A True Story of a Coffee Meeting Gone Horribly Wrong
A little over a year ago, I scheduled a coffee with a Wall Street equities analyst who worked at a large money center bank. I was just a wet-behind-the-ears intern with a lot of gumption and a desire to get my name out there, so I was excited at the opportunity to meet with somebody who was actually on the earnings calls that I so often listened to.
Wanting to have a substantial and targeted conversation, I did my homework about this analyst’s sector, his current ratings, his research, and his team. We sat down and had a nice conversation about a company in his book that I had followed for a long time. This particular company has a “razor-and-blades” sales model, where they have a loss-leading primary product line (like a Keurig Coffee Maker), while also selling a high-margin consumables line (like the K-Cups that go into a Keurig Maker). Note: The company we spoke about was not Keurig. Even a baby knew that this is how the company operated. As we spoke about the company’s product mix, he made note of the slowing sales in the primary product line, when I blurted out, “Yeah, but the margins on that line are terrible!”
He looked at me for a moment without saying a word. It was intense! I started looking for exits. I recalled the propensity for Wall Streeters to have a short fuse, and began scanning the outline of his suit jacket, looking for the bulge of a concealed handgun. The tension was palpable, and in his glaring eyes I could hear the words that he wanted to say to me, “You insolent little punk, don’t you think I know that?”
You Will Never be Smarter than the Market
The gentlemen in question took my remark in stride, and was cordial about it. But, this story beckons an important point about stock analysis. In no world, and with no amount of time, education, or research, will you ever be smarter than the market. The stock market pricing mechanism is a collaboration of tens of thousands of extremely well-paid, exceedingly smart, and highly dedicated individuals that have studied their art and honed their craft for decades. Also lending a hand are millions of less-well-paid retail investors that are trading and investing their own money. Information is so cheap and abundant that even dudes like Retire29 get in the on the analysis game and see themselves as modern day Ben Grahams. The point is, there is simply too much knowledge and education out there. The price of any stock is the weighted average of every possible outcome with all known information, dissected and modeled beyond recognition and reformulated into a ‘perfect’ price. Heck, several hundred pages of Damodaran on Valuation are dedicated only to identifying the discount rate of a single security—and lots of people have read it! The amount of collective knowledge that flows into the pricing of stocks is unrivaled. Your belief that Apple should be worth $130 per share means nothing to the millions of people that have priced it at $127.
Academics call this the efficient market hypothesis, which basically says stocks will always be fairly valued because prices quickly and accurately reflect all available information. There are several forms of the EMH, and stocks are believed to exhibit semi-strong efficiency, meaning that inside information could still give you an edge. Additionally, the presence of biases, behaviors, and sentiment (non-informational inputs), can still swing stock values away from fair value.
This means, to me, that finding your edge on Wall Street cannot easily be done (if at all) through numbers. Stocks that seem deliriously undervalued can stay that way for decades (Hello, Altria and Wal-Mart!). The opposite is also true. Folks thought Shake Shack was overvalued when it set an initial IPO price of $14, then they raised it to $21, then it opened for trading at $40, then it rose in value two months later to $96. Nothing changed fundamentally, just “irrational” turned into “foolish” which then turned into “unbridled insanity.” Netflix has been called overvalued for its entire existence.
I have good news, though. You, my friends, DO have an edge on Wall Street. What is your edge? Well, you have three of them: Patience, Independence, and good ol’ Retire29.
Your Edge on the Market
- Patience means that you don’t have quarterly targets to reach. You aren’t working against a benchmark and you can ride out the ebbs and flows of the market and of your stocks. Patience means that you are invested for the long haul (10+ years), so your investment thesis has time to play out. A bad quarter isn’t a reason to sell, it’s a reason to buy. Patience means that you can dollar-cost-average, buying less when prices are high and buying more when prices are low.
- Independence means you answer to nobody. You manage your own money, so clients aren’t taking distributions when markets take a tumble and you are forced to sell. You don’t need to window-dress your portfolio and conform to an client’s investment suitability. Independence means that nobody is breathing down your neck about your performance, forcing you to make more decisions that needed (excessive trading). Finally, independence means that you have the ability to see things in stocks that numbers won’t always make clear; you can take a ‘soft touch’ approach to your analysis.
- Retire29: This is maybe your biggest asset (sorta kidding). But, below, I’m going to give you my analysis framework, which takes about 12 minutes to perform on any company. Not only is this far more efficient, but it also should yield you far higher returns over time. It’s unique, it’s simple, it’s repeatable, and it’s scalable.
But First, My Credentials: Am I Lucky, or Good?
For an analyst, “luck” and “skill” are often intermingled. This runs the gamut of experience, too. Meredith Whitney was one of many that publicly predicted the 2008 financial crisis. Was this luck, or skill? Well, since that accurate prediction, she has long maintained that hundreds more banks would fail every year, “the worst is yet to come,” “the other shoe is about to drop.” This, of course, hasn’t happened and she’s now been wrong far more than she’s been right, but that didn’t stop her from founding her own firm on her savant reputation and becoming a regular on CNBC. The moral of the story—over short periods of time, anyone can look like a genius and luck and skill are indistinguishable from each other. As the saying goes, even a broken clock is right twice a day. In investing, you can have stellar returns versus the S&P for 1, 3, or 5 years, but that could still be just one lucky play working for you, and you might give it all back shortly thereafter when your strategy gets exposed.
