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One Up On Wall Street

19 May, 2020 | Book Notes, Investing

This book explains how the individual investor can make returns that beat the pros.

Peter starts by explaining why individual investors have some meaningful advantages compared to fund managers. From there, he explains what he looks for in great companies. It’s a clear and entertaining read - which is rare for investing books.

One of my favourite investing books.

Rating - 10/10.

View here: One Up on Wall Street

You may also want to view my other book notes.


TLDR

5 takeaways if you don’t read the full text.

  1. You come across stock opportunities in your day to day life, either as a consumer or in your work. Make it a habit to check companies and see if you can invest. Always do your research!
  2. Small companies have bigger price moves. If you want tenbaggers, you need to buy into small companies.
  3. You can swap in and out of Stalwarts on dips. Over time, you can compound these 20-30% gains.
  4. Think of stocks as a story. Is the story getting better? Is it holding up? Sell when the story disintegrates.
  5. Have a process and stick to it. You need to have discipline when investing.

small companies big moves

Summary

Introduction to this Edition

  • Doesn’t view internet (“dot com”) companies very favourably. Instead, he liked businesses where fundamentals are increasing.
  • Most investments take 3-10 years to play out.
  • His view is that stock price, eventually, will always follow earnings. So try to pick companies where earnings (profits) over time are growing.
  • How to think about buying stocks? You can work backwards to understand probabilities. For a stock to increase 10x, its market cap must first increase 10x. Then at that higher market cap, you can apply an industry average PE ratio to see what earnings it would have to achieve yearly. Then you can ask yourself, is that earnings target realistic? Whats the chance it can do that in its market?
  • A key point not to mistake - He believes that you can see companies around you in your day to day to add to your list, but you still need to do the research! Don’t just buy what you like as a consumer. You still need to check the financial condition, the competition, etc. What you know and see is just the starting point.
  • How can the individual investor compete with the pros?

    • Access to information is better and faster than ever before (the internet).
    • Buying stocks is cheaper than ever (no fees).
  • 6/10 winners in a portfolio still produces a great results, as losses are capped on the downside but winners can keep on winning.
  • Market change: dividends are down and share buy-backs are up.
  • Market change: markets are increasingly volatile, with several 1% changes a month (he suspects caused by increased day trading).
  • On market timing - Its tempting to think you can exit at the right time. But there is no guarantee you will buy back in at the right time. And if you miss the biggest increases, you results change dramatically.
  • The short of it - A stock is attached to a company. Pick a company that increases its earnings over time and you’ll do well.

Introduction

  • He believes individual investors can do as well as pro investors: “the smart money isn’t so smart and the dumb money isn’t so dumb”. In fact, the individual has some built in advantages.
  • Doesn’t mean ignore mutual funds, they still have a place:

    • If you don’t have time or inclination to invest.
    • If you seek diversification but have small contributions.
  • But if you are going to do stock picking, use your own research (rather than following others):

    • Others may be wrong and surely are around 40% of the time.
    • If they change their mind, you might never know.
    • You have better sources yourself.
  • Important to realise the outsized effects large winners can have on a portfolio. If you pick a tenbagger, it can drag a whole portfolio from being average to being excellent.
  • Common Knowledge can help you outperform. What goods to you like, use and enjoy? What companies around you seem to be growing? Look into those. Always be thinking about good products you encounter and then check if the company is public.
  • And beware of things you don’t know. If you don’t understand what the company does, maybe give it a miss.

Preparing to Invest

You want to have decided a few things first, personal things. Like how much to invest and what kind of investments. Whats your risk appetite?

Making of a Stockpicker

  • Most the math you need is from grade 4. Picking stocks is more art than science (trends, quality of product, market). It’s also practice rather than theory, you need to check things out
  • People who have had bad experiences of the stock market tend to warn you off. Don’t let them.
  • At college, he learned to doubt the efficient market hypothesis. When you know someone who has made 20x on an investment and explained why they thought it might do so, it’s difficult to believe the market had it right.
  • His approach was to own a lot of stocks, but this is a matter of flavour.

