15 Questions With Tom Jacobs

Today we are interviewing investing author Tom Jacobs. We talk about how he got his start in the market, the first stock he ever bought as well as the bargains he is finding in today's market.

1. How did you get started investing?

I started reading the stock tables in the paper when I was 12. Growing up in Rochester, New York, I was fascinated that you could actually buy Eastman Kodak (KODK, Financial), Xerox (XRX, Financial) and Bausch & Lomb stock. My dad, raised in the Depression and who worked at Kodak in the training department, noticed my interest and taught me about dollar-cost averaging. He said, "Let's buy $100 worth of some stock you pick." I narrowed it down to Ford (F, Financial) (which we drove) and Wrigley (which I chewed). Wrigley's P/E (price-earnings ratio) was too high – I didn't know about the off-balance sheet value of the brand – so I bought Ford. By the way, $100 of course bought an odd lot, and the commission was probably 30% of the total trade cost!

2. What is your background?

I started my first business at 15 and have worked ever since. I must have been the only person graduating from Cornell who went into high school teaching, but it was my love and allowed me to teach in Venezuela and Kenya. Then, years of reading The Economist got me interested in business on another level, but I chose to go to law school – business school somehow seemed too raw capitalist for me. What a crazy distinction and how astonishing in retrospect! Did corporate law briefly and then 10 years in public service with EPA (Environmental Protection Agency) and the Department of the Interior. My clients included the Bureau of Indian Affairs, which turned my concept of history upside down. Great times. Then my old passion returned in the dot.com boom, and I was fortunate to be hired by The Motley Fool and given complete freedom to research, learn and write. I owe that company so much. So then from there I was in the stock research (newsletter) world for them and on my own over 15 years, which is pretty much about enough for anyone. (As the author of "Midnight in the Garden of Good and Evil" said, after making bazillions on that book, when asked why he stopped writing for GQ about men's clothing and started on the novel, "There are only so many things you can say about men's underwear.") After my first book came out in 2012, people started approaching me for money management.

3. Describe your investing strategy.

I serve individuals throughout the U.S. and even internationally in separately managed accounts (SMAs). This allows investing for annualized not annual returns, unlike hedge funds, who live and die by the calendar. Of course, the fees are lower, but the relationships are better and I can service some smaller clients (that's the teacher side of me). My clients, unlike those in the newsletter world, are not focused on "beating the market." They want reasonable returns and, as is common, are often volatility averse. So I use a value-income strategy for the latter and then small cap shareholder yield for those who can withstand volatility. More on the details in a bit.

4. What drew you to that specific strategy?

Losing money in the dot.com crash. Pure and simple. Speculation was not working, clearly. I got severely burned. At the time, two guys I worked with, now-Centaur Capital's Zeke Ashton (Trades, Portfolio) and Truelight Capital's Matthew Richey, were sharing vials of secret value investing potion in dark alleys at the Fool, and I asked a lot of questions. Whitney Tilson (Trades, Portfolio) was writing weekly value columns. Value doesn't sell in the newsletter world so it was a whole new thing for me. Value evolved for me over time as a discipline against my tendency to take too much risk.

5. What books or other investors influenced you?

Like everybody else reading this, probably, the Jason Zweig edition of Graham's "The Intelligent Investor" and Joel Greenblatt (Trades, Portfolio)'s "You Can Be a Stock Market Genius" turned my world upside down. I've also immersed myself in stock market and finance history because it really helps put everything in perspective – that nothing is really new and that long term is not a few years. Steve Frader's "Every Man a Speculator," "Reminiscences of a Stock Operator" and of course "Where Are the Customers' Yachts?" are great for that. Justin Fox's "The Myth of the Rational Market" put together so much and showed how academia can often deny reality in the face of data in order to preserve its perquisites. Confirmation bias, confirmation bias, confirmation bias.

Under exclusive license from the copyright holders, I'm also republishing the complete works of Maurece Schiller, the inventor of special situations and completely unknown outside of Greenblatt's Columbia classes. We know almost nothing about him biographically and invented an entirely new and original field completely alone and unheralded. His books are a challenge. He was an extraordinary research mind and doing something no one else ever had, and he apparently never met an active verb, but to see his take on Wall Street and stocks from the early 1900s to 1966 (the date of his last book) is breathtaking. So he's been a great influence. And of course Warren Buffett's shareholder letters. Taleb's two great books, "Fooled by Randomness" and "The Black Swan," are so valuable, even if all one could say was to turn you to Benoit Mandelbrot's "The Misbehavior of Markets" and understand, throw out the Bell Curve and see most investors as picking up nickels in front of steamrollers.

