Winter is Coming...

Winter is coming…

…but I’m actually looking forward to it.

Pardon my Game of Thrones reference, but Mr. Market, like the weather, can fluctuate wildly day-to-day.

Also the market, like the weather, follows slightly more predictable patterns over longer periods of time.

I can’t predict what the temperature is going to be next week, but I know there’s a high probability that the weather will be warmer in July than it is in May.

The last few years in the stock market have been like a sweltering summer. Total returns over the past 5 years were 26.5%, 15.1%, 2.1%, 16.0%, and 32.4%.

But what are the next 5 years likely to bring?

Well, S&P 500 earnings are at all-time highs, and history shows that S&P 500 earnings declines occur fairly often.

Corporate profits margins are at all-time highs, and are likely to revert. (This time usually isn't different)

The market seems (to me) on the slightly expensive side at 18x earnings, but If we “normalize” those earnings to normal or closer-to-normal margins, then the market seems closer to 25x normalized earnings, which is VERY expensive.

I wouldn't be shocked to see the S&P 500 go basically nowhere for the next 5 years or so. 1880 on the S&P 500 in 2018 would not be surprising.

Again, I have no idea what the market is actually going to do between now and then, but it seems logical to me that the annualized return of the S&P 500 (not including dividends), between 5/21/14 and 2017-2019, will likely be less than 5% annualized.

So why am I excited for poor returns over the next few years?

Here’s why: as a rookie investor, at 25 years old, and have only been studying investing since about 2011, a raging bull market is really the ONLY market that I’ve ever experienced. (Lucky me)

Buffett said “It’s only when the tide goes out that you see who’s been swimming naked.”

Since I started investing 3 years ago the tide has only been coming in, coming in, and coming in.

The past 3 years have been a gravy train. The next 5 are almost certainly NOT going to be.

Inevitably, the tide will eventually have to go out, and when it does, I will see if I have been swimming naked or not. (It will also be fun to see who else gets caught with their pants down)

That is the EXCITING part. What I've learned over the past few years of this bull market will soon be put to the test.

Just as the tide must go out eventually, this “5 year summer” we've enjoyed in the stock market must eventually give way.

Winter is coming.

Thanks for reading,

-Philly Value Investor

And some fun links: 

http://www.multpl.com/s-p-500-earnings/

http://www.businessinsider.com/hussman-profit-margins-wil......

http://www.multpl.com/shiller-pe/

2014 ROE Champions List

It is time to unveil my 2nd annual Return on Equity Champions List.

 

The inspiration for this original screen list can be found in the 1987 Berkshire Hathaway Letter, see excerpt below:

 

"Here's a benchmark: In its 1988 Investor's Guide issue, Fortune reported that among the 500 largest industrial companies and 500 largest service companies, only six had averaged a return on equity of over 30% during the previous decade.  The best performer among the 1000 was Commerce Clearing House at 40.2%.

 

Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.  That is no argument for managerial complacency.  Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized.  But a business that constantly encounters major change also encounters many chances for major error.  Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise.  Such a franchise is usually the key to sustained high returns.     

 

The Fortune study I mentioned earlier supports our view.  Only 25 of the 1,000 companies met two tests of economic excellence - an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%.  These business superstars were also stock market superstars: During the decade, 24 of the 25 outperformed the S&P 500.    The Fortune champs may surprise you in two respects.  First, most use very little leverage compared to their interest-paying capacity.  Really good businesses usually don't need to borrow.  Second, except for one company that is "high-tech" and several others that manufacture ethical drugs, the companies are in businesses that, on balance, seem rather mundane.  Most sell non- sexy products or services in much the same manner as they did ten years ago (though in larger quantities now, or at higher prices, or both).  The record of these 25 companies confirms that making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics." - (1987 Berkshire Hathaway Letter)

 

Inspired by that excerpt, every year, I conduct a modern day re-creation of that same study, by going page-by-page, through all the companies that Value Line covers. I screened by hand for companies with: 1) a 10 year average ROE over 20%, AND 2) Zero years in the past decade with a ROE below 15%.

