Important Insights From The Investing Greats

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Find A Strategy You Can Stick With

“The great strategy you can’t stick with is obviously vastly inferior to the very good strategy you can stick with.”
— Cliff Asness

This is why protecting your downside is more important than maximizing your upside. Forget the horserace and look to a strategy you can live with in good times and bad. For me, that strategy is investing largely in defensive, high quality companies that grow their dividends. It may lag in a bull market, but I can sleep like a baby in tough times. The key is that I know it works and I believe in it. That inoculates me against selling and locking in a big loss during a bear market.

You Don’t Get Extra Points For Degree of Difficulty

“If you’re in a wonderful business for a long time, even if you pay a little too much going in, you’re going to get a wonderful result if you stay in it a long time.”
— Warren Buffett

High quality companies can be great long term compounders.

Figure Out What Not To Do And Don’t Do That

“It is 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.”
— Charlie Munger

Inversion is the key to Munger’s success. Learning from the folly of others and avoiding their mistakes gives you a huge advantage in life and investing. Figuring out what not to do is more important than trying to be brilliant.

The Cost of Taxes Should Be Included In Your Opportunity Cost Calculations

“Intelligent people make decisions based on opportunity costs. It’s your alternatives that matter.”
— Charlie Munger

“Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum. In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15% or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.
— Charlie Munger

Something I struggle with is the temptation to always be doing something. If I have a position with a big gain that is trading above fair value, I start to play with alternatives. The problem is that action for the sake of action should be avoided. It helps me to remember Munger’s comment about the huge advantage you can get from letting a company compound tax deferred over the long term. Unless there is something fundamentally wrong with the business or I have a much cheaper and more desirable alternative, sticking with a high quality winner generally makes sense. This helps me by increasing my hurdle rate to action in such a situation. 3.5% is Munger’s high end estimate for a company with a 15% annual total return, so depending on the company, I adjust downward. Since my holding period is less than 30 years, I generally figure between 0.5% and 1.5% for the benefit for long term tax deferral. If it’s a close call, taking no action can make sense.

A Half Dozen Or So Things I Have Learned from Josh Peters About Investing

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Congratulations to Josh Peters, who is moving on from being founding editor of the Morningstar DividendInvestor newsletter to managing a mutual fund. I’ve made some real money by looking over his shoulder and getting turned on to some great companies by him over the years.

But more than that, I am deeply grateful to Josh for his unvarnished sharing of his investment process, warts and all. Crystal clear thinking coupled with honesty and integrity oozed out of everything he wrote for the newsletter. Josh, thanks for being a great mentor and good luck in your new job!

Here are some things I’ve learned from Josh over the years:

1). A secure and growing dividend can give you a margin of safety beyond just price.

2). Don’t rely on forecasts or make big macro bets, but have a range of reasonable planning assumptions, like a normalized 10 year treasury yield of 4 – 5% in your valuation models.

3). Investing for income and total return are not only not mutually exclusive, they are better together. A secure and growing dividend bought at a reasonable price is a good foundation for meeting your long-term financial goals.

4). Valuation matters when investing in dividend paying stocks. It should never devolve into just a hot trade where you are buying them at any price because it has worked in the recent past.

5). The most important question to ask about a potential investment in a dividend paying stock is this: Is the dividend safe? You want to understand the cash flow dynamics of a business to avoid dividend cuts, as this is the key to successful equity income investing. Josh did this well with his decision to bail on the Kinder Morgan family in 2014, more than a year before Kinder Morgan (KMI) cut its dividend by 75%.

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6). Josh’s Dividend Drill is a great format for evaluating a dividend-paying stock. It has 3 main steps:

Step 1 — Is it safe?

Step 2 — Can it grow?

Step 3 — What is a reasonable long-term total return target?

To me, Josh has represented the best of Morningstar, of which I am a big fan. His successor, Mike Hodel, has some big shoes to fill, but here is hoping he is up to the task. It certainly helps that he has the entire Morningstar team behind him.

See also:

DR 167: Interview of Josh Peters of Morningstar March 18, 2015: Soundcloud and Transcript

A Dozen Things I Learned from Todd Wenning About Investing

A Dozen Sentences Explaining what I’ve Learned from Warren Buffett about Investing

A Dozen Things I’ve Learned from Charlie Munger (Distilled to less than 500 Words)

Becoming Warren Buffett (HBO Documentary Films)

How To Sell Finance Books Like Harry Dent

humility and curiosity
“It’s what you learn after you know it all that counts.”
— Earl Weaver

5 things I’ve learned from Charlie Munger

Hempton on Valuation Analysis and here

Normal Accidents

Moats and Knights

“The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low….Our evidence thus contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. Rather, it is consistent with anecdotal tales about managers signaling their earnings expectations through dividends or engaging, at times, in inefficient empire building.”
— Rob Arnott and Cliff Asness

Can You Handle The Truth? Are You A Soldier For Your Beliefs Or A Truth-Seeking Scout?