Wall Street Oxymorons

  • Most investors invest and fail in the same ways. You have to be prepared to do something different.
  • In particular, large funds can hear about new companies fairly late. So as an individual you can get into early companies (where the biggest returns often are).
  • There is also groupthink amongst fund managers. There is significant career risk of doing something different and failing, so they typically look alike.
  • Even when investors avoid groupthink, there may be other limitations on them. For example, the fund may enforce a certain amount of diversification, or the SEC may limit their buying (as a % of whole company).
  • Size also plays a role. A bigger fund is harder to make great returns. Law of large numbers.

Are some of these outdated? I checked with people in the industry and they said groupthink is a real problem as its career risk.

Is this Gambling?

  • No. When you invest in companies, you invest in the progress, ingenuity and creativity of people. If you do out in a systematic way, with research and a process, it’s a solid way to grow your wealth. Doing your research is equivalent to knowing the cards in a poker match, if you know the cards, you can play the hand optimally.
  • You need to be able to manage your Psychology, so one bad hand doesn’t scare you out of the game.

Mirror Test

First, understand if you should/could even be investing in stocks?

  • Do you own a house? If not, may want to consider buying one. Saves you rent, can buy with leverage and generally goes up in price. It’s also a long term hold for most people.
  • Do you need the money? If so, put it aside for its immediate use-case. Have savings.
  • Do you have the personal qualities? Patience, common-sense, detachment, willingness to research, etc. You’ll need to be able to ignore “gut” feelings and apply discipline in your approach.

Interesting he recommends a home. Other people, like Ramit, don't.

Is this a good Market?

  • People always want to ask if it’s a good market? No one is good at predicting this. Instead, focus on picking good companies. This is something you can reasonably achieve. Good news is, this goals has to be achieved whether the market is good or bad. Good companies, good price. You’ll know a market is near the top if you can’t find a single company that meets those two criteria.

good companies over good markets

Picking Winners

How to pick stocks and exploit an edge.

Stalking the Tenbaggers

  • Most people come across good investment prospects 2 or 3 times a year. You need to develop a habit for observing a change and then acting on it - “can I invest in this?“. Changes may come about from technology but also from peoples behaviour.
  • Everyone has at least two edges, which make up you stock detection system:

    • Consumer edge - What you know and buy. Perhaps you notice a new store or a good product?
    • Professional edge - Perhaps you notice something in your work. An insurance product everyone is buying or some new Sass that people love.
  • Buy what you know. If you have exposure and are early to something, that is an advantage.

I’ve got it, What is it? (Process)

  • When you find a company, treat it as a lead. You still need to develop the story i.e. do your research. People spend hours finding the best price for flight or hotels but won’t do their stock research!
  • Some things to consider:
  • If you’re interested because of a new product, how important is that product as a part of the whole business?
  • How big is the business in its industry? Big companies will have smaller overall market cap changes. All things equal, smaller companies will drive better returns.
  • Place it into 6 Categories

    • Slow Growers / Sluggards - Companies were once fast growers but have since pooped out or market matured. e.g. car companies. They pay a high dividend. He doesn’t recommend these.
    • Stalwarts - Grow about 10-12% a year. Big brand names. Depending what price you buy them, can make a good return. He’ll buy at good values, sell at 30-50% gain and recycle. Always has a few in the portfolio as they are safe in recession. These are big companies so a 50% increase is meaningful and might trigger a sale. You want to buy on the dips, when they are undervalued.
    • Fast Growers - The aggressive companies grow at 20-25% a year. They take market share or ride growing markets. The trick is to understand how much to pay for the growth and then hold on.
    • Cyclicals - They rise and form in line with some cycle (government change, boom & bust). But when you catch them on an up-swing they grow well. Trick is to not confuse them with Stalwarts.
    • Turnarounds - In dollars these can be the great winners as you can buy a sizable chunk. You buy a depressed business and ride it up. Some ideas: a profitable business inside a larger conglomerate or a restructuring.
    • Asset Plays - The original Ben Graham model. They have some assets that haven’t been factored into the price.
  • Companies are dynamic, so they can change category. Fast-growers become stalwarts. Stalwarts become cyclicals. etc. The category should affect your sell strategy. High growers are long term holds, whereas Stalwarts you might sell with decent gains.