Then, you have guys like Warren Buffet, Benjamin Graham, David Dremer, Jack Bogle, or Carl Icahn. These are household names that would be first-ballot inductees in any Investor’s Hall of Fame. These guys made the grade year and year, decade after decade. They didn’t outperform every year, but over long periods, they exhibited huge outperformance and a knack to finding alpha. Each of them had their own style: Graham and Buffett looked for deep value and high return on capital, Jack Bogle was an emotionless sociopath when it came to investing, David Dremer was a true contrarian in a sea of “contrarians-in-name-only”, and Carl Icahn is a savvy operator who can unlock value in an activist way. They are clearly skilled, rather than lucky.
Where do I, little old Eric from Retire29, fit into the “luck” vs. “skill” question? Well, I started investing on January 31st, 2006, when I opened my Roth IRA. From that day until today, my portfolio has returned 15.21% a year vs. the S&P’s 7.56%–more than double the return of the S&P over a 9.4 year period. Now, I’m not even close to a Warren Buffett or any of those other names, but, at worst, I’m straddling the fence between a “lucky investor” and a “skilled investor.” I’m also getting quite confident in my strategy for analyzing stocks and companies.
The Analysis Framework: The Six Tests
When I look at any stock, I run it through a series of six short tests. In my opinion, each one of these tests can be performed in 2 minutes or less. If the stock can get a rough pass on each of these six tests, then I’d call it a “Buy.” If it fails any test, then it’s a “Not Today.”
1. The “Storm the Hill” Test – The buck stops with the guy at the top. In any company I invest in, I want to make sure that the leadership has my best interests in mind. This is exhibited in a number of ways. Is the CEO adequately tenured in the firm? Or, even better if he or she rose through the company ranks. Is the founder still actively involved with the business? Does the company leadership have a significant personal stake in the stock?
I also want some confidence in the strategic vision of leadership. This is usually answered when the founder is still actively involved. Facebook wants to connect the world. Tesla & SolarCity want to save the world from carbon emissions and fossil fuels. Phillip Morris wants to get cigarettes into the hands of every man, woman and teenager–societal costs be damned. The vision need not always be altruistic, but it needs to be focused.
Leadership is, hands down, the most important aspect of any company. Good leaders inspire good employees, and good employees make strong businesses. Good leaders streamline operations and unlock efficiencies. Bad leaders that lack a clear focus or that employees don’t particularly like working for are huge red flags.
For these reasons, I would love to invest in Elon Musk (Tesla), Lyndon Rive (SolarCity), Marc Benioff (Salesforce), Richard Kinder (Kinder Morgan), Tim Cook (Apple), Reed Hastings (Netflix), Indra Nooyi (Pepsi), Howard Schultz (Starbucks), Larry Page (Google), Jeff Weiner (LinkedIn), Jeff Bezos (Amazon), Mark Zuckerberg (Facebook), or Greg Garrabrants (Bank of Internet). I see all of these individuals are visionary leaders with a clear focus on company direction, a genuine care for their people, and a passion for their product.
I call it the “Storm the Hill” test, because you must ask yourself, would these be leaders you would follow up the hill into battle (with your dollars)? You need to have faith and belief in management, otherwise ownership will be far too trying.
2. The “Delorean” Test – This is perhaps my favorite test. For any company I may invest in, I look (at a minimum) ten years into the future. Will I still be using still this company? How is this company positioned in the economic landscape? Is it realistic that this company will still be around and not be disrupted? Is this company still in my home or in my wallet?
I look at a company like Apple and a common worry is that “the next big thing” will come along and usurp the iPhone. Am I worried? Not really, because when I look ten years into the future, I see myself not only with an iPhone, but with a Mac, an iPad, several Apple TVs, and lots of other iOS-enabled devices. I love the iPhone, but I love more the ecosystem Apple is creating that makes its gadgets sticky.
I’m also quite confident and I’ll be brushing my teeth in 10 years, so P&G is probably a safe play.
This sounds like a simplistic way of thinking, but it’s vital! You are investing for a minimum of 10-year timeframes, so you should be looking out ten years and seeing how a company may be positioned. As Dr. Suess would say, “You don’t have a crystal ball, but you can see the writing on the wall.”
Companies either grow or die, there’s rarely any middle ground. It’s not often that a company just muddles along for decades (cough, AOL, cough). Because of this, if you can envision a future where a company is still serving customers, then it will almost certainly be doing so with a far larger market cap than it has today.
3. The Trend Test – Warren Buffett once famously said, “I realized that technical analysis didn’t work when I turned the chart upside down and didn’t get a different answer.” For the most part, I agree. Technical analysis is the art of inferring future price movements of a stock based on past movements and volume. I, and many others, think technical analysis is only viable because so many people subscribe to technical analysis–a classic self-fulfilling prophecy. If enough chartists say, “it looks like we’re going to have big support at $50,” then people will start buying right around $50 to catch the bottom, thereby creating support. Or, “it looks like we’ll have big price resistance at $100,” then many investors will sell around $100 believing that the upside is limited.