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An important thought for all of us in these fraught and emotional political times for the country. Are we more soldiers for our ideas, or scouts who yearn to see reality as it is and not as we would like it to be to fit our preconceptions? Remaining a whole country may require both sides to seek truth and uncertainty even when it is unpleasant to our ego and pet ideas and beliefs. Interestingly, high IQ is not correlated with truth seeking. Instead, the scout mindset is associated with curiosity and openness to being wrong. Food for thought for every one of us. We need to get back to giving each other the benefit of the doubt in terms of good intent or we are gradually slouching toward a civil war. Hillary Clinton and Barack Obama are patriots and heroes in that they are promoting reconciliation. They are following the example of George W. Bush in the transition to President Obama in 2008. We should all try to be curious and see the other person’s point of view. We also need to question and examine our own biases and preconceptions.

Much less important, this is also the mindset you need to be a good investor. So we can potentially save the country and make a few bucks in the process by being curious. What’s not to like? Are you willing to see reality as it is rather than as you would like it to be? Can you handle the truth?

Recent Portfolio Moves

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Mid-Year Portfolio Moves

I’ve maintained radio silence for a while, but I haven’t been idle. Being largely invested in a mix of defensive dividend yielders and growers, I’ve had a great first 6 months of the year, up 18.6% on a total return basis. With utilities, REITs and consumer staples up big year-to-date, I’ve trimmed some of my winners. I raised about 9% cash and put about half of that to work in a new stock. I may be early, but risk management is my discipline.

Contenders for New Money

There are a lot of great stocks I have on my watchlist. Here are some of them, and my thoughts on them:

TJX (TJX) — The parent of T. J. Maxx, Marshall’s and HomeGoods is a formidable discount retailer. Many consider it Amazon-proof because of their ability to source high-quality discount goods. There is also the treasure hunt factor luring shoppers into the stores and away from their computers. Yields 1.3%. Ross Stores (ROST) is their competitor and a similar good performer. Stock is just not cheap enough and the yield is not high enough to get me to pull the trigger. Probably my loss.

Wells Fargo (WFC) — The best of the big banks. More involved in “boring old banking” than their megabank peers. Warren Buffett owns just shy of 10% of their shares. The upside is that it’s relatively cheap. I also like this one for its portfolio diversifying properties — it benefits from higher rates and a stronger economy. The downside is that the current low interest rates and the flat yield curve are crushing their NIM (Net Interest Margin). Political bashing in this election year makes for short-term downside, but now highly-regulated banks are in their best shape from a safety and soundness and capital standpoint in decades. Despite a generous 3.2% yield, I don’t see the urgency to buy it here, especially since their dividend growth rate downshifted to 1/2 a cent per share per quarter in 2016.

Ford Motor (F) — The only car company not to be bailed out in the financial crisis. Great turnaround under Alan Mullally. Fat 4+% yield (plus special dividends) is attractive. Just too cyclical for me. With some auto loans stretching to 72 months, what happens to demand when the economy slows, and/or the Fed raises rates? Reported earnings today and was slammed down by 8% on guidance for a contraction in sales in 2017.

Compass Minerals (CMP) — Sells mainly highway deicing salt for winter driving and has a small (10% of revenue) sulfate of potash business. Their long-lived, low-cost salt mines like the one at Goderich in Ontario benefit from salt’s low value-to-weight ratio and their access to cheap shipping throughout the Upper Midwest by barges on the Great Lakes and Mississippi River. Great 4% yield. Short-term concerns include the very warm winter last year leading to high salt inventories and weak pricing. 20% of their salt business by volume occurs in the UK and will take a currency hit from Brexit. A normal-ish winter in terms of snowfall would increase cash flows and help the dividend growth outlook. The long-term concern of global warming means that I want a big margin of safety on this one. Recent selloff has my trigger finger getting a bit itchy.

Fastenal (FAST) — A great operator in a fragmented industry, sells fasteners and other industrial supplies to industrial and retail customers. Nice 2.9% dividend yield. They have been struggling to manage their transition from their hyper-growth store opening phase, to their current effort to invest in their sales force to sell their vending solutions to industrial firms. This and recent weakness in manufacturing prompt me to take a pass for now.

Microsoft (MSFT) — Thank God for the arrival of Satya Nadella to replace Steve Ballmer. Nadella has refocused the company on investing in and growing their cloud business, Azure. Azure offers IaaS (Infrastructure as a Service) and PaaS (Platform as a Service) on a subscription model — you only pay for what you use. They are number 2 in the cloud to Amazon Web Services and growth was over 100% in the recent quarter. Given the explosion in data and computing power needed in the future, this looks like a secular grower with a lot of runway. They also have a SaaS (Software as a Service) business that is transitioning their legacy businesses to Office 365, and their Dynamics business includes ERP & CRM solutions. I don’t really know much about the wisdom of the LinkedIn deal, but given his performance so far, I’m willing to give Nadella the benefit of the doubt. With much improved capital allocation including a 2.6% dividend yield and good historic and expected dividend growth (this article anticipates an 11% dividend increase announcement in September), this is my kind of stock — a cash cow with good growth prospects.