 

Just 145 out of 1705 companies (or 8.5%) passed both of these two hurdles from 2004-2013.

 

Those 145 companies on this year’s list are:

 

***drumroll***

 

AAP, ACN, ADP, AMX, AMGN, APH, APOL, ATK, BAX, BCR, BDX, BF.B, BLL, BOH, BTI, CAT, CEB, CHRW, CI, CL, COH, COKE, COL, CPA, CPB, CPSI, CSCO, CTSH, DCI, DD, DE, DECK, DLTR, DRI, DST, DVA, EAT, EFX, EL, EMN, EMR, ENR, ESI, EV, FAST, FDO, FDS, FII, FMC, GGG, GILD, GIS, GPS, GRMN, GSK, HD, HIBB, HRB, HSY, IBM, IDXX, IFF, IGT, IMO, INFY, INTU, IT, JBHT, JCOM, JNJ, JOY, JWN, K, KMB, KMP, KO, KR, LDR, LH, LXK, LLTC, LLY, LMT, MA, MAT, MCD, MDT, MHFI, MIDD, MKC, MLHR, MMM, MMP, MNST, MRK, MSFT, MTD, NDSN, NKE, NSR, NUS, NVO, OMC, ORCL, PAYX, PBI, PEP, PETM, PETS, PII, POOL, PX, PZZA, ROK, ROL, ROST, SAP, SBUX, SCCO, SEIC, SHW, SLGN, STJ, STRA, SYK, SYY, TECH, TEN, THI, TJX, TROW, TSCO, TSM, TTC, TUP, UL, UPS, UTX, VAR, WAT, WDC, WMT, WEX, WU, YUM

 

92.8% of last year’s ROE Champions were Champions again this year. Here are the 7.2% that either failed to pass one of our two tests of economic strength, or were de-listed in 2013: ABT, AVP, AZN, FRX, JW.A, UNH, QSII all failed to pass at least one of our two tests of economic strength. CEC was acquired, and taken private.

 

Miscellaneous adjustment : McGraw Hill’s (old ticker MHP) successor company is now listed under the ticker MHFI after selling its education unit, and remains on the Champion list.

 

The only liberty I took with this was to make a handful of exceptions for wonderful business with negative ROE due to having negative equity. An example is WU, which has been insanely profitable, if you look at ROA and ROIC, but would be excluded due to having negative book value.

 

Lastly, just for fun – Here are the companies’ that will reach the 10th consecutive year of 15%+ ROE/10 yr AVG >20%, if they perform well in 2014, and would likely qualify for next year’s list:AAPL, NILE, BA, BKE, CE, CBRL, FTI, GWW, GES, HLF, HON, OI, RAI, TEF, TXN 

 

If you’ve made it this far, thanks for reading.

 

For those interested in my research, I have something new to add this year.

 

Though, I am not really a big fan of mechanical investing, I try to keep an open mind. I’ve always considered Greenblatt’s Magic Formula interesting, but somewhat inadequate. As a result, I have created my own experiment that follows a similar line of thinking, but is hopefully a slight improvement. There are two significant weaknesses in Greenblatt’s Formula, in my view. (The formula calls for a mechanical portfolio of businesses with high ROIC, and low EV/EBIT multiple.)

 

Weakness #1 is that only the most recent years ROIC is used. I truly believe that consistency of quality is key. By that I mean 40% ROTC last year is great, but if your 5 or 10 year average ROIC is below 10%, than I don’t want to invest there. My solution is to substitute Greenblatt’s trailing ROIC number with my ROE Champion list, which demands very consistent, high profitability, over the long-term.