However, not all technical analysis is bad. For instance: Stocks in a trend will stay in that trend until they don’t. This might sound like common sense, but it’s true. If you regularly look at lists of new 52-week-highs and 52-week-lows. You’ll start to see the same names appear on each list day after day, month after month. Palo Alto Networks, Netflix, Skyworks, Disney, Hasbro, or Starbucks are in multi-year uptrends. They’ve been hitting 52-week-highs every few days for years. The same is true for 52-week-lows—although stocks tend to find their lows much more quickly than they find their highs. Take a look at this 3-year chart of Apple:
What you see is the price (black line), the 50-day moving average (blue line), and the 200-day moving average (yellow line). In my opinion, a stock is “buyable” if the blue line is above the yellow line, meaning if the last 50 days has been better than the last 200 days. By adhering to this rule, you avoid the tendency of trying to “catch a falling knife.”
4. The Elevator Test – You don’t need to know everything about the business, but you should at least have a reasonable idea. Peter Lynch said “never invest in any idea you cannot illustrate with a crayon.”
This is not meant to be taken literally, but you should have a level of comfort with any idea to the extent that you could have a short “elevator” conversation about the company. This means you should generally know how the company makes its money. You should generally know where they operate. And you should generally know the prospects and strategic plan of the company. These things are not hard to find. Every quarter, most companies give an investor presentation, which is a clean little powerpoint-like show that talk about these things (this is usually available on the company’s website under “Investor Relations”). If this doesn’t exist, every company will publish 10-Ks and 10-Qs to the SEC, and these all have a business overview and management commentary.
I realize that this might take more than two minutes if you know nothing about a company. However, you probably have a general idea about a company long before you consider buying it.
5. The Passion Test – You need to care about your investments. At the end of the day, it is your money that is on the line, and your dollars are aiding in the company’s operations and liquidity. If you don’t care or disagree with what the company is doing, and you can’t be a promoter and advocate for the company, then your dollars are better placed elsewhere. So, ask yourself, can you be a proponent of the company? I know I could never invest in SeaWorld (SEAS), no matter the valuation, because I completely disagree with the imprisonment of Orca whales. Others may object to a business that endangers lives, like bullet-maker Raytheon or cigarette maker Reynolds American. Maybe you even refuse to invest in Coke or Pepsi because you see the dangers of sugary beverages and what they’ve done to America’s waistline.
You can take up issue with any company for any reason–its your prerogative, and that’s cool. But, there’s no better promoter of a company than the owner, and a shareholder is an owner. So, own what you love!
6. The Smell Test – The final, and easiest test, is the smell test. You might also call this a “gut check.” In essence, how does this company make you feel? Does the CEO seem like a genuine guy, or does he sound like a used car salesman? Does the company operate like a pyramid scheme (Hello, Herbalife)? Does it engage in highly risky, leveraged operations (Annaly or Chimera)? Do you sleep well at night knowing your money is tied up in the investment?
When I invest in something, I want to feel like I’m on the better end of the deal; I don’t want to feel like I just got hustled. For so many companies, investing in them is a privilege. It’s a relationship that will yield mutual benefits for years to come. I don’t want to get nervous and worried because I feel like I’m in over my head.
Valuation Doesn’t Matter
Eric, what’s the deal? What about valuation? In my opinion, the valuation of a stock doesn’t really matter. Now, most would disagree, and this would be the point of the interview where a lead analyst would say to me, “Whelp, it was great to meet you. We’ll keep your resume on file.” Most people would say, “You’re crazy, Eric! Valuation matters more than anything!” I disagree.
Recall from above that information is abundant, and that the efficient market hypothesis will tend to give any stock, at any price, a 50/50 chance of risk-adjusted outperformance of the market. It should come as no surprise that even monkeys perform better than the experts and the overall market. What’s more, maybe I did want to see a valuation case on an investment. I could spend hours building a model (which is exactly what I do when I write a stock pitch on SeekingAlpha), or I can just hop onto any one of hundreds of sources on the ‘net for current analyst research and price targets (your brokers site will have this, but you can get good stuff on Yahoo! Finance or Morningstar). In a matter of seconds, I get troves of financial data and estimates that would take me forever to create.
Investing should be fun. But, understand your edge on the market, and know that your edge has nothing to do with valuation. If you can see a company serving customers ten years from now, it will almost certainly be doing so as a much larger company than today. If you trust in the vision and expertise of management, and you have a passion for the business, then you’re halfway there. If the stock is in an uptrend, that’s good reinforcement. And if you have a good understanding of operations, and the company allows you to sleep well at night, then it might be a good time to dip a toe in.
In the end, we’re not looking for the 10-20% returns over a few months or years that could be had from some small mispricing. No, we’re looking for the thousands of percent gains over many years or decades that can be had with just a bit of foresight and bit more patience than what most people have.
Good Investing! And thank you for reading!