Jack Bogle gave us the index fund. Warren Buffett has said most people should put their money into index funds.
Personal finance bloggers—especially in the FIRE* community—spout “index fund” like it’s a nervous tick. And you might have noticed this blogger has the same nervous tick.
Some are worried about all this index fund investing. The concern is index funds will control so much of the market that it will lose its efficiency. I remember the same concerns in the 1990s, when I was a stock broker, about mutual funds in general, most of which were actively managed.
Index funds will not break the market any more than actively managed mutual funds did. For one, there will still be plenty of people investing in individual stocks. And the hedge fund guys will do their share providing liquidity.
Index funds are automatic investing. All mutual funds and ETFs for that matter. You drop in your money (dollar cost averaging is suggested) and let time perform its magic. The broader based the index fund, the better your chances of enjoying the stellar performance of the market averages.
But some people don’t like “average”. And even the most hardened index fund investor periodically finds a company she would like to own a piece of directly.
That is where we come in today. Finding a gem that can add to your portfolio’s performance isn’t easy, but possible if you know where to dig. Many have made a career out of beating the market with thoughtful investments.
Index funds should be the home for a good chunk of your money. However, you might have a mad money account or even a serious money account for investing in businesses you feel are under-priced while possessing future growth potential.
Investing in individual companies can be very rewarding, but carry significant risks. I’ve been fortunate in finding great businesses that have performed well over the decades. My individual stock investments have outperformed the market. I’ve also noticed I think differently about an investment than most.
Today I will share why I buy what I buy, and more importantly, why I pass on so many opportunities that seem so obvious.
Buy the Hated, Be Leary of the Loved
Most people buy the hot stock because everyone is doing it and the recent price action has been tilted steeply up. These are the loved stocks. In the early 1970s they were called the Nifty Fifty; we now call them FANG (Facebook, Apple, Netflix and Google, the parent company of Alphabet) today.
Buying hot stocks is easy because everyone is doing it. That always causes me to pause.
For disclosure, I own one share of Facebook and a modest amount of Apple. I never owned any Google stock, but had a brief fling with Netflix.
Most loved stocks are priced accordingly. While I do own some shares of FANG companies, they are not predominant in my portfolio.
Let’s do a brief rundown of the list. Netflix is sporting a 134 price/earning (p/e) ratio as I write. While NFLX has a dominant market share and there are reasonable barriers to entry from competition, NFLX faces stiff competition from Apple and more importantly, Disney. NFLX doesn’t have to fail to drop significantly. If Disney captures even a small slice of NFLX’s business the stock is in trouble.
Google is also richly valued at over 40 times earnings. Facebook is a company I want to own, but management is concerning. FB has a dominant platform and not much in the way of competition. When FB dropped below 130 in December, the margin of safety was large enough for me to buy. But it was a modest investment.
Apple is a story we’ll address shortly.
I’m not saying there is never value in popular businesses. What I am saying is they tend to be over-priced. Warren Buffet once said he preferred a great company at a good price than a good company at a great price. Think about that for a moment.
NFLX and GOOG are excellent businesses, but are difficult investments to make at the current price. You don’t buy a great company at any price! You want to buy great businesses at a good price (or better) with plenty of margin for safety. Things do go wrong, you know.
Another area I tend to avoid are the socially acceptable investments. Everybody wants to invest in green companies these days. As a result, all that extra money is pushing these investments to levels too rich for this accountant’s blood. There can be select quality investments in this area, but none of it is cheap.
Since investing is about making money and not some ethical or moral statement, I seek value where others tend to avoid. Think of the most hated stocks: oil, coal, tobacco, processed foods.
I don’t own Exxon-Mobile (XOM), but I did take a look-see. As longtime readers are well aware, I own a lot of Altria stock, one of the largest tobacco companies on the planet. This is a good place to start our research on what makes a business worth buying.
Anatomy of a Good Investment
I think it was Warren Buffett who said, “It costs a penny to make and it’s addictive. What’s not to like,” about Altria (MO). In my opinion, Buffett would own a large slice of MO if he didn’t have a reputation to uphold.
