"To cease to think creatively is but little different from ceasing to live." Benjamin Franklin
When I was young and endeavored to become "The World's Greatest Handicapper," the first book I read on thoroughbred handicapping was Tom Anslie's classic work "The Complete Guide to Thoroughbred Handicapping.” http://www.amazon.com/Ainslies-Complete-Guide-Thoroughbred-Racing/dp/0671656554
The book was considered required reading for anyone who wished to attend the races on regular basis for good reason. It was an in depth description of all the accepted factors which determined the outcome of a race; discussing the importance of such things as pace, distance, class, conditioning etc. The book remains a classic and it still provides a fantastic introduction to the art of thoroughbred handicapping.
After absorbing the book completely and then studying "The Daily Racing Form," I headed to the track brimming with confidence and armed with a few "locks" which fills multiple categories described in the book for selecting a winner. Much to my dismay, when post time came around, my list of cinches all turned out to be "heavy chalks" (decisive favorites). In reality, what I had learned was not how to make money at the race track, rather how to think precisely like the other "experts" and select the favorite well in advance of the race.
The ability to predict low-priced favorites which offer no betting value is quite similar to the ability to predict popular stocks which offer little long-term value and little hope of outperforming the general indices. The subject of this article is an analysis of some of the factors which can aid an investor in achieving above average long-term gains by "thinking outside the box.”
Groupthink and Investing
Groupthink can be defined as the process of accepting the consensus opinion rather that engaging in critical thought in regard to identifying a problem or creating a solution. During times of stress the process becomes amplified and creativity is frequently stifled completely.
The vast majority of money managers, analysts and individual investors unwittingly engage in groupthink. Indeed the act of disdaining groupthink during times of market panic or overexuberance is likely to lose a considerable amount of business for a money manager. Even a relatively brief period of underperformance is likely to send fickle investors in another direction in search of a "hot" manager when the market surges, or to a more "conservative" one when the market declines. The pressure to buy the same stocks as the majority of managers in your group must be enormous. Managing a "lemon fund" even in the short term, is not only psychologically- damaging, it is also career-damaging for the fund manager.
For most investors the stress created by downward movements in the overall market is almost overwhelming. It is almost as if genetics has provided humans with a telescopic spine which retracts during periods of market weakness while extending as the market ascends. This "turtle's head" approach to investing may be soothing to ones psyche but it can be extremely damaging to the ones long-term capital appreciation.
Identifying Areas of Individual Expertise
Followers of Seth Klarman are well aware of his affinity for entering areas which normal investors and investment funds tend to avoid. The process makes perfect sense; values tend to exist in areas where relatively few mainstream funds or institutional investors choose to enter. Klarman and his researchers might enter areas which are deemed as too speculative such as biotech or extraordinarily complicated ones such as the telecommunication sector. These are areas where less competition exists and the potential to find value is maximized.
Individual investors can follow the same approach by focusing on areas where they hold above average knowledge and possess an above average interest.
Avoiding Competition by Investing Is Tiny Companies
Back in the 1950s and 1960 a young Warren Buffett trounced the indices by identifying and purchasing tiny companies which were under followed and under appreciated by Wall Street. One of the principle advantages a small investor holds over institutional and fund investors is the ability to buy a meaningful position in a tiny company which trades at a small percentage of its intrinsic value.
As previously stated, the easiest way to make money is to enter an area where competition for shares is limited so long as extensive value propositions can be identified. It may be a long and lonely path to value recognition but almost always the value is realized over time. If investors do not appreciate the value and bid up the price per share over time, management, particularly if they hold significant positions in the company, will generally extract value through dividends, buybacks, or an outright sale of the company. The fact that no one has heard of the company is a decided advantage for the investors, although it is frequently deemed to be a reason to avoid the stock.
Creativity and Investing
Creativity is the polar opposite of groupthink, it is also the polar opposite formula investing. While formula investing utilized in the form of various stock screens, is an excellent way to acquire leads it is the ability to differentiate between the leads which determines ones ultimate investing success.
