid competitive positions. If you know they are cheap – and you know they can make you 10% a year – those are stocks you can feel safe buying.

So when I say I’m not finding stocks to buy – I am saying I’m not finding stocks that check all 3 boxes at once. They need to be worth more than they are trading for. They need to be safe. And they need to offer a return of 10% a year.

There are some stocks I know are safe. A good example is Copart (CPRT). That is a safe stock. Demand for the service is stable. It will be around as long as car insurance. Copart’s competitive position is solid. I like the management. The balance sheet – which is chock full of land – is fine. It’s clearly a safe stock.

But is it cheap? Copart trades at 21 times earnings. It trades at over 4 times sales. And the price to book is so high it has no meaning.

So I like Copart. I follow Copart. But I don’t own Copart. It only checks one of the boxes I need checked. It is a good, safe business. But it isn’t cheap. And it doesn’t promise 10% annual returns. So I can’t buy the stock.

Then there are stocks that are cheap. No one doubts they are cheap. But are they safe? Are they the kind of business I feel comfortable owning?

Think about Bank of America (BAC). Or Hewlett-Packard (HPQ). Or even Microsoft (MSFT).

Whether you can buy these stocks depends on where you draw your circle of competence. HP is definitely outside my circle. There is not even a kernel of understanding in that business for me to latch onto. I don’t know their products. I don’t know their customers. I don’t see how they differ from others.

And I’m writing this on an HP desktop. But I only own that desktop because another – non-HP computer – broke. They could ship an HP that day. So I bought an HP. I don’t like or dislike the desktop. And I wouldn’t buy another HP.

A lot of companies – mostly big companies – fall into the HP category for me. They are big. They compete with other big companies. And I’m not sure I understand what they do. Why they make the products they do. Why they provide the services they do. And why any customer would stick with them.

These stocks may make good bets. It might be a great idea to buy Hewlett-Packard LEAPs. I don’t know. It isn’t the kind of stock I am looking for. Because I’m looking for a business I understand. Where I understand the company’s behavior. And I understand their customer’s behavior. That – more than anything – is what gives me comfort.

So no HP for me. No matter how cheap it is. What about Bank of America? Warren Buffett has a preferred investment in Bank of America. He obviously thought the common stock was cheap. He got 10-year options as part of the deal.

I’m a Bank of America customer. And I have no doubt that – in five years – they will have more of my dollars at their bank than they do now. That’s a good sign.

There are very few businesses that can count on getting more of my business in the next five years. I’m sure Amazon (AMZN) will make more money off me in 2017 than they do now. I’m sure Southwest (LUV) will make more money off me. And I’m sure Bank of America will too. That’s about it.

These businesses all have some things in common. They scale well. They have big competitors. And parts of the experience they offer are unpleasant.

Amazon benefits from how little I liked shopping at Wal-Mart (WMT). It was never a fun place. Some people like being in actual stores. I’m not one of them. So Amazon doesn’t need to match stores on price to keep my business. I’m always willing to pay up a little for the convenience of online shopping, home delivery, etc.

Southwest is a more direct winner. They offer more frequent flights on the routes I want. They have good prices. And I like the actual experience a bit more. Again, very big, unimpressive competition is part of why I can be sure I’ll fly Southwest even more in the future. The alternative is worse.

So why am I sure I’ll bank more with Bank of America? It’s a sticky business. It’s a big hassle to move. They own a broker – Merrill Lynch. Online banking is important to me. Their brokerage and online services can match anyone’s. And I don’t like going in a branch. So superior customer service by a local competitor won’t get my deposit.

Finally, the real reason Bank of America has my business is location. My old bank was Wells Fargo. I liked Wells Fargo better than Bank of America. I still do. But Wells Fargo doesn’t have a branch I can walk to. Bank of America has one a couple blocks from my apartment.

Does that mean Wells Fargo can open a branch next door and get back my business? No. Banking is a sticky business. I moved banks when I moved. Moving my account for any other reason is a pain I don’t need. Bank of America will have to drive me away with mistakes. A competitor can’t win me over if I’m even remotely content. Banks are not something people shop for. They are something they switch only when they need to. Like when their current bank screws up. Or when they move.

So Bank of America won my deposit with location. They’ve won a lot of deposits that way. And even a competitor like Wells Fargo can’t do much to them. In the U.S., every bank has a small share of national deposits. The competition between big banks – for deposits – is not as rough as the kind of competition Amazon and Southwest have to deal with. It’s more local. And more fragmented.