 

Weakness #2 is that instead of a plain vanilla valuation multiple, which does not take future growth into account, I will I will replace Greenblatt’s EV/EBIT multiple with Value Line’s projected 3-5 yr total annualized return. Though this is certainly NOT a perfect metric, which I think is a better indicator of future returns than a blind PE or EV/EBIT multiple. For extra conservatism, I will rank stocks by the lower bound (for those familiar) of Value Line’s 3-5 total annualized return projection.

To test my hypothesis, I have created a brand new, Motley Fool CAPs tracking portfolio with the username MagicROEchamps. http://caps.fool.com/player/magicroechamps.aspx

 

This portfolio will consist of the top 20 stocks on my ROE Champion list, that have the highest lower-bound Value Line 3-5 year total annualized projection. (Again, for those not familiar with Value Line, this number can be thought of as Value Line’s minimum 3-5 year projected forward rate of total return.)

 

I will rebalance the portfolio on the first trading day of each month.

 

Should be a very interesting experiment! 

 

Thanks so much for reading, and please add some feedback to these ideas, as well as point out any errors or mistakes I made.

 

Happy Investing,

-John

Sit-On-Your-Ass Investing, and other concepts from Poor Charlie’s Almanack

Here's my review of the expanded 3rd addition of Poor Charlie’s Almanack.

The 532 page book is a bit pricey ($55 used, $150 new), but well worth it, in my humble opinion.

I hope you find this review both useful and enjoyable. Please forgive any grammatical errors, as I am sure you will find many.

 

My notes are organized by topic as follows:

1.       The Early Years

2.       A Multidisciplinary Approach to Business Analysis

3.       Keys to Investing Success

4.       Sit-On-Your-Ass Investing

5.       The Willingness to Change Your Own Mind

6.       On Life

7.       Miscellaneous

8.       Examples of Mental Models

9.       Charlie Munger’s suggested Reading List

 

Poor Charlie’s Almanack : The Wit and Wisdom of Charles T. Munger

 

“Success obtained via a combination of concentration, curiosity, perseverance, and self-criticism, applied through a prism of multidisciplinary mental models.”

 

“Acquire worldly wisdom and adjust your behavior accordingly. If your new behavior gives you a little temporary unpopularity with your peer group…then to hell with them.”

 

The Early Years:

As a boy, in Omaha, Charles Munger got his first job working at the Buffett & Son Grocery store, owned by Ernest Buffett, Warren’s grandfather. Charlie, like the other Buffett & Son employees, worked 12 hr shifts with no meals or breaks. Warren, six year younger than Charlie would later go to work at that same store, a few years after Charlie had moved on.

 

Young Charlie was very smart, but didn’t work very hard. He used a family connection to get into Harvard Law without a bachelors degree. He did very well at Harvard Law and got a decent job at a reputable firm. (keep in mind that lawyers today, make A LOT more money, relative to other career paths, than they did in the 1960s when Charlie started.)

 

Despite a good start, Charlie faced significant emotional challenges. By age 29 he had already married, divorced, and lost his young son to leukemia. During this time of his life, people recall often seeing Munger walking through the streets of Pasadena, CA, crying his eyes out, for hours at a time.

 

Munger eventually remarried and had A LOT of kids. (some acquired by marriage) Though a successful lawyer, Munger wanted much more money than a 1960s lawyer was bringing in. His quest for wealth was fueled, not by a desire for material possessions, but by a desire for independence. (Like his hero Ben Franklin) He turned to outside ventures and alternative ways to generate more income. In the mid-1950s and 60s, Munger started buying stocks, as well as equity in the private businesses of some of his clients. In 1961, he got into property development and developed condominiums and turned a large profit. From there, he took on other construction projects in the Pasadena area. He started his own law firm, Munger, Tolles & Hills. He then opened a small investment partnership soon thereafter. By 1964, Munger had acquired a nest egg of about 1.4 million.