Peter Lynch, in his book Beating the Street, shared his wisdom with a set of principles. Peter Principle #14 said: If you like the store, chances are you’ll love the stock. While Lynch is a legend in the investing world with a whopping 29.2% average annual return (better than Warren Buffett’s) when he managed Fidelity’s Magellan Fund from 1977 to 1990, there are times his principles are not hard and fast.
Take, for example, Amazon. AMZN is a great company with great management. I love the company and buy plenty of stuff from the platform. Unfortunately, the stock price is not so great. Buying even a great company with great management at nearly 100 times earning is a serious risk. AMZN is a great company, but probably not the best investment for me.
Which illustrates a point. I don’t smoke. Never smoked. But I do love MO as an investment. Their track record is unbelievable and they are doing it in a shrinking industry.
Still, my purchases of MO slowed these past few years. The price was a bit high for the situation and the 30 years of a declining cigarette market was starting to look problematic. True, MO has the world’s leading cigarette brand in Marlboro and are one of the best managed companies publicly traded. Management loves rewarding shareholders which is also a good sign.
The declining market size didn’t concern me the most; competition did. Peter’s Principle #16 says: In business, competition is never as healthy as total domination. I agree. And MO was facing serious competition for the first time in decades from a new foe: Juul.
Vaping isn’t exactly the most loved industry either. However, vaping was taking market share from MO and it was starting to move the needle. MO made attempts with their Nu Mark product to no avail. Juul was taking over the vaping market the way MO took over the cigarette market. And the regulatory environment creates plenty of barrier to new entrants.
What turned me the most positive on MO in my life was the 35% purchase of Juul. And the best part is vaping costs less than a penny to make and is also addictive. (MO also invested in a Canadian marijuana company.)
My greatest excitement with Altria is the potential size of the vaping market. When you review the numbers it is not hard to see Juul could be a larger company than MO. And more profitable due to the lower taxes on vaping products.
Excitement is not a good thing when investing! Boring is best because this is going to be a long slog. Patience is the most important quality when investing. I bought my first shares of the now Altria in the early 1980s. If you reinvested the dividends, MO was one of the best performing stocks of the last 30 years. And you enjoyed a couple of profitable spin-offs along the way.
Here are the things I looked at when purchasing more MO in December and earlier this year:
Is there an existential threat?
The massive investments MO made in late 2018 required review. The question has to be asked: If the government shut down Juul today would if put MO at risk of collapse?
After researching the issues it became clear the answer was “No”. If Juul went out of business MO would lose their $12.8 billion investment. But(!), this would not be enough to cause a dividend cut. Dividends would climb slower, no doubt, but the enterprise would continue. Also, if Juul disappeared, the people using the vaping products would probably turn to cigarettes for their nicotine fix, which MO has a dominant share of the market.
What about debt?
All else equal, I prefer companies with less debt. MO certainly has debt. The debt they issued to buy Juul will increase interest expenses. MO management said cost-cutting would be enough to offset the entire additional interest expense. Very encouraging.
An over-leveraged company should be avoided as the risks are too high. The balance sheet should provide all you need to determine the debt level the business has.
Everybody hates it!
MO’s stock took it on the chin as investors hated the Juul investment, at first. For a brief moment I was able to buy a great company in a hated industry that was hated by even its own investors. And there was nothing to warrant such a response. Yes, MO paid plenty for Juul. However, looking at Juul’s growth, the price will look like the steal of the century in less than a few years. So I backed up the truck. Now my dividends are even higher.
You do not need to be an accountant or tax professional to read a public company’s financials. But you do have to read them. Let’s take a look at MO’s balance sheet.
The balance sheet is the most important financial to review. (The cash-flow statement is a close second.) Income statements can be cooked, if you will. The balance sheet tells me how solvent the firm is. It also tells me if a recent investment creates an existential threat.