Creativity spawns analytical thought processes which are essential in determining the underlying value of a company as well as the risks associated with its business. Before purchasing shares in a company, Bruce Berkowitz attempts to think of every possible scenario which could kill the profits and value of a business. The process of envisioning possible pitfalls requires enormous creativity. When the potential pitfalls are identified, the Berkowitz team then evaluates the likelihood of the hypothetical scenario unfolding. The process resembles an actuarial approach to investing, similar to approaches used by successful insurance underwriters when determining premiums.
Employing creativity to identify the potential upside to a business is equally important although it is largely a component of ones own individual expertise and interests. Successfully identifying creativity in a management team can result in the investment of a lifetime as the following section will describe.
Combining Creative Analysis and Business Valuations
The following charts depict the trailing 10-year valuations of two famous companies in terms of P/E, P/S, P/B and net profit margins:
By merely examining the valuations of the two companies nine to ten years ago, the former appears to be a potential buying opportunity while the latter appears to be a possible short candidate. Although, the latter was absurdly priced by all metrics it was deemed to be a virtual "monopoly,” possessing a long history of high profit margins and sales growth.
Ten years prior, the latter was owned by almost every large cap mutual fund and a favorite among large institutional investors. The former was more or less considered a "laughing stock" (pun intended) and largely viewed as a company which should be avoided without regard to its then low valuations.
By the way both are technology companies, 10 years ago technology stocks were trading at the apex of all sectors, yet the former company was available for sale at less than 1x sales and just slightly above book value. Further, the former company had recently introduced a revolutionary product with excellent demand and possessed a highly creative management team which was clearly "thinking outside the box" when it came innovative consumer products. The recently introduced product was called the iPod and its release helped Apple return to profitability.
The type of investor who bought and held Apple (AAPL, Financial) nearly a decade ago was not the savvy institution who recognized the low valuations and future demand for iPods, instead it was the younger tech-savvy crowd who realized the utility of the iPod as opposed to it alternatives. Maybe some of these investors recognized the low valuations as well.
The latter company was Microsoft (MSFT, Financial) and although its near monopolistic position in computer operating systems and extreme profitability would continue for many years into the future, its bloated valuation would result in underperformance for its shareholders, for many years to come.
Investors who disdained groupthink, exercised creative thinking or merely purchased a company that had created a superior product which better fit the needs of consumers, literally bought the value of lifetime. More importantly, the company possessed reasonable valuation metrics as well as holding the potential for increased profits. As it turns out the iPod was the catalyst that the company needed to increase sales as well as expand the multiple which Wall Street was willing to pay for Apple stock.
Of course other factors entered into the picture, including the quick sell off in the late summer of 2002 which facilitated buying opportunities in numerous stocks, as well as the long-term reputation of Apple as a second rate enterprise that lingered long after Steve Jobs had returned the company to profitability in the late 1990s.
No one could have predicted the magnitude of the success story of Apple in the next decade but very few investors including myself paid any heed to the value proposition which was clearly laid before their eyes. A friend of mine, a broker which I did business with at the time recommended the stock to me at around $10, based on its strong balance sheet and turnaround possibilities. He was the last person I was going to take advice from about computer companies, he could barely operate a mouse, let alone understand the value of such a company, at least so I thought. I never even considered purchasing a share, I guess we know now which one of us was really the computer-illiterate individual.
When I was young and endeavored to become "The World's Greatest Handicapper," the first book I read on thoroughbred handicapping was Tom Anslie's classic work "The Complete Guide to Thoroughbred Handicapping.” http://www.amazon.com/Ainslies-Complete-Guide-Thoroughbred-Racing/dp/0671656554
The book was considered required reading for anyone who wished to attend the races on regular basis for good reason. It was an in depth description of all the accepted factors which determined the outcome of a race; discussing the importance of such things as pace, distance, class, conditioning etc. The book remains a classic and it still provides a fantastic introduction to the art of thoroughbred handicapping.
After absorbing the book completely and then studying "The Daily Racing Form," I headed to the track brimming with confidence and armed with a few "locks" which fills multiple categories described in the book for selecting a winner. Much to my dismay, when post time came around, my list of cinches all turned out to be "heavy chalks" (decisive favorites). In reality, what I had learned was not how to make money at the race track, rather how to think precisely like the other "experts" and select the favorite well in advance of the race.