That makes it sound like I could buy shares of Bank of America. And I could – if all that mattered to a bank is deposits. I have no doubt Bank of America will get cheap money far into the future.

The problem is the past. And what they do with deposits. I need to worry about everything Bank of America did in the past. And all the loans they will make in the future.

I like to put 25% of my portfolio into one stock. I don’t feel comfortable putting 25% of my portfolio into Bank of America. It is cheap. And it can return 10% a year. But it’s not in my comfort zone.

Finally, there’s Microsoft (MSFT). This stock is also clearly cheap. And it’s also a business where I have experience as a customer. I’m running Windows 8 right now. I love it. I have no idea what the long-term future of Windows will look like.

I also have an Xbox 360. And – of course – I use Microsoft Office. I’m very likely to use all three – Xbox, Windows, and Office – in their next generations. So Microsoft has their hooks in me. And in a way HP doesn’t. My next desktop will not be an HP. My next operating system will be Windows.

Microsoft seems like an easy business to understand. And in some ways it is. But it depends a lot on what computers look like. It worries me a lot that the line between my desktop and my Kindle Fire is not a wide one. Windows only has a moat in one of those devices.

I just don’t know what the future of computers will be. And whether there will be a place for Windows. And how big it will be. So I know Microsoft is cheap. But I’m not comfortable buying it.

Why did I turn a question about macro investing into a question about micro investing?

Because that is always what it comes down to. I have 75% of my portfolio in cash – because I said no to stocks like Microsoft and Bank of America and HP. Not because I have a view of the market. Not because I have a view of the economy.

If the stock market was overpriced and the economy was in the toilet and Carnival was trading for $15 a share – I would buy it. Why? Because in 20 years, I believe the cruise industry will be bigger than it is today, Carnival will be the leader in the cruise industry, and the leader in the cruise industry will earn its cost of capital. If those things are true – and Carnival is trading for a fraction of book value – then I should buy Carnival. Nothing else matters.

The macro picture – by which I mean the level of the stock market, the strength of the economy, and the level of interest rates – will change a lot in 20 years. It changed a lot during the 23 years in which Warren Buffett owned Coke. But if he was right about Coke in 1989 – he didn’t need to be clairvoyant about the future of everything else.

Thinking about the big picture is often dangerous. Because it’s often used as a way to justify dumb decisions. Not clearly dumb decisions. But borderline decisions. Carnival at $35 a share is a borderline decision. If you are right about fuel prices – that they will be lower in the future than they are today – you may make buckets of money buying Carnival at $35 a share. If you are wrong, you may not. It’s a borderline decision at $35 a share. It is clearly a good decision at $15 a share.

Waiting is the hardest part of investing. You have to wait long enough to buy a good idea. And once you own the idea, you have to wait long enough to see it play out.

Right now, I am waiting for a good idea. And that means I made 5% this year. And the market made 11%. That’s the price of a good idea.

The value of cash is as an option. Cash is an option on future, lower stock prices. For a market timer – it’s an option on future, lower general stock prices. For a stock picker – like me – cash is an option on future, lower specific stock prices.

I don’t have 75% of my portfolio in cash because I think the stock market will be lower in the future. I have 75% of my portfolio in cash because the price of Carnival and Copart and DreamWorks (DWA) are not low enough yet.

Those stocks may get cheaper in the future. If they do, I may buy them. Or they won’t get cheaper. And I’ll never get to buy them.

The only other option is lowering your standards. Which Warren Buffett refused to do in 1965. Stock prices were too high. He couldn’t find good ideas to buy. It wasn’t the game he was used to playing. So he wound down his partnership.

Why didn’t he just stay in cash? Because he was investing for others. Many of the people reading this article are not professional money managers. You can live with earning 5% a year when the market earns 11% a year. That’s the advantage you have over money managers. Use it.

[]Talk to Geoff about What To Do When Good Stocks Aren’t Cheap[/url]

Read Geoff’s Other Articles

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Re What to Do When Good Stocks Aren t Cheap
Posted by: becomingbuffett (IP Logged)
Date: November 15, 2012 07:34AM

Great article, Geoff! Thanks!

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Rating: 5.0/5 (1 vote)

Re What to Do When Good Stocks Aren t Cheap
Posted by: tkervin (IP Logged)
Date: November 15, 2012 11:13AM

I am in the same boat. My equity percentage is currently 28%. My overall interest in the market now is low (though if it keeps falling that may change). I have found business opportunities that I believe offer better returns then the stock market at this point.

While it is easier to own a partial interest in a business than owning a business outright I am ready to do either given the potential return.