 

While returning to Omaha, to visit family, Munger attended a dinner that included a fellow named Warren Buffett. Charlie, remembering the surname from his boyhood job at the Buffett & Son grocery store, hit it off with Warren right away. Warren tried to persuade Charlie to give up Law as soon as possible to focus on investing full time. He eventually did just that.

 

Over 14 years, the Munger Investment Partnership returned a compounded annual rate of return of 19.8% vs the Dow Jone’s return of just 5%. Though Munger and Buffett were partners in some investments, and traded ideas by phone almost daily, they both had separate partnerships. Eventually, their investments became so intertwined that it made more sense for them to more formally merge. Munger was chairman of Wesco. Buffett’s Berkshire bought 80% of Wesco, and Charlie became Vice-Chairman of Berkshire. The rest is history.

 

A Multidisciplinary Approach to Business Analysis:

According to Munger, many people suffer from “man with a hammer syndrome.” “To the man with only a hammer, every problem looks like a nail.” To avoid this common problem, Munger says we must develop a diverse mental “tool box”, by utilizing a multidisciplinary approach to investing (and life.)

 

“If you want to go through life like a one legged man in an ass-kicking contest, be my guest. But if you want to succeed like a strong man with two legs, you have to pick up these methods.”

 

“You must know the big ideas in the big disciplines and use them routinely – all of them, not just a few. Most people are trained in one model, economics, for example - and try to solve all problems in one way”. You know the old saying, “To the man with a hammer, the world looks like a nail.” This is a dumb was of handling problems.”

 

Munger incorporates history, psychology, mathematics, biology, and other academic disciplines into his mental toolbox for evaluating businesses. He refers this combined latticework of knowledge as “worldly wisdom.”

 

“Worldly wisdom is mostly very, very simple. And what I’m urging you to do is not that hard if you have the will to plow through and do it. And the rewards are awesome – absolutely awesome.” Munger says.

 

“I consistently see people rise in life who are not the smartest, and sometimes not even the most diligent. But they are learning machines. They go to bed at night a little wiser than they were that morning. And boy, does that habit help, particularly when you have a long run ahead of you.”

 

Keys to Investing Success:

“The number one idea”, Munger claims, “is to view a stock as an ownership of the business, and to judge the staying power of the business in terms of its durable competitive advantage. Look for more value in terms of discounted free cash flow than you are paying for. Move only when you have an advantage. It’s very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor. “

 

He also stresses the importance of staying within your “circle of competence.” [I assume you Fool blog readers understand that concept so I won’t repeat it here.]

 

When it comes to competitive advantage, Munger stresses that what matters is not how strong the advantage is today, but how strong it will be in 5, 10, even 20 or more year from now. Munger asserts that, “Anything less [than a long-term competitive advantage] is too risky.” Competitive destruction results in few businesses being able to survive over multiple generations. Munger cites a 1911 Buffalo Evening News clipping showing the 50 most important stocks on the NYSE. Of those 50, only GE survives to this day as a large independent business. He suggests that the best business to own would be “a simple, easy to understand, dominant business franchise, that can succeed in all types of economies.” He asserts that people overestimate the importance of quantitative methods of analysis and valuation, because they are easy to understand, and conversely, underestimates the importance of the durable competitive advantage and other qualitative aspects of a business, which are more difficult to understand.

 

Sit-On-Your-Ass Investing:

"If you buy a business just because it's undervalued, than you have to worry about selling it when it reaches its intrinsic value. That's hard. But if you can buy a few great companies, then you can sit on your ass. That's a good thing.”

 

“When Warren lectures at business schools, he says, “I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so you had twenty punches – representing all the investments that you get to make in a lifetime. And once you’ve punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do much better.”

 

He advises, “You’re paying less to brokers, listening to less nonsense, and if it works, the tax system gives you an extra 1, 2 or 3 percentage points per annum.” In his view, a portfolio of three companies is plenty of diversification.