As you can see, MO has reasonable amount in cash and investments in other companies. If MO sold all investments in other companies they own for the price they paid they would have enough to retire all debt. MO investments in Juul and ABInBev are solid investments so they probably could sell these investment holdings at a profit. But we’ll discount some of these investments anyway to pad our safety margin.
When you review MO’s cash and investments against it’s debt and consider the shareholder’s equity, it is easy to see MO is not facing an existential threat due to their Juul investment.
One thing to note. The reason for the large negative number for Treasury Stock is due to share buybacks. This is not unusual.
A Few More Investments
As I noted in the beginning, I have a large share of my liquid investments in index funds. My retirement funds are almost 100% index funds or cash. My non-qualified monies (money in non-retirement accounts) are partially in index funds; a large portion is also in individual stocks. Buying good companies and holding them for a long time by default will increase the percentage not in index funds.
Apple is one of my newer investments. I will not provide financials as I did for MO. You can see Apple’s financials at CNBC.
I prefer buying when a company is on sale. December last year when the market was down ~20% had me buying heavily. APPL has been in my portfolio for years and I added to it. I never used their products so I didn’t know if I’d love them or not, but I am fully aware of the cult status Apple users feel about their Apple products.
APPL is a popular FANG stock so it might be something to avoid. Except, the stock price increase was accompanied by increasing earning, low debt, loads of cash and stellar management. Of all the FANG stocks, APPL has the best management team.
If you take the cash and subtract all debt, APPL still has ~$35 per share in cash! This means the p/e ratio is lower than listed. In other words, the enterprise has a 13.74 p/e ratio on it as I write. This is more than a reasonable purchase price for a company in a class by itself and a cult-like following. Though, I would prefer it “more” on sale before buying more.
Knowing When to Sell
Selling can be harder than buying. Even the world-renown Warren Buffett, who says his favorite investing horizon is forever, sells investments periodically.
Even your favorite accountant has sold a few shares of his beloved MO in the past.
Let’s take an example of why selling is different than buying. Buffett’s fourth largest holding is Coca-Cola (KO). He bought KO in the 1980s (if memory serves) and has held it since. The dividend is solid and growing.
If you looked at KO today (a hated stock because they sell sweet drinks bad for teeth and accused of causing obesity) you would probably take a pass. The company is awesome with an awesome product and solid management, however. KO is dominant in their industry. But where is the growth coming from?
KO has a lot in common with MO. People are drinking less fizzy soda water and the world population is no longer growing fast enough to power profits higher. Unlike MO, KO can’t raise prices as easily.
That said, If I owned KO I might not sell it. (I owned KO from the mid-80s to the late 90s.) The financials don’t excite me enough to buy a piece of the company. However, selling doesn’t make sense either. Selling would cause a serious tax bill if you held the stock a long time. And dividends like that are hard to come by.
When I sell it tends to be early on. If my original premise starts to erode I sometimes exit the investment. I bought Tesla and eventually sold. Of course I look smart because the stock was straight up at that time. However, my investment was more along the lines of keeping an eye on the company rather than a new serious investment position. The issue: Tesla without Elon Musk is in big trouble and they might be in big trouble anyway. I consider that a management issue in a very competitive market getting more competitive by the day.
When Facebook did a Faceplant in December, I bought. After considerable thought I came to the same conclusion about management and sold.
Like Buffett buying KO, I bought Aflac (AFL) in the B’C.’s (actually the early 1980s) and held it ever since. I haven’t bought more in longer than I can remember. The dividends are climbing and it has been a good investment with a very accomplished management team. I looked at AFL recently (for this article) to see if I should buy more. There are certainly reasons to buy, but not enough for me to add to my position.
Certain things will have me selling fast. Hints of accounting irregularities are usually a sign to exit. If new management is failing, I leave. (I owned GE once upon a time and sold all of it because I had no faith in new management after Jack Welch left.)
Patience is key to winning at investing. You wait for the right deal, then buy and wait forever as the business value keeps climbing. The stock price and dividends soon follow.
Finding a list of “hated” companies is easy. I want big, dominant companies in my portfolio. This reduces the chance of catastrophic failure. A good example is Boeing (BA).