The ability to predict low-priced favorites which offer no betting value is quite similar to the ability to predict popular stocks which offer little long-term value and little hope of outperforming the general indices. The subject of this article is an analysis of some of the factors which can aid an investor in achieving above average long-term gains by "thinking outside the box.”
Groupthink and Investing
Groupthink can be defined as the process of accepting the consensus opinion rather that engaging in critical thought in regard to identifying a problem or creating a solution. During times of stress the process becomes amplified and creativity is frequently stifled completely.
The vast majority of money managers, analysts and individual investors unwittingly engage in groupthink. Indeed the act of disdaining groupthink during times of market panic or overexuberance is likely to lose a considerable amount of business for a money manager. Even a relatively brief period of underperformance is likely to send fickle investors in another direction in search of a "hot" manager when the market surges, or to a more "conservative" one when the market declines. The pressure to buy the same stocks as the majority of managers in your group must be enormous. Managing a "lemon fund" even in the short term, is not only psychologically- damaging, it is also career-damaging for the fund manager.
For most investors the stress created by downward movements in the overall market is almost overwhelming. It is almost as if genetics has provided humans with a telescopic spine which retracts during periods of market weakness while extending as the market ascends. This "turtle's head" approach to investing may be soothing to ones psyche but it can be extremely damaging to the ones long-term capital appreciation.
Identifying Areas of Individual Expertise
Followers of Seth Klarman are well aware of his affinity for entering areas which normal investors and investment funds tend to avoid. The process makes perfect sense; values tend to exist in areas where relatively few mainstream funds or institutional investors choose to enter. Klarman and his researchers might enter areas which are deemed as too speculative such as biotech or extraordinarily complicated ones such as the telecommunication sector. These are areas where less competition exists and the potential to find value is maximized.
Individual investors can follow the same approach by focusing on areas where they hold above average knowledge and possess an above average interest.
Avoiding Competition by Investing Is Tiny Companies
Back in the 1950s and 1960 a young Warren Buffett trounced the indices by identifying and purchasing tiny companies which were under followed and under appreciated by Wall Street. One of the principle advantages a small investor holds over institutional and fund investors is the ability to buy a meaningful position in a tiny company which trades at a small percentage of its intrinsic value.
As previously stated, the easiest way to make money is to enter an area where competition for shares is limited so long as extensive value propositions can be identified. It may be a long and lonely path to value recognition but almost always the value is realized over time. If investors do not appreciate the value and bid up the price per share over time, management, particularly if they hold significant positions in the company, will generally extract value through dividends, buybacks, or an outright sale of the company. The fact that no one has heard of the company is a decided advantage for the investors, although it is frequently deemed to be a reason to avoid the stock.
Creativity and Investing
Creativity is the polar opposite of groupthink, it is also the polar opposite formula investing. While formula investing utilized in the form of various stock screens, is an excellent way to acquire leads it is the ability to differentiate between the leads which determines ones ultimate investing success.
Creativity spawns analytical thought processes which are essential in determining the underlying value of a company as well as the risks associated with its business. Before purchasing shares in a company, Bruce Berkowitz attempts to think of every possible scenario which could kill the profits and value of a business. The process of envisioning possible pitfalls requires enormous creativity. When the potential pitfalls are identified, the Berkowitz team then evaluates the likelihood of the hypothetical scenario unfolding. The process resembles an actuarial approach to investing, similar to approaches used by successful insurance underwriters when determining premiums.
Employing creativity to identify the potential upside to a business is equally important although it is largely a component of ones own individual expertise and interests. Successfully identifying creativity in a management team can result in the investment of a lifetime as the following section will describe.