 

“The idea of excessive diversification is madness.” “Our experience tends to confirm a long held notion that being prepared, on a few occasions in a lifetime, [and] to act promptly in scale,…will often dramatically improve the financial results of that lifetime.”  “…All that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available, as a result of prudence and patience in the past.”

 

“It takes character to sit there with cash and do nothing. I didn’t get where I am today, by going after mediocre opportunities. "If you say no to 90% of investing ideas, you're not missing much.

 

He then repeats the famous Buffett quote, “Few people ever get rich on their 7th best idea.”

 

The Willingness to Change Your Own Mind:

Charlie hates dogma. He bears not only a willingness, but an eagerness to find his own mistakes and learn from them.

 

“If Berkshire has made a modest progress, a good deal of it is because Warren and I are very good at destroying our own best-loved ideas. Any year that you don’t destroy one of your best-loved ideas is probably a wasted year.”

 

Keynes said “It’s not bringing in the new ideas that’d hard. It’s getting rid of the old ones.” And Einstein said it better, attributing his mental success to “curiosity, concentration, perseverance, and self-criticism.” By self- criticism he meant becoming good at destroying your own best loved and hardest-won ideas. If you can get really good at destroying your own wrong idea, that is a great gift.

 

Ask yourself, how am I fooling myself? Why is this company cheap? Is it for a good reason or for a superficial reason? Play devil’s advocate with yourself. Constant self-criticism is key to investment success.

 

“The best defense is that of the best physicists, who systematically criticize themselves to an extreme degree.” Munger says. Then he quotes Nobel laureate Richard Feynman, “The first principle is not to fool yourself, and you’re the easiest person to fool.”

 

On Life:

“Get out of debt, and have a want for very few material possessions. Also, be a very reliable person, learn from your experiences, don’t envy or resent others, and NEVER give up.”

 

“The way to win is to work, work, work, and hope to have a few insights.”

 

“The safest way to get what you want is to try and deserve what you want. It’s such a simple idea. It’s the golden rule. You want to deliver to the world what you would buy if you were at the other end.”

 

Miscellaneous:

“I should concede, at the outset, that I have never taken a single course in economics, nor tried to make a single dollar, ever, from foreseeing macroeconomic changes.” Be a business analyst, not a market analyst or macroeconomic analyst.

 

Munger believes that aggressive accounting is rampant in corporate America. "I think that, every time you see the word EBITDA, you should substitute the words, "bulls*** earnings."

 

“It's remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent."

 

Munger advocates create your own investing checklist and utilizing it every time you consider making an investment. "How can smart people so often be wrong? They don't do what I’m telling you to do: use a checklist to be sure you get all the main models and use them together in a multi-modular way." Guru investor Monish Pabrai, a Buffett/Munger fanboy in his own right, takes this advice literally.

 

Munger calls Value Line a wonderful tool. (Available for free in most libraries)

 

Examples of Mental Models Used in This Book:

Invert, always invert (Try to solve problems backwards)

Redundancy/backup system model (engineering)

Compound interest (math)

Combinations/permutations (math)

Fermat/Pascal systems

Decision Tree Theory

Accounting

Gaussian distribution

Break point/tipping point/autocatalysis models (physics/chemistry)

Darwin synthesis (biology) (Specifically how it relates to competitive destruction in capitalism)

Cognitive misjudgment (psychology)

Cost benefit analysis (economics)

Advantages of scale (economics) (Coca-Cola example)

Social Proof (psychology) (Coca-Cola example)

Pavlonian Association (biology) (Coca-Cola example)

Classical conditioning and Operant conditioning (more Pavlov)

Pari-mutuel betting (horse racing)

The power of incentives (psychology) (Example FedEx story)

Incentive-caused bias (Psychology)

Man w/ hammer tendency

Agency costs

Marginal utility

Consistency principle

***Munger claims that when multiple models combine in your favor, the “lollapalooza effect” kicks in, and the power of each individual model increases exponentially.***

 

Munger's Reading recommendations:

Munger quotes his famous partner, “In my whole life, I have known no wise people who didn’t read all the time – none, zero.” "I read everything. 10-K's and 10-Q's, biographies, histories, and 5 newspapers a day. Reading is key. Reading has made me rich over time." Then he adds an idea from Cicero’s that a man is never too old to learn something totally new. Munger cites Socrates learning to play the fiddle late in life as an example.