I have friends that have withdrawn much of their market investment and have purchased properties in the last couple of years. Their thought was that homes were "on sale" and they were not daunted by being landlords.

Lots of ways to skin the profit cat.

The market simply is a game that you don't need to play when the risk/return odds turn down.

This clearly is more difficult when you are just starting.......your capital base is most likely too small to take advantage of alternative investment approaches.

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Re What to Do When Good Stocks Aren t Cheap
Posted by: [email protected] (IP Logged)
Date: November 17, 2012 10:20AM

this article is absurd.
1, the 10% return on your investment is what you think you may get but may fall out of your expectation.
2, lots of times the right stock will be lagging and languishing for quite a long time, even for several years before make tremendous return on your account, which brings to you another question what is your time scale for your initially planned 10% return investment.
3, what does it mean for your in regard to long term investment? annual return is not a matter of long term one, in long term perspective average annual return is the one we may project for 5 years, 10 years or even longer
4, lots of business is unpredictable, the assumed 10% return is based on sands when some unpredictable events appear in the company you invested. if you don't take long term perspective you may lose on the annual performance

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Re What to Do When Good Stocks Aren t Cheap
Posted by: Seanickson (IP Logged)
Date: November 19, 2012 06:32PM

I think stocks are overvalued but I dont think the prospective returns from here on out are as bad as you might think. Stocks certainly are not nearly as overvalued as they were in 2000 or 2007. For holding that much cash to be right, a correction would have to happen fairly quickly as time starts to work against you. There are also other options to consider such as real estate or a long/short portfolio.

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Re What to Do When Good Stocks Aren t Cheap
Posted by: tonyg34 (IP Logged)
Date: November 20, 2012 10:24AM

late to the party but liked the article
there really is always work to be done somewhere
wouldn't recommend it carte blanche but there are ample opportunities out there to investigate
NXY, PENN, EBIX just to name a few
so if you can't find a buy and hold forever company look into merger/arb or spin-offs or headline arb

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Re What to Do When Good Stocks Aren t Cheap
Posted by: [email protected] (IP Logged)
Date: November 23, 2012 03:50PM

Absurd. The author is so scared of risk he would be better off just putting his money in a high yields saving account. No risk, no return. I have made plays that looked awful in the early months of purchase. All have netted greater than 5% per annum over the long run because I researched them, bought them cheap, and waited. The author is trying to pick the perfect stock at the perfect price. One problem. The market is not perfect. Buyers are irrational. Bear markets will tear down the share price of the best researched firms, too. Companies experience massive changes to competition and product services over time. If the author puts 25% of his portfolio into each stock he is heavily leveraged to a company that could falter. If the author is only looking for 10% per year and leveraging 25% per equity, I would not do business with him. A real shocker. There is merit to waiting and holding cash but this author is sacrificing a massive earnings potential with the strategy.

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Re What to Do When Good Stocks Aren t Cheap
Posted by: SeaBud (IP Logged)
Date: December 9, 2012 03:06PM

I don't think labeling this investing approach "absurd" is fair or productive, although I do disagree with the author. Warren Buffett would recommend a focused portfolio of stocks with a high margin of safety within your circle of competence - what the author advocates. Just because his margin of safety is more absolute than yours, or his portfolio is more focused, does not make it absurd IF it works for him.

In my experience, finding stocks that give 10% "risk free" requires a market meltdown (ie '07/08) and stones of steel, you have to constantly dig in the dumpster, or pick up on headline trading (ie, I bought WMT after the mexican bribery came out for +10% in months).

I do own BAC because I am convinced banks will be around and profitable in 10 years. Saying that banks went insane once over the last 40 years so I should not buy them is not persuasive to me. I own Microsoft, with less conviction, because they are more than computers (xbox, sw) and they pay a nice dividend while I wait. If revenue growth is just 7% and the stock matches revenue, with the dividend of 3.45% you are doing over 10%. Is there risk to revenue? Yes, but there is upside too.

I think the 10% "risk free" annual return from the author is the toughest thing for me to swallow - but he only is looking for 4 stocks. My perception of "risk" is different on banks as BAC at below $7.50 was a no brainer to me. So the author's limit of four stocks and definition of risk are different than mine, but are not absurd.

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Re What to Do When Good Stocks Aren t Cheap
Posted by: superguru (IP Logged)
Date: December 9, 2012 07:32PM

I have also been pretty much sitting on sidelines for same reasons. Great article Geoff.
Though I differ from you on MSFT as in our family we use no MSFT products except Office for mac.

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