Tag Archives: freezing assets shout out

Learning from our Most Painful Successes

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I think that every investor dreads the end of the quarter portfolio review—even when your quarter was successful.  Why? Because even in the best of quarters there are always the zombie stocks of your portfolio stumbling around for all to see.  We all struggle with defending these stocks to our peers and clients after they failed—even if the stocks were sold and it was the right decision to sell them at the time.  And we spend a lot of time analyzing these undead. All too often our successes go unanalyzed in these reviews because we attribute success to our intelligence, foresight and ingenuity of our investing process.  Unfortunately lots of avoidable future failures can be learned from our investment “successes”.

The Holy Grail of investing is developing a winning process that is unique, repeatable and sustainable. Achieving that goal means asking tough questions about success as well as failures. Investor hubris often comes from mistaking your intelligence for stumbling upon a bull market or your investing style coming into vogue for one’s clairvoyance. The key question, which rarely if ever gets asked, is what did you do differently this time that you did not do last time and is it repeatable? Equally as important is what insight drove you to that successful decision?  Why did others miss that insight? Will that insight continue to be overlooked? If an investor cannot answer those questions, success probably didn’t have anything to do with your stock picking skill. It probably had everything to do with luck.

Don’t get me wrong, luck is great as long as you can identify a particular success as such. It makes exiting out of a lucky position much easier of a decision. But again, achieving this takes some tough self-analysis and self-questioning, and not being afraid to admit to one’s weaknesses and misjudgments openly—even in the face of “success”.  Not always the easiest thing to do! Therefore long-term success means asking difficult questions about our winners as well as our losers. If they are truly winners, we can learn from them, incorporate what worked into our investment process and have (hopefully) even stronger results in the future.

We know how to question ourselves in our failures. They are there for all to see. Honesty is required in these situations. But good results don’t lie do they? Yes they do. Therefore brutal honesty is required here as well.

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Living on the Edge Part III: Let’s Get Small

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Last week we discussed if investors can get an edge on large cap stocks. This week is focused on smaller cap stocks (e.g. $3 billion or less).  Most investors and academic studies usually concur that one can get an edge on small cap stocks because there can be an informational advantage as smaller companies get less coverage on both the buy and sell sides.  Investors can occasionally see their money double or more as Wall Street becomes aware of these underfollowed companies.

That’s the good news. However, for every success story there are dozens of small cap stocks that will continuously languish in obscurity. The investor’s challenge is often not if you can get an informational edge on an underfollowed small cap, the challenge may be determining if anyone besides you will ever care enough about the name to purchase it. This is a major concern, especially with illiquid stocks that can take days, if not weeks, to exit a position if the stock fails to work. Therefore it is crucial to not only know a small cap company and the catalysts that theoretically should propel it higher, but also the ownership structure.

Knowing the ownership structure not only entails knowing how much of the float is owned by management (and oftentimes the management’s family) but also other investors that are currently involved in the name and activities surrounding those investors that could “loosen up” some shares of a small cap company. These activities can include things as changes in Portfolio Managers, tax needs of the investor, estate property changes or modifications, or any number of things other than valuation reasons that can influence the sell decision for an investor.

It also helps to know, or get a sense from your analysis, if there is a secondary offering coming, which improves the number of shares not held by management. Those offerings usually are followed by growth initiatives such as M&A activity, increasing the distribution channels of the company, increasing capacity, international expansion or any number of investment opportunities.

Therefore the investor can likely get an informational edge with a small cap stock, but sometimes that might not be enough. You need to know other factors quite well, such as ownership structure, for that edge to matter and happen within the investor’s time horizon as well for the stock to work.

Living on the Edge, Part II—Make Mine a Large (Cap)

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Late last month, we asked if you can get a real edge on individual equities in general. This week we ask if you can get an edge on large cap stocks in particular. We think yes. We think there are lots of ways to get an edge on large cap stocks—more ways than we can fit in here. So we’ll discuss just one of our favorites: Looking beyond the next handful of quarters in earnings estimates.

One of the toughest parts of an analyst’s job is deciding whether to use a short-term or long-term outlook as he or she develops an investment thesis. Often—perhaps too often—the shorter view wins out for less-than-the-best reasons. Because analysts usually are judged on quarterly performance, for example. Or because there are so many voices chattering about the same issues concerning a particular security.

Those short term perceptions are often what drive a stock, but in our experience, short term noise and thinking can create biases in analysts’ financial models—particularly in forecasting next year’s earnings estimates.