Here are Munger's reading recs:

Deep Simplicity: Bringing Order to Chaos and Complexity by John Gribbin

F.I.A.S.C.O.: The Inside Story of a Wall Street Trader by Frank Partnoy

Ice Age by John and Mary Gribbn How the Scots Invested the Modern World: The True Story of How Western Europe’s Poorest Nation Created Our World and Everything in It by Arthur Herman

Models of My Life by Herbert A. Simon

A Matter of Degrees: What Temperature Reveals About the Past and Future of Our Species, Planet, and Universe by Gino Segre

Andrew Carnegie by Joseph Frazier Wall

Guns, Germs, and Steel: The Fates of Human Societies by Jared M. Diamond

Influence: The Psychology of Persuasion by Robert B. Cialdini

Autobiography by Benjamin Franklin

Living Within Limits: Ecology, Economics, and Population Taboos by Garrett Hardin

The Selfish Gene by Richard Dawkins

Titan: The Life of John D. Rockefeller, Sr. by Ron Chernow

The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor by David S. Landes

The Wealth of Nations by Adam Smith

The Warren Buffett Portfolio: Mastering the Power of the Focus Investment Strategy by Robert G. Hagstrom

Genome: The Autobiography of a Species in 23 Chapters by Matt Ridley

Getting to Yes: Negotiating Agreement Without Giving In by Roger Fisher, William Ury, and Bruce Patton

Three Scientists and Their Gods: Looking for Meaning in an Age of Information by Roger Wright

Only the Paranoid Survive by Andy Grove

Also Munger suggests your read: The Wall Street Journal, Forbes, Fortune, and Value Line.

 

The End.

If you've made it this far, thanks for reading this unusually long blog post. I hope you found it worthwhile.

 

Please leave some comments, questions, or general feedback.

 

Kind regards,

-Philly Value Investor

The Facebook (FB) Bubble.

Here’s my attempt at a Charlie Munger style “inversion” type thought process.

FB was selling the other day at about at $66.50 per share, and for FB to be a worthwhile idea, I’d like to see at least 10% or better annualized returns over the next 5 years or so, with a high level of confidence. So, at today’s prices, to achieve that desired 10% annualized return, FB shares would be selling for about $107 per share, or more, in about 5 years.

So what has to happen for FB to be rationally worth $107 in five years? What has to happen for FB NOT to be worth $107 in 5 or so years? Call me old fashioned, but I think it’s extraordinarily rare that a business is rationally worth paying more than 30x earnings for. So I’ll use 30x as my future multiple in this example.

[Let’s pause for a quick commercial. Yes, 30x is a highly subjective multiple. I encourage you to replace that multiple that of your own choosing, and then recalculate for yourself. And, please, PLEASE, if you can come up with a more rational future earnings or cash flow number, and accompanying multiple, that justifies the current valuation, PLEASE share it in the comment section. I’d love to hear it.]

So, I’ll assume FB is selling at 30x earnings in 5 years. $107 per share/30x = $3.57 earnings per share. Now I look at FB and say, ok, what are the chances that FB will be earning $3.57 or more per share in earnings and/or free cash flow in about 5 years? More importantly, what are the chances they'll be earning less? Is this a bet I really want to make?

Compared to $0.60 in EPS and $1.14 in fee cash flow, in the last year, we’d basically NEED Facebook to be bringing in AT LEAST 3 to 6 TIMES as much profit in 5 years than they are bringing in today. How many companies can you REALLY count on to grow at such an astounding rate? Are there any? Is Facebook REALLY that special?