Combining Creative Analysis and Business Valuations
The following charts depict the trailing 10-year valuations of two famous companies in terms of P/E, P/S, P/B and net profit margins:
Avg P/E | Price/ Sales | Price/ Book | Net Profit Margin (%) | |
|---|---|---|---|---|
| 09/10 | 15.10 | 4.14 | 5.60 | 21.5 |
| 09/09 | 13.30 | 3.86 | 5.19 | 19.2 |
| 09/08 | 24.00 | 3.09 | 5.11 | 16.3 |
| 09/07 | 26.50 | 5.55 | 9.21 | 14.2 |
| 09/06 | 29.20 | 3.50 | 6.59 | 10.3 |
| 09/05 | 24.10 | 3.27 | 5.98 | 9.5 |
| 09/04 | 38.80 | 1.74 | 2.88 | 3.2 |
| 09/03 | 89.80 | 1.21 | 1.80 | 1.1 |
| 09/02 | 112.80 | 0.93 | 1.29 | 1.1 |
| 09/01 | -185.80 | NA | 1.39 | -0.7 |
| Avg P/E | Price/ Sales | Price/ Book | Net Profit Margin (%) | |
|---|---|---|---|---|
| 06/10 | 13.10 | 3.29 | 4.32 | 30.0 |
| 06/09 | 13.40 | 3.66 | 5.35 | 24.9 |
| 06/08 | 16.30 | 4.31 | 6.94 | 29.3 |
| 06/07 | 19.90 | 5.70 | 8.89 | 27.5 |
| 06/06 | 21.70 | 5.54 | 5.85 | 28.5 |
| 06/05 | 23.60 | 6.81 | 5.53 | 30.8 |
| 06/04 | 35.70 | 8.45 | 4.15 | 22.2 |
| 06/03 | 36.50 | 8.67 | 4.25 | 23.4 |
| 06/02 | 62.60 | 10.71 | 5.62 | 18.9 |
| 06/01 | 45.90 | 16.09 | 8.31 | 30.5 |
By merely examining the valuations of the two companies nine to ten years ago, the former appears to be a potential buying opportunity while the latter appears to be a possible short candidate. Although, the latter was absurdly priced by all metrics it was deemed to be a virtual "monopoly,” possessing a long history of high profit margins and sales growth.
Ten years prior, the latter was owned by almost every large cap mutual fund and a favorite among large institutional investors. The former was more or less considered a "laughing stock" (pun intended) and largely viewed as a company which should be avoided without regard to its then low valuations.
By the way both are technology companies, 10 years ago technology stocks were trading at the apex of all sectors, yet the former company was available for sale at less than 1x sales and just slightly above book value. Further, the former company had recently introduced a revolutionary product with excellent demand and possessed a highly creative management team which was clearly "thinking outside the box" when it came innovative consumer products. The recently introduced product was called the iPod and its release helped Apple return to profitability.
The type of investor who bought and held Apple (AAPL, Financial) nearly a decade ago was not the savvy institution who recognized the low valuations and future demand for iPods, instead it was the younger tech-savvy crowd who realized the utility of the iPod as opposed to it alternatives. Maybe some of these investors recognized the low valuations as well.
The latter company was Microsoft (MSFT, Financial) and although its near monopolistic position in computer operating systems and extreme profitability would continue for many years into the future, its bloated valuation would result in underperformance for its shareholders, for many years to come.
Investors who disdained groupthink, exercised creative thinking or merely purchased a company that had created a superior product which better fit the needs of consumers, literally bought the value of lifetime. More importantly, the company possessed reasonable valuation metrics as well as holding the potential for increased profits. As it turns out the iPod was the catalyst that the company needed to increase sales as well as expand the multiple which Wall Street was willing to pay for Apple stock.
Of course other factors entered into the picture, including the quick sell off in the late summer of 2002 which facilitated buying opportunities in numerous stocks, as well as the long-term reputation of Apple as a second rate enterprise that lingered long after Steve Jobs had returned the company to profitability in the late 1990s.
No one could have predicted the magnitude of the success story of Apple in the next decade but very few investors including myself paid any heed to the value proposition which was clearly laid before their eyes. A friend of mine, a broker which I did business with at the time recommended the stock to me at around $10, based on its strong balance sheet and turnaround possibilities. He was the last person I was going to take advice from about computer companies, he could barely operate a mouse, let alone understand the value of such a company, at least so I thought. I never even considered purchasing a share, I guess we know now which one of us was really the computer-illiterate individual.