He talks about companies as "stories" which you need to research. Perhaps a useful metaphor is a detective investigating a case.

The Perfect Stock, What a Deal!

The simpler the company, the better! Thirteen traits he likes to see:

  1. It has a boring name - The more boring it is, the fewer people will follow it.
  2. It does something boring - Same as above, plus it’s easier to understand.
  3. It does something disagreeable - Like cleaning car parts or smoking.
  4. It’s a spinoff - A company from within another normally gets a boost from the parent (it failing would look bad).
  5. Institutions don’t own it, analysts don’t follow it - Signals you are early.
  6. Bad press - It may be undervalued.
  7. Something depressing about - Again, people avoid it.
  8. It’s in a no-growth industry - This doesn’t matter if the company itself is great. It will just steal market share, because less competition.
  9. It’s got a niche - Can own its vertical and will have pricing power. Brand is also a niche.
  10. People have to keep buying it - Like consumer stables, or medical equipment servicing.
  11. It’s a user of technology - Can benefit from cost reductions.
  12. The insiders are buyers - There are many reasons they might sell, but only one reason they buy.
  13. The company is buying back shares - They think it is undervalued.

Throughout the book he seems negative on tech stocks, yet tech stocks have been the best performers in recent history?

Stocks To Avoid

  • He’d avoid anything hot. When something is “hot” or “sexy” it’s so competitive the price goes up, but it can come down as quickly.
  • Beware “the next X” - it rarely is.
  • Beware “diworsifications” - acquisitions are usually poor ways to invest money. For an investor, you may be able to benefit if a company poops out from diworsification and you swoop in for the turnaround/restructuring. He prefers share buy-backs to acquisitions.
  • Beware the whisper stock. It’s the new thing, but the story is better than the substance.
  • Beware the middleman, that is, companies who are too dependent on a a single customer.

Earnings, Earnings, Earnings (Profit)

  • Company value is driven by earnings and assets, but mostly earnings - the ability of a company to make money. It may take time, but eventually a companies stock reflects its ability to earn. Assets are all the things a company owns and has (net). Whereas earnings is their ability to make money (products, positioning, brand, etc).
  • P/E ratio = Price / Earnings per share - is commonly used to discuss value. You can think of it as the number of years to ear your money back. If PE ratio is high, company will take longer. Hence’ high growth companies often have a higher PE ratio. This is where the categories above become important. You’ll accept different PE ratios based on how you categorise the co.
  • When you buy a co. with a high PE ratio, you’re making a bet that they will have sustained high growth in earnings later on. Similarly, when you buy a co with a low PE, its earnings have to grow less dramatically to make a return.
  • There is a relationship between interest rates and market PE ratio. If interest rates are low, more people will put money into stocks (driving PEs up).
  • So how does a company increase earnings? 5 primary ways: raise prices, sell more products into new markets, sell more products in existing markets, cut costs, or close poor operations. So really, its two ways: increase revenues and cut costs.

price follows earnings

Two-minute Drill

  • A growing company is dynamic. Stuff has to happen for it to reach an increased value. In two minutes, you should be able to describe what the company is doing, what needs to happen for success and what could possibly cause it to fail.
  • For slow-growers, consider how strong the dividend is?
  • For cyclical companies, you want to figure out where they are in their cycle.
  • For asset plays, how much are the assets worth?
  • For a turnaround, has the company put in a turnaround plan? How is it going?
  • For stalwarts, the key issue is price. Is it at a good value? And is the thing that caused the dip permanent or temporary?
  • For fast-growers, whats the growth story? How and where will it continue to grow? Have they shown they can repeat the model in other places?