I believe a rational bet on FB today requires a prospective investor to believe, with a high degree of certainty, that the odds are very LOW, that FB WON’T grow earnings and free cash flows by at least 300%-600% over the next 5 or so years.

You’re basically betting that FB will be the greatest company of call time.

With a bet like this, if ANYTHING goes even slightly wrong, you’re in VERY big trouble. While most investors concentrate on how much they will gain if their assumptions are correct, I think truly intelligent investing is as much, or perhaps more so, about how much you stand to lose if you’re wrong.

Great investors look for positive asymmetrical bets. (Heads I win big, tails I still do ok) Facebook, to me seems more like “heads I do ok, tails I lose A LOT of money.”

Facebook (FB) at current prices seems like a pretty crazy bet to me.

I would be utterly shocked if FB beats the S&P 500 over the next 3, 5 or 10 years.

I would not be shocked if we see FB shares drop from $66.50 to $20 or $30 in the next couple years.

Thanks for reading, -John

A Fun Little Portfolio

As my multi-year investing journey/experiment continues into 2014, I thought I’d take this opportunity to report a virtual 13-F filing.

My objective with this virtual portfolio, between now and the end of 2017, is simply to determine whether or not I should invest on my own – or simply go with a low-cost index fund. At the end of 2017, I will examine my performance, and then make a rational decision about my investment future. I’m a young, nearly broke MBA student, so this seems to be the perfect time to experiment with investing, before I actually have the opportunity to invest a lot of my own money in real life. I have spent the past three years studying and practicing value investing, hopefully, not in vain.

Here’s a snapshot of the portfolio, which I call Teego Capital.

Despite having lagged the market in the 11 months since inception, I think there’s a decent chance that this portfolio beats the S&P 500 by a significant margin between now and 2017.

Thanks for reading (and hopefully following)!

-John

Why I made IBM 33% of my portfolio.

I recently was speaking with a professional fund manager about investments, and he criticized my IBM idea simply because "everyone knows about IBM" and suggested that ideas should be found among the less followed smaller market cap stocks.

 

I respectfully disagree.

 

Micro caps are great, but when Mr. Market throws a wonderful business like Big Blue at you for cheap, it's irrational to refuse action simply because IBM is widely followed.

 

Anyway, here's why I put almost 1/3 of my capital in IBM:

 

Over the past few decades, IBM has evolved from a hardware company into the 800 pound gorilla of the business services and technology services industries.

The company is truly global in scale, operating in over 170 counties. In addition to these economies of scale, IBM enjoys high switching costs due to very “sticky” relationships with clients. (Many of IBM’s contracts are set for 10 or more years) Consequently, IBM is so ingrained in global business and technology services that it would simply cost too much for many companies to switch away from IBM. Additionally, IBM has an extremely valuable brand. The brand is valued at 4th in the world by Interbrand. http://www.interbrand.com/en/best-global-brands/2013/Best-Global-Brands-2013.aspx These competitive advantages existing in combination (scale, high switching costs, and a formidable brand) creates an exponentially stronger business than one that only had one or two of these advantages.

Next, we’ll examine some quantitative evidence of these competitive advantages at work. The first thing that jumps out is IBM’s consistently outstanding returns on shareholder equity. The 10 yr avg is 50% and, incredibly, steadily increasing. It was 65% for 2010, 75% for 2011, and an insane 85% for 2012. That level of profitability puts IBM in the top 2 or 3% of all publically traded American businesses.

IBM has also grown per-share earnings remarkably consistently, seeing year over year increases in 9 of the past 10 years. Over the past decade EPS growth has annualized a strong 14%.

IBM has set a goal of $20 of per-share earnings by the end of 2015. They would need to grow EPS by about 11.65% between now and then to do that, and that’s certainly possible. If you hypothetically assign a very reasonable PE of 15 on that 2015 EPS of $20, you’d get a price of $300 per share by the end of 2015. (Which, at today’s prices, would be a 17.45% annualized return over the next 3 years, not even including dividends.)