BA is one of two major aircraft manufacturers in the world. (There are some smaller firms, but BA and Airbus control most of the market.) Recent crashes of Boeing 737 Max planes put BA under pressure. I bought a share so all the news stories would populate my feed. The stock started climbing so I thought I might not get a chance to buy at a “good” price. It happens. Most “watch list” businesses never become a real investment.
BA came down again, but not enough for me to buy. Personally, I like BA more than airlines. Buffett disagrees, but I’m okay with that.
Another watch list stock is JNJ. I owned JNJ in the past and I forget why I sold. (It was a dumb idea.) The recent asbestos in baby power/talc court ruling drove the price down. A little. Not enough to buy.
I’m watching Microsoft (MSFT) also. They really found their mojo after years where management struggled. I think Satya Nadella is a good leader at MSFT.
Of course, I own other businesses not discussed here. The idea is to give you the mindset necessary to win at investing.
Here is my final note: There is no crime is holding cash! Sometimes I catch heck when people realize I’m holding cash instead of investing in index funds. I can handle it. When the market is up I buy less because good investments are harder to find. When the market declines, like it did late last year, some businesses get discounted more heavily than others. Usually I find reasons to put my cash to work at those times.
Now the market is near a new high again and new money is still looking for a home.
So I wait. Patiently.
* FIRE: Financial Independence, Retire Early
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One of my favorite pastimes is thumbing through the financials of public companies. Hidden gems do exist, but they are rare with the myriad analysts using serious computing power to scrub large firms daily. This is one of the reasons investing in an index fund makes so much sense.
There are good investments in the large company world. As I write, Apple Inc. has around $50 per share in cash in the checkbook. When you subtract cash the enterprise value is in the low teens. This is a good value from most perspectives. However, there are risks associated with Apple. First, it’s hard to move the needle on such a large company. Second, they manufacture a large part of their product in China. A quick glance at recent news and it becomes clear the risk involved. Third, each product launch needs to keep growing larger at a rapid pace to stay on top the pack. The one thing Apple has going for it is a large margin of safety.
The Wide Open World or the Wild West (You Decide)
Large international public corporations aren’t the only game in town. There is another world fraught with many risks and the promise of undiscovered gems worth many multiples of its listed price.
These quasi-public companies are followed by virtually no one. Worse, audited financial data is hard to find if available at all. And the biggest problem of all: insider trading.
These companies are listed on what is called the Pink Sheets, a throwback to the days when their quotes were printed daily on pink sheets of paper. Quotes were hard to come by in the past. Today, most of these companies can be pulled up from most online trading platforms (E*Trade, et cetera). One thing to remember, pink sheets is a quotation service only. Online brokers get their quotes for these stocks from that source.
The reasons for listing on the pink sheets are varied. A large number are outright scams. Others are companies who have fallen on hard times. Large international firms outside the U.S. sometimes opt to list on the pink sheets so they don’t have as heavy a reporting burden. Nestle is a prime example.
The world of small stocks isn’t littered with pump-and-dump scams only. Many small banks also list on the pink sheets. A small, one-branch bank in a small town in rural America has no chance of selling shares on the broader exchanges. The reporting requirements alone would be disruptive to their business model. The small bank can instead opt to list on the pink sheets. They will still report to the banking regulators and provide some financial statements on which to make an investment decision. Find a small one-branch bank near where you live and pay them a visit. Ask if they have stock you can buy. You might be surprised. They sometimes pay an attractive dividend.
A Round of Golf, Anyone?
Your favorite accountant has some experience buying stocks from the pink sheets. It doesn’t happen often because there is far more garbage then gemstone in the detritus. The smell tends to get on your hands and it doesn’t wash off worth a darn.
Outside tax season I like to waste an afternoon several times a year scouring the pink sheets based on geographical location of the listed company. The screener I linked also has OTC listings in addition to the pink sheets. I’ll let you play around with it on your own.
For our discussion we will focus on one stock I did buy in the early 2000s. I set the screen to list U.S. companies only. I started scrolling down the list looking for all listings in Wisconsin, my home state. I made a note of each Wisconsin listing.