Oh, and at the risk of going on and on, hedge fund manager Alex Rubalcava turned me on to Gary Taubes' "Good Calories, Bad Calories," telling me that regardless of what I thought about the science, it told a gripping tale about confirmation bias. Proof? We've just learned that industry bought off Harvard profs in the 1960s to steer nutrition research away from sugar and to saturated fat. Taubes' book explained what happened as a result, and years ago, too. So both a confirmation bias tale helpful for investors and a cautionary tale to always go to the sources, not buy just the brand name ("Harvard prof").

6. How has your investing changed over the years?

We already see that I was willing to learn from the dot.com burn. With colleagues' – now friends' – help, I immersed myself in value. First plain old cheap but not deep value, then deeper, followed by special situations, and then the shareholder yield of value and special sits (the latter with mixed success, due to style drift, the great demon). Interestingly, almost all my shareholder yield comes with special situations by accident, and arguably the free cash flow circle of shareholder yield is a special situation because you can calculate return so long as the company is steady state. Shareholder yield may come with age, as I see time and compounding from the perspective of having had more time. Working with younger clients who think they can afford more risk of loss but actually can benefit most from long-term shareholder yield and my contemporaries who may be retiring but have 20 to 30 years of inflation ahead has really showed me the value to clients of small cap value plus shareholder yield. And of course a dividend-income strategy, value-based, for newer retirees. I don't do the bonds-equal-your-age thing. The so-called "glide path" research is disposing of that.

7. Name some of the things that you do that other investors do not.

Probably I have to spend more time than the average person managing my emotions! I have to set all sorts of rules to keep them in check. Guy Spier's book and an article in the AAII Journal really help. The entire section of my new book, "Rule of 72: How to Compound Your Money and Uncover Hidden Stock Profits" (no publisher will publish anything without something like that last part, right?), is 20% about behavior and behavioral finance. Richard Thaler and Cass Sunstein (whom I was lucky to have as a law professor)'s collaborations have helped me see behavioral traps more and more. Kahneman and Tversky. Justin Fox captures well the conventional wisdom's horror as Kahneman, a sociologist, won the economics Nobel and Thaler's article "Mental Accounting" refuted efficient markets. I can do the analysis. It's the emotions that are hard to manage. We are more human than otherwise, after all. If it weren't for the relationship challenges, I'd be happy to be Michael Burry.

8. Where do you get your investing ideas?

I have a huge weird glue-and-Scotch-tape Excel file for tracking my take on shareholder yield using YCharts plug in (I can't afford Cap IQ) and frankly, with SeekingAlpha publishing the conference call transcripts, YCharts pretty much does it all anyway. Tracks buybacks, valuation metrics to check on the value of those buybacks, drilling down on the dividend and debt paydown and so on. Free cash flow, free cash flow, free cash flow. The growth people think that buybacks and dividends are the end of investors' paydays. I think they are the end of management's paydays and the beginning of investors' better reward for the risk.

9. Name some of the traits that a company must have for you to invest in it.

Small cap plus value plus free cash flow plus paid to us in one or more of value-based buybacks, solid and rising dividends and high-interest debt paydown.

10. What kind of checklist do you use when investing?

For ongoing portfolio management, it's all about sizing positions for risk and style drift. Every poor investment decision I've ever made was due to style drift. I don't repeat the same ones, but I still make mistakes. The equation in No. 9 is the key.

11. Before making an investment, what kind of research do you do?

A lot. And of course original sources. The spreadsheet is just to make sure I don't miss anything obvious. But it's the financials and footnotes, as you might guess from my first book. Somebody's got to do it. And with small caps, someone who does the research can get an edge. I'm never going to have an edge on anyone with Microsoft (MSFT, Financial), Apple (AAPL, Financial) and the like. What do I bring to Johnson & Johnson (JNJ, Financial)? Charlie Munger (Trades, Portfolio) and many others advise to go where others aren't, where the competition is less. Value investors say that all the time, and yet it's still hard.