Moreover,  IBM is VERY shareholder friendly. They have reduced the number of shares outstanding by 35% over the past decade. (Roughly 4% annualized) Add in the 2% dividend yield to the 4% average buybacks, you get a very attractive amount of cash being returned to shareholders.

Going back to IBM’s extraordinary record of consistently superior profitability and growth, numerous competitive advantages, and shareholder friendly management, you’d think Mr. Market would require you to pay a significant valuation premium over the S&P 500’s current PE of 17-18, right? Luckily, that assumption would be wrong. Mr. Market will sell you his share of this wonderful business, today, at the low, low price of 12x earnings, (which is about a 30% discount to the S&P 500) and a P/FCF of about 13, which is even more attractive.

And the cherry on top? You can get an even better deal than Buffett did. Berkshire’s annual report shows that Buffett paid an average of $171.47 per share of IBM, mostly in the 2nd and 3rd quarter of 2011. That $11.6B purchase was the most money Buffett has EVER put into a single equity. IBM had a PE of about 15 at the time of the purchase, when the S&P 500’s PE was about 14. Today IBM has a PE of 12 vs 17 for the S&P 500. More importantly, IBM’s EPS has grown 24.7% since 2011, but the share price has only gone up about 8.6%. That disconnect between IBM’s intrinsic value, and its current price, is the kind of rare opportunity that I salivate over.

Bottom line: IBM is a consistent and stable profit machine, with durable competitive advantages, selling at a silly cheap price. I believe IBM will significantly outperform the S&P 500 over the long-term.

Long IBM (largest personal holding)

Thank you for reading!

Hello World!

Hello world, and welcome to the Philly Value Investor Blog!

 

My name is John, I'm 24 years old, and I began studying value investing about 2-3 years ago. I started out reading Buffett's letters, and was soon off to the races. I’ve been pretty much obsessed with investing ever since. I try to read every investing related book I can get my hands on, run a virtual portfolio, and make occasional real-life investments.  (More on that later) I also recently begun an MBA program, am hoping to end up in a field where I can think about durable competitive advantages all day long.

The purpose of this blog is to serve as an honest record of my picks and thoughts on in investing while I'm in school over the next two years. Due to tuition costs, I'm not going to be doing very much real-life investing, and this blog seems like a swell place to leave a record to look back on in a few years.

My core investment strategy is to achieve superior long-term returns, without taking unnecessary risks, by investing in a focused portfolio of high quality businesses, within my circle of competence, that possess the following characteristics:

1) Mouthwatering Economics

My investment process begins by using a variety of screens (and common sense) to narrow my initial universe of about 5,000 equities to about 300 or so. The common denominator that separates the truly exceptional businesses, from the merely very good, is that they consistently generate very high returns on capital, and display consistent growth in earnings and cash flows, over long periods of time.

 

2) Durable Competitive Advantages

The nature of capitalism is such that the businesses that possess “Mouthwatering Economics” will also be the most vulnerable to competition. The only way a company can keep competitors at bay, and maintain those mouthwatering economics well into the future, is to possess strong durable competitive advantages. Examples include, but are not limited to: brand loyalty, economies of scale, barriers to entry, high switching costs, network effects, patents, regulation, etc.

 

3) An attractive Price

While the previous two qualities are used to separate wonderful businesses from fair businesses, an attractive price (valuation), is what isolates the wonderful investments among the wonderful businesses. I seek to buy wonderful businesses that are selling at a significant discount to their true underlying value. Such an event is a relatively rare occurrence, and taking advantage of such opportunities will almost always require thoughts and actions that are contrarian in nature.

 

 

 

And that's basically it.

 

It's simple, very simple, but not easy.

 

In my next post we'll discuss my first pick. I'll give you a hint, it's a household name.

 

See you soon, and thanks for reading!

-John