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Geoff Gannon
Geoff Gannon
Articles 

How Should You Divide Your Research Time?

February 24, 2012 | About:

Someone who reads my articles sent me this question: My…question has to do with the type of investments you tend to put your energy toward. Evaluating a net-net is a whole lot different than evaluating a company that has a competitive advantage and trades at much higher multiples. To me, the net-net evaluation process is a whole lot more straightforward, as there are fewer intangibles (if any) and less prediction about the future involved. I don't have to worry about whether GTSI (GTSI) has any competitive advantage – I know it doesn't. Then again, I look at a company like Becton Dickenson (BDX) and I see a highly predictable company with a decent moat selling at a reasonable price. I can look at BDX and figure I might earn 10-15% annually over a long time frame. That's really different from thinking about investing in a net-net where I can see how it's 30-50% undervalued now, but it's not something I'm going to hold onto for decades. It's more of a matter of waiting for that one-time "pop" that will happen sometime in the next 1-5 years. How do you decide where to put your energy?

Thanks again,

Dan

I put my energy towards whatever is most clearly undervalued. I focus on the situations where I expect I will be most comfortable. I don’t spend a lot of time – at first – trying to figure out which type of investment will get me better annual returns. Obviously, I have some idea of that just by looking at what kind of stock we’re talking about.

Net-nets will give you better annual returns. That’s just a fact. It’s very hard to find high quality companies – especially large, high quality companies – that will return anything like what net-nets will do. So, if you can find net-nets you are comfortable owning, you’re going to make a lot more money that way a lot faster.

This isn’t a secret. Warren Buffett didn’t switch from buying net-nets to buying Coca-Cola (KO) merely because he decided investing in big, high-quality companies was a better way to make money than net-net investing. He did it because he had too much money. And because stock prices had gone up since the 1950s. But mostly because he had too much money.

It is extremely rare to find big net-nets. Because of that, investors with lots of money – like hedge funds – have to focus on buying great companies at reasonable prices. They can’t buy companies at deep discounts to their value to a private owner.

Should individual investors simply focus on net-nets?

Yes. If you like net-net investing, that’s what you should do. You’ll make the most money doing that. Read about Ben Graham and Walter Schloss. You can read about Warren Buffett’s early days if you want to. But especially learn everything you can about Walter Schloss. He applied Ben Graham’s ideas successfully into the modern era. The method that worked for Schloss for decades will work for you too if you are as disciplined and emotionally stable as he was. To invest in net-nets, you have to be comfortable holding – for what feels like a painfully long time – stocks that do not go up right away and that everyone will think you are crazy to own. If you can do that, you can make money in net-nets. And if you can make money in net-nets, that is where you should put 100% of your energy.

This is especially true if you are not a professional investor. In other words, if you are severely time constrained – as most folks with a day job are – your investment time should be laser focused on the area that will prove most consistently fruitful. And that’s net-nets.

But you didn’t ask about most investors. You asked about me. Where do I put my energy?

Well, it just so happens I can give you an overview of my personal portfolio – this excludes the (very small, about $7,500) – Ben Graham Net-Net Newsletter’s model portfolio.

The Ben Graham Net-Net Newsletter’s model portfolio is funded with my own money. But this is really just to allow actual trading of illiquid stocks for GuruFocus’s reporting. We want to be honest and include commission costs, bid/ask spreads, etc. in full. The only way to really do this – not just apply some theoretical value – was to have a portfolio that makes real trades using real money. Since I was the guy who thought the Ben Graham Net-Net Newsletter needed to use a real brokerage account to get an accurate picture of the costs of net-net trading – and because I’m the guy actually picking the stocks – I put in my own money. So, technically, I own 11 net-nets other than what I’m talking about here. But these are net-nets I have to own (in very small amounts) because of the way the Ben Graham Net-Net Newsletter works.

It’s misleading to count those. So, I won’t. But, obviously, if I did – they’d all be net-nets.

Okay. What’s in my own portfolio?