My hopes weren’t high I would find anything of value. Even if a gemstone rose to the surface I may never recognize it. Remember, information is hard to come by on many of the companies.
One name jumped out. A golf course less than a two hour drive from my home caught my eye. I was vaguely familiar with the establishment and didn’t know they were listed.
This is where it gets risky legally. The golf course on my radar was interesting so I started a pet project of researching the company. They hadn’t published any financial information in quite a while. Intrigued, I decided to go one step further.
My first reaction to any pink sheet listing is to stand clear. Our friendly golf course just hit me right. Wanting to know more I took a day trip. I can’t golf worth a crap, but I do get more value than the average golfer because I get to swing more often than they do. The trip was all in the name of research.
The golf course was well kept when I arrived. The parking lot was full; the golf course teaming with old guys wasting their day; and the clubhouse was doing brisk business. I was excited!
My research to his point was similar to analysts using satellite data of Wal-Mart parking lots during the Christmas shopping season. There is nothing illegal about visiting a company whose stock you are considering for purchase. Having a drink and playing a round of golf (I did) is also acceptable behavior. No security laws have been broken.
However, I had to be careful! Since financial reports were not published in a while I couldn’t jawbone with the golf course’s accountant to glean information. It would have been risky to even jawbone with bartenders or anyone connected to the club. Trading on non-public information is called insider trading a very illegal!
The stock of the golf course traded around $3. Based upon their location (close to my home) and how busy they were when I visited, I decided to buy. I bought all my shares from slightly under $3 up to $4. Because of the risk I would hear something I shouldn’t I never visited again. I bought $30,000 of their stock over several months and sat on it. There was no dividend so it was one of those things I collected on the back shelf and didn’t think about for a long time.
A few years later I checked on the stock to discover it started climbing at a slow and steady pace. My $30,000 was worth six figures. I was happy! I also knew if I tried to dump my shares I would probably not get the current listed price.
I tucked the stock on the back shelf again. Intrigued, I periodically checked the price. It kept slowly climbing. About six years after my purchase the stock was in the mid 20s when it disappeared. Oh-oh!
My dreams were shattered. There were still no financial reports and a quick drive to the golf course showed they were still open. Was it a scam?
Nope! A few weeks later a check came in the mail. They were bought by another golf course for cash. My reward for six years of holding the stock was a 14x gain.
Before you run out and try to replicate my experience, know lightening has only struck once in my field. I got lucky. My luck was weighted in my favor by verifying the company was really there and viable. (They had customers!) I bought with a lot of blind faith. Every other pink sheet investment (there have only been a few) produced less than respectable returns.
The golf course was my biggest venture into the pink sheets. It was also a bet (you decide if I invested or gambled) I was willing to take because it looked like a nice place. All public information legal to trade on.
My other investments from the pink sheets and OTC markets usually involved banks. Returns were less than spectacular. In some cases I even lost money. In my defense I never took a flyer buying a true penny stock.
Where is the Respect?
Penny stocks in rare cases can be a respectable investment as my experience has shown. I do NOT encourage such investments! They are very risky and only for those willing to do some extra legwork without crossing the boundary between legal and insider trading. You also must be willing to lose 100% of your investment.
For some reason a few penny stock journals follow this blog and republish articles from time to time (always with permission). I wanted to share my one positive example so these guys have an article that will resonate with their readers.
For regulars around here, I still recommend the bulk of your money finding a home in a broad-based index fund. This is the best place for most people to invest long-term. If you have an itch to scratch digging for buried treasure the pink sheets and OTC markets have possibilities.
One caveat. You will spend a lot of time digging before any morsel reveals itself. It’s just the nature of the game. The good news is that Wall Street isn’t watching. You don’t have to compete with large hedge funds and the super-wealthy. The value of all pink sheet companies combine is around $1 billion. Too small for mainstream investments bankers to waste their time on.
Now, if we’re done here, I know a clean golf course where we can knock a couple balls around.