Getting the Facts

  • Now you have a thesis, you want to check it holds up. You can: speak to your broker, call the company, visit the HQ, meet investor relations in person, trying the product yourself, speak to their customers and definitely reading the financial reports.
  • How to read reports in a few minutes? Go to the consolidated balance sheet. Total their cash position, current assets and marketable securities - their cash position strong? Then look at their long-term debt, how much? Compare the two. Are they in a position to survive? To thrive? Then look at the 10-year summary. Have their shares increased or reduced over the years? Divide their overall cash position by outstanding shares - how much cash per share? This provides the floor of the stock in theory.

Some of these feel a little outdated. For example, buying on the internet, you don;t actually have a broker to call. Nonetheless, the point is to develop a process for finding out more information and doing your research.

Some Famous Numbers

  • Percent of Sales - Is the product meaningful to the company?
  • PE Ratio - A measure of value. A “fair” PE ratio is equivalent to its growth rate. If the ratio is higher than growth, it suggests the valuation is rich or you expect the growth to actually increase.
  • The Cash Position - What is the cash per share? This provides a base value on stocks. You also need to believe they will be prudent with the cash.
  • The Debt Factor - How much do they own? How much do they owe? Standard balance sheet might have 75% equity and 25% debt. The higher the equity, the stronger the balance sheet. This measure is important when talking about survival (turnarounds, recessions).
  • Dividends - If a stock pays a dividend, investors are willing to pay more for it. If they don’t, you need to trust management to allocate that capital wisely. I downturns, dividend paying stocks are usually more resistant, hence some Stalwarts in the portfolio can bolster resistance. Dividends normally come at the expense of higher growth, so there is a balance.
  • Book Value - Whilst easy to get these days, is often not that useful. Something in book value (e.g. inventory) may not be worth that much in reality. If you buy based on book value, you really have to dig into whether it matches up to reality.
  • Hidden Assets - Book value may also understate assets, like land, gold, patents, etc. which may be noted at an initial or abstract price. Remember when Yahoo owned lots of shares in Alibaba?
  • Cash Flow - How much money a company makes from doing business, after spending. Some companies have to spend a lot of money to do their business.
  • Inventories - Do they have lots of product left over?
  • Pensions - Does it have a large pension commitment? (Turnaround)
  • Growth Rate - And remember growth doesn’t just come from expansion. It can also come from reducing costs or raising prices (e.g. Philip Morris).
  • Bottom Line - Profits after taxes. You want a company with high profit margins.

Rechecking the Story

  • Part of your process needs to involve checking in on companies. All companies go roughly through three phases: startup phase, expansion phase, saturation phase. You want to understand how your company is moving through these phases as it should shape your buy/sell decisions. e.g. is a restaurant already in all metropolitan areas?
  • You also want to check if the companies strategy has changed. Has it moved to do something different? Is this better or worse than what you thought? Finally, you need to judge the opportunity cost. Is there better stuff out there?

The Final Checklist

  • For all prospects, you’ll want to know:

    • It’s PE ratio. High or low?
    • Insider ownership high? Institutional ownership low?
    • Are insiders buying? Is company buying back shares?
    • Is earnings growth high? Is it consistent?
    • Does the company have a strong balance sheet? High cash? Low debt?
  • Then for the specific categories:

    • Slow-growers - Is the dividend always paid?
    • Stalwarts - Is the growth rate keeping up and consistent? How did it fare in last recession? Is it at an attractive valuation right now?
    • Cyclicals - Where is it in the cycle?
    • Fast-growers - What is the growth-rate? Can they keep it up? Is their expansion speeding up or slowing down? Have they proven they can move into new markets? Or launch a second product to their customers? Can they up-sell?
    • Turnarounds - Is it in a good cash position? Can it survive?
    • Asset plays - Whats the value of assets? Is there debt that detracts from that? Is there a raider in the wings to help the asset be realised?