Right now, there are eight stocks in my portfolio. Every single one of these eight stocks was a net-net when I bought it. However, my top position – which accounts for 24% of my portfolio – is no longer a net-net. In fact, it hasn’t been a net-net for a while. But I still own it. And I have no plans of selling it anytime soon. It’s actually a pretty high quality company. Definitely a “hidden champion” type. And one of the best quality business I’ve ever seen on a list of net-nets. There’s another company of similar quality in the Ben Graham Net-Net Newsletter’s model portfolio. However, I think that one faces competitive risks that the former net-net I own does not. But it also has much better growth prospects. It’s not necessarily a worse stock. But I wouldn’t be as comfortable owning it. I certainly wouldn’t make it 25% of my portfolio.

Okay. So, my top position is 25% of my portfolio. It’s a former net-net. I’ve owned it for well over a year. And I have no plans to sell anytime soon. Next is an actual net-net. It’s about a 10% position. And it’s an American company. So, that’s 35% of my portfolio.

After that, we have 6 Japanese net-nets that together account for exactly 50% of my portfolio at the moment. They’re pretty much equally sized. So, let’s call them roughly 8% positions.

Finally, I’ve got around 15% of my portfolio in cash. Don’t know what I’ll do with that. Usually, I keep cash close to 0% when I have good ideas. I don’t have good ideas right now. So, it’ll stay at 15% till I do. Alternatively, if I sell a net-net or two, cash might rise to around 25% – and I could put all of that into one stock.

In fact, let’s talk about the idea of putting 25% into one stock. Because I actually tried to do that last fall. And it wasn’t a net-net. So, this is where things get interesting in terms of how I divvy up my attention.

As I’ve already mentioned, my portfolio is now 50% Japanese net-nets, 25% American non net-nets, 10% American net-nets, and 15% cash. However, the 25% American non net-net was a net-net when I bought it – I just didn’t sell it when it zoomed past NCAV – so really that doesn’t tell you anything about what kinds of stocks I focus on.

At the time of purchase my portfolio looked more like: 50% Japanese net-nets, 35% American net-nets, 15% cash.

Let’s back up a bit. In the fall of 2011 my portfolio looked a little different. It was: 50% Japanese net-nets, 25% American net-nets, and 25% cash.

At that point, I decided I would put 25% of my portfolio into a specific stock if I could get it at the price I wanted.

That stock was DreamWorks Animation (NASDAQ:DWA).

Now, when I check DreamWorks’s 52-week low – I’m told it was $16.34 a share. I actually don’t remember it trading there. So, I probably couldn’t have gotten it there even if I’d wanted to. But I do remember it trading just under $17 a share several times. It was at one of those times – I think it was October, that I decided I’d buy DreamWorks. So, I put in a buy order at $15 a share.

As you know, the stock never traded below $16.34 a share.

I should note that there’s no reason I had to put in an actual order. The price I was willing to pay was around 10% below where the stock was trading. DreamWorks is not an illiquid stock. It has a market cap well over $1 billion. So I simply could’ve waited to see if it traded near $15.

Why didn’t I just do that?

I don’t like to worry about the actual buying and selling of stocks. I hate watching tickers. Looking at whether a stock is up or down on the day. It’s a waste of time. Peter Lynch mentioned in one of his books that he spent too much time on that stuff. With illiquid stocks, I know I do. The important thing is picking the exact right company. And then picking the approximately right price. In reality, whether I got DreamWorks at $15, $16, or $17 wouldn’t be the difference between a fantastic investment and a big mistake. At most, we’re talking 10%. What matters is:

· Was DreamWorks the right stock to buy?

· Was 25% the right allocation?

Those were the big questions I needed to get right. Is this the right company? And can I go ahead with a really big position. I decided the answers were: yes and yes.

Why did I pick $15 a share?

No good reason. It was an arbitrary number. When I buy a stock I like to know the stock is worth more than I pay for it. Personally, I think DreamWorks is worth a lot more than $15 a share. It’s not even close. The reason I picked $15 is that the company’s book value was higher than that. And nothing could be clearer to me than that DreamWorks was worth more than its book value. I should mention we’re not talking tangible book here – and even if we were, DreamWorks is a movie company and therefore has film inventory on its books which is accounted for in an unusual way. All of this is much more specific detail than you need to know. The point is just that I picked a number where I’d make DreamWorks 25% of my portfolio. And that number was not the market price. It was about 10% lower.