For instance, if an analyst is convinced that shorter-term factors are going to have a negative influence on a particular stock, chances are that perception will bias his-or-her longer-term estimates. Such a bias can keep estimates artificially low, as the analyst may have a difficult time explaining to clients a negative thesis on a stock with accelerating longer-term forecasts.

Simply being aware of the potential for such a bias can be a powerful tool, especially when an analyst believes the longer term potential of a stock outweighs the short-term risks.

So when we hear that most investors are waiting for that “one last negative factor” to subside before getting more constructive with a security, we get interested.  Usually, with well-known products and names, the negative factors are already well-known and anticipated—and factored into short-term forecasts.

But longer-term recoveries from those negative factors in subsequent year’s numbers are often overlooked. The result is a potential edge for the investor willing to cultivate the long term perspective.

There is, of course, the risk that those shorter term factors will drive down the price after one purchases a security. But if your long term investment thesis is unchanged after those events such a price dip often is a great time to add to a position.

What is Art, Besides Keith’s Guitar Work?

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We are taking a break from our series on getting an edge in the market because of what we read in an article in the Wall Street Journal about Keith Richards, the Rolling Stones, the song “Street Fighting Man” and the creative process. Some people might look at us strangely but we have always considered equity analysis as at least partly a creative process, not unlike the creation of a song, or a piece of art. Therefore we occasionally refer to our job as being a “financial poet”. Sound unusual? It really isn’t. There are two parts to our job. The first is determining theoretical asset values using well-worn financial analytic tools.

In actuality, determining the intrinsic value of a company mathematically is what we need to know to become analysts in the first place.  We all know the tools and the language. We all know what questions to ask. We all know how to read financial statements. But there is so much more. What is that? Specifically it is the art of investing. That’s the second and equally crucial part of our job.

Yes, we feel financial analysis is an art and a creative process; not unlike Keith crafting music on his guitar. Most guitar players can bang out notes and play a song, but how many can do so with emotion, feeling and originality? The same is true with the financial analyst. Feeling and originality in our case is determining value. Value is different than valuation. Valuation is an empirical term that can be measured by standard formulas and measurements. Value is much more esoteric and often cannot be measured by mere accounting measures. Accounting measures are more backward looking. How do we look forward? This is where the art comes in.

Taking a forward look means determining future values, user tastes, and various other things that are unknown. It means we need to look at needs and how the need can potentially be fulfilled. This is also how we differ from entrepreneurs and business managers. Entrepreneurs and managers try to craft an idea and make a business out of it. Financial analysts look at many ideas from entrepreneurs and managers, especially in smaller companies, and attempt to determine which one is the most viable and will succeed as an investment.

The challenge is eliminating our biases. In that regard, we need to put ourselves into the mind of the person whose problem is being solved by that new product or service and then try to determine if it is an investable concept. For instance, how many people are there that will be motivated to act by that product or service? Would, say, a Chinese citizen react differently than an American to that product or service?  How about a younger person versus an older one? Analysts essentially have to leave our experiences, biases and beliefs at the door and look at the world from a different perspective in determining value.

Once we determine value, then can we open up our financial toolbox and determine valuation. Therefore we are not unlike Keith Richards (minus the chemicals). Keith had to learn the chords and notes before he could play the guitar. However, to make the guitar tell a story he needed to determine if a concept he had was worth pursuing. That takes art.

This will be the last Freezing Assets Shout Out until after the New Year. Happy Holidays everyone!!!

Living on the Edge, Part 1

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Snow and us have a mixed past. We loved it growing up, but our liking for it soured when we moved back here from grad school in the South—just in time for the 1991 Halloween blizzard. Lucky us. Overall we like winter, but the first storm irritates us because it is shock to our system. What else irritates us? Near the top of our list is when people ask us “do you have an edge on the stock?” when discussing a new idea.

We dislike that question since people in the investment community usually talk to the same analysts, read the same regulatory filings, go to the same conferences and often know each other in the financial community by name at least locally—how does one get an informational edge when there is that much intimacy with the companies we follow, especially with mid and large cap stocks? We think a better question is how does your investment thesis different than conventional wisdom and why?

Having said that, we think that the “edge” question is an occupational hazard we must live with daily. Therefore over the course of the next couple of weeks we’ll explore the topic if can one get an edge from both a large cap and small cap perspective and if is it relevant. What do you think? Can one get an edge on a particular stock/security?