The Long-Term View

Designing a Portfolio

  • If you’re taking the time to pick your owns stocks, you should be getting > 12% returns. S&P index or managed equity funds can do this, so why do it for anything less. He recommends including all costs in this analysis, including research tools, subscriptions.
  • How many stocks to own? Some people say you should diversify in a big way, others say concentrate. It really depends on the stock you pick. If its a winner, then 100% on it is great. But if it isn’t then it sucks. He recommends investing in as many that a) you have an edge in and b) hold up to research. For a small portfolio, 3-10 seems reasonable. The 10x winners can often come as a surprise, so covering a few bases helps.
  • You may also want to diversify through sector and type of company. e.g. Stalwarts add resilience.
  • His preference is to be fully invested. He keeps little in cash, instead preferring to rotate between his stocks. He monitors price in relation to the story. If the price is looking lofty, pull some out and move into one where it’s looking more attractive.

portfolio

Best Time to Buy and Sell

  • When to buy? He’s not a market timer - the best time to buy is when you believe you’ve found a good company at a good price. Having said that, two times to watch out for a) end of tax year and b) dips!
  • When to sell? This can be really tricky. You need to check in with your story and check against the fundamentals. It’s easy to be talked into a sale when you see some profits, but if the story is still good and the fundamentals are still growing, then hold. Similarly, if the story disintegrates then sell.
  • When to sell a slow-grower? The company is losing market share. They are investing money poorly (e.g. diworsifications).
  • When to sell a Stalwart? Main sell driven is PE becomes out of line with earnings. New products have been bad. Other options have become more attractive.
  • When to sell cyclical? You want to time it for the end of its cycle.
  • When to sell a fast-grower? The trick is not to sell if its performing well. Otherwise, you want to judge if it’s coming toward the end of its growth phase. The growth rate starts decreasing. Or if management team is leaving.
  • When to sell a turnaround? Once it’s turned around… then you re-categorise it and judge it by normal factors.
  • When to sell an asset play? Normally, when an active investor comes in to push it.

Twelve Silly Things People Say About Stocks

  • “It’s already dropped so much, it can’t go down anymore” - Of course it can, check the fundamentals.
  • “You can tell when a stocks hit bottom” - Not always. So have a good edge if you’re buying a turnaround.
  • “It’s gone so high already, it can’t possible go higher” - There is no arbitrary limit on stocks. That is the point. If the story and the positioning of the business keeps improving, then keep riding it.
  • “It’s only a $3 share, what can I lose?” - If it goes to 0, its still useless.
  • “Eventually, they always come back” - Nope. Stocks represent businesses, and businesses don’t always make a comeback. That is dynamic capitalism.
  • “It’s always darkest before the dawn” - As above, sometimes its just not. Markets die. Businesses die too.
  • “When it rebounds, I’ll sell” - Sometimes recent performance is indicative of future performance. It might not.
  • “Conservative stocks don’t fluctuate” - Sometimes they do. You never know when regulation will change or some external force.
  • “Its taking too long for anything to happen” - The big winners require patience.”
  • “Look at how much I lost, I should have put money in” - Don’t regard others gains as your losses. It’s not productive or healthy.
  • “I missed that one, I’ll catch the next one” - The next X is rarely so.
  • “The stocks gone down, I must have been wrong” - Not always, review the story, review the fundamentals. Maybe the market just hasn’t caught up yet.

Futures, Options and Shorting

  • Future and options - both are confusing and he doesn’t recommend them.
  • Shorting - Make money when stocks are going down in price. How? You find a company that is richly valued, you short it to get the credit into your account, then when the price falls, you buy at the cheaper price and pocket the difference. But, you have to keep the amount to cover it in your account. In fact, if it goes up you’ll end up paying more for it.

Final Thoughts

  • We operate in a stock market now that is particularly liquid. Stocks change hands frequently and index funds buy and sell frequently. He’d actually prefer a shorter market so people trade less and focus more on research. Remember, part of being successful is leaving your winners to win. So don’t go dipping your hand in all the time and messing it up.

You may also want to view my other book notes.