What’s much more relevant to your question is the amount of energy I put into researching DreamWorks. It’s actually possible to trace this pretty easily. For example, I saw both Kung Fu Panda 2 and Puss in Boots in theaters because I was researching DreamWorks. The first of those two movies – Kung Fu Panda 2 – came out in May. I’d been researching the stock for months – not weeks – before that movie opened. So, the answer is that I spent probably half a year thinking about buying DreamWorks Animation before I put in my buy order.

How did I decide how much energy to put into researching an investment like DreamWorks? Well, for one, DreamWorks was always going to be a 25% position. I’d either make it 0% of my portfolio or 25%. I wasn’t interested in anything else. This wasn’t a net-net.

Also, DreamWorks would’ve been – if I bought it – a long-term investment. It was extremely unlikely I’d sell the stock within three years of buying it. So, we’re talking about a company that was going to take up 25% of my portfolio for at least three years.

Contrast this with some net-nets I’ve owned which take up only 10% of my portfolio for just a smidgeon longer than on year. While I’m not saying that multiplying the percentage of your portfolio times the number of years you intend to own a stock is a perfect way of seeing how high a priority claim it should have on your research time – it’s not a terrible way to think. By that logic, DreamWorks was likely going to be seven times as important to my investment returns as a typical net-net. A typical net-net for me is a 10% position held for just over a year.

So DreamWorks certainly deserved a huge chunk of my research time.

But I didn’t buy it.

Was that a mistake?

Almost certainly. I mean, the stock is up near $19.50 or so now. But that’s not what I’m talking about. The issue is whether I should’ve cared that much about price. No. I shouldn’t have. I should’ve just bought the stock when I decided this is the business I wanted to own.

Why didn’t I?

Old habits die hard. I’m a value investor. I buy net-nets. Things like that. I have certain price ratios and things in my mind. They hold me back sometime. It’s irrational. At $17 a share, I should’ve just bought DreamWorks. It seemed then that it had a margin of safety – a level of comfort – at that price that was equal to the net-nets I normally buy.

Which brings up the tricky part. It’s very hard to explain how comfortable you are with a stock. We can talk a little bit about how safe a net-net is because those are mostly quantitative measures. It wouldn’t do much good for me to discuss what I thought DreamWorks was worth and why to explain my thinking.

The key points are that I thought the stock could double in about three years. Over a three to five-year holding period, you could – potentially – make 30% a year in DreamWorks if you bought at $17 a share.

That was my judgment. It could be terribly wrong. But that’s the upside I saw. I figured this would be a $35 stock within three to five years. So annual returns could be in the 15% to 30% range.

Net-nets return around 20% a year. Walter Schloss made 16% a year over a very long time. You can maybe do 20% a year if you are working with very, very small sums of money. If you look at what net-nets – with no size cut-off – do, it’s in the neighborhood of 20% a year.

So, if you find a high-quality company’s stock that you think can return 15% to 30% a year for the next three to five years – and you’re as confident it’s worth more than today’s price as the net-nets you usually buy – you can buy that stock instead.

And, like I said, there’s certainly the possibility a company like that can be worth seven net-nets – or more – in terms of your eventual returns. That’s because if you flip a net-net every year (as sadly, I’ve tended to) you need to find quite a few net-nets to equal one longer-term investment’s impact.

Finally, when I’m super comfortable with a stock I make it a 25% position. It’s really rare for me to make a net-net a 25% position. In fact, I can only think of one time I did that.

So, the simple answer for me is that I spend almost half my time looking at net-nets and almost half my time looking at high quality companies. (The two almost never overlap). On average, I spend way more time on each high quality company I research – because I research far fewer high quality companies.

I look at a lot of net-nets. But I look longer at each high quality company I research.

Ask Geoff a Question about How He Divides His Research Time

Check out the Ben Graham Net-Net Newsletter

Check out the Buffett/Munger Bargains Newsletter

About the author:

Geoff Gannon



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