12. What kind of bargains are you finding in this market?

It's amazing how many community banks are still ignored and priced below book. For the dividend-income-value side, it's crazy how many perfectly good closed-end bond funds are selling for discounts to NAV that we've never seen, taking into account whatever interest rate scenario you see. You have to be picky, but when don't you? And the stuff the growth folks have thrown out is so cheap it's – yes, I'm gong to say it – a cornucopia of low cost or free call options. You don't have to know anything about hepatitis B (I exaggerate, but still) to know that Gilead Sciences (GILD, Financial) is a low-to-no-cost call option today. And because we have to have some controversy, Sears Hometown and Outlet Stores (SHOS, Financial) is the second-most undervalued equity there is today. I'm glad people are afraid of it and see it as a value trap. What Eddie Lampert is doing there is amazing, and of course he's not telling us about it. People have long since dismissed him because of Sears Holdings (SHLD, Financial), but they don't follow the details. Footnotes, small print, imagination (ha!). I never make predictions, but if I did, it would be that this will be very rewarding at today's valuation. Unfortunately I was in early before managing SMAs, but fortunately my clients are better off, invested at something like 25% of tangible book, which unlike some commentators assert, is pretty tangible.

13. How do you feel about the market today? Do you see it as overvalued?

There's this great story about a questioner asking the late Justice Antonin Scalia at a talk about how he and Justice Thomas shared the same originalist view of the Constitution. Scalia reportedly disagreed saying, "I'm an originalist, but I'm not crazy!" I feel the same way about the market. I buy businesses, not stock markets, and valuations of companies, not markets. But that said, I'd be crazy not to pay attention to the broad market extremes, no matter how long they may and do last. So for what it's worth, I do not see the stock market at any extreme today. But don't listen to me. I thought it was overvalued from January 2011, along with Prem Watsa (Trades, Portfolio) who hedged Fairfax's equity portfolio 100% starting then! It doesn't matter anyway. I don't own any of the big stocks that drive the S&P 500. Like I said, small caps.

14. What are some books that you are reading now?

With daily SEC filings, all the reading for the Maurece Schiller republication, I need to take a breather from investing at the end of recent days. I just finished Kevin Roose's "The Unlikely Discipline" about going undercover as a student at Liberty University. Talk about a lesson in confirmation bias – whether a Liberty devotee or the opposite! Wonderfully told. Walter Isaacson's bio of Benjamin Franklin. Taking time but every page a delight. Vladimir Nabokov's "Pale Fire," which is the funniest book I've read since Aziz Ansari's "Modern Romance." How did I miss it? And we do watch tons of Netflix (NFLX, Financial), Amazon (AMZN, Financial) Prime and Acorn.tv.

15. Any advice to a new investor?

Practice, practice, practice. Benjamin Graham: "We urge the beginner in security buying not to waste his efforts and his money on trying to beat the market. Let him study securities values and initially test out his judgment on price versus value with the smallest possible sums." I think it took me 10 years in value investing before I could see the dawn and another four to hit get to lunch. If it takes an analyst Malcolm Gladwell's 10,000 hours to be any good, and we work 48 weeks a year, able to focus six hours a day five days a week on learning (you just can't study investing more than that each day, seriously, and I've found that my decades of working weekends probably have added nothing), that's about seven years so part time it's multiples of that. So either go to Vanguard or commit to studying. Screening alone, newsletters – anything that means not reading original sources is like talking about a book or movie you haven't read or seen (remember, everyone's got an angle, as Bing Crosby said in "White Christmas," and newsletters are a business first). Other people's opinions may point you to something, but you have to do your own research. I speak from having paid for not doing this in the early years. And finally that great thought from Philip Fisher, that there is no right way to invest. I've found mine, but if you do well trading options, pork belly futures or even based on (horrors!) technical analysis, more port to you. I can't. I need value to save me from myself and best serve clients. Others may not. Heck, I can't even trust myself with growth at a reasonable price!

I've tried not to give you the formula investor letter style that value managers think everyone must use, but on the other hand they probably have way more AUM. At my age, you are who you are. I couldn't convince anyone otherwise anyway.

Thanks for the opportunity to chat.

Disclosure: No position in the stock mentioned.

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