If you can’t guess, Microsoft was the winner of my investment derby, and is the newest member of my portfolio, with a 4%+ weighting.

Don’t Let Anyone Tell You Dividends and Dividend Growth Don’t Matter for Stock Returns

EE S&P 2% Yld

This great chart from Eddy Elfenbein shows the S&P 500 scaled against a 2% dividend yield. The rally since 2009 has been more than just the Fed. But, so-called bond-like stocks are expensive now. You want to discriminate between them (no ETFs for me) and prepare your portfolio for higher rates.

In a time of low projected future returns on the indexes from the likes of Jeremy Grantham at GMO and Rob Arnott at Research Affiliates, people have rationally decided that all else equal, a higher yield with mid single digit growth will get you closer to a high single digit total return than an S&P 500 index fund is likely to do. As long as you sell the ridiculously overvalued in favor of the less overvalued and manage your risk.

But I believe it is definitely time to lean a bit more toward value and the unloved. On this basis, Wells Fargo and Compass Minerals are high on my list for future buys.

See also:

Calculated Risk: The Future is still Bright!

Jeff Saut Still A Secular Bull

Why Home Solar Panels No Longer Pay in Some States

Best-Paid CEOs Run Some of Worst-Performing Companies

Non-Traded REIT Sales Plunge 75% in Three Years — Hurray!

Charlie Munger, Buffett’s partner on 50% declines — on Vimeo

Mohnish Pabrai Lecture at Univ. of California, Irvine (UCI), May 24, 2016 – YouTube

Understanding Some Things About The Markets & Investing

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Figure Out What Not To Do & Don’t Do That

When you are learning something from scratch, Charlie Munger’s tool of inversion is very helpful. In other words, figure out what not to do and stay away from that. Learning from the mistakes of others is much cheaper than making them all yourself, in life and especially in investing. And Charlie really likes to rub his nose in his own mistakes, so the lessons sink in and aren’t repeated.

Chase Heavily-Hyped Innovation At Your Peril

Warren Buffett has always been wary of investing in innovation. Two of the greatest industries for innovation in the 20th Century were autos and aviation, and the historical record is littered with dozens of companies that have gone out of business in both sectors.

Much more important is finding a business with an economic moat, which means one or more sustainable competitive advantages that keep competitors at bay. To an investor, boring can be beautiful, especially if you can find it with a moat and buy it at a discount. Areas like consumer staples aren’t cheap these days, but selloffs will come.

If you are ready with a watchlist of great stocks and some cash, you will know what to do when everyone else is selling and losing their minds. Investing is a marathon, not a sprint. Don’t let your ego make you chase the high-fliers, especially without a margin of safety.

“The Big New Thing is often a terrible, terrible investment. Even if it pans out, there will be gobs of competitors.”
Eddy Elfenbein

The Rule of 72

Divide 72 by your annual return and it will tell you how many years your investment will take to double. An 8% annual return with reinvesting will double your money in 9 years.

This also works for inflation in an inverse fashion: 3% inflation will cut your purchasing power in half in 24 years. Hat tip to Don Yacktman, who notes that 3% inflation for 100 years turns a dollar into a nickel.

Incentive-Caused Bias Predicts Behavior

Charlie Munger talks about incentive-caused bias being a superpower in terms of its ability to predict the behavior of others. Moral suasion that runs counter to strong incentives to the contrary has little chance of getting the desired result. It helps to think about the motivations and incentives of the guy on the other side of the table or the other side of the trade. Looking at the compensation incentives at a business also helps to make sure they are aligned with the best interests of shareholders.

Politics & Investing Don’t Mix

If you let your politics rule your investing, you will pay a grievous price. With all of the negativity and polarization on talk radio and Fox News, many people have dug themselves quite a hole in the Obama years by assuming that the economy and the markets would go off a cliff. These folks have missed out on one of the great bull markets of all time.

Are Things Getting Better or Getting Worse?

As Jeff Saut says, the market doesn’t care about the absolutes of good or bad, but whether things are getting better or getting worse. Another reason to compartmentalize your political opinions when thinking about investing.

Doom and Gloom Is for Losers

Related to the point about politics, doom and gloom is for losers. There have been near infinite and continuous market crash and hyper-inflation predictions over the last 7 years. Anyone who has followed such doomsayers as Paul Farrell, Zero Hedge, or Peter Schiff has had their rear end handed to them.

The strength of America is in its people and their ability to work hard and innovate. We face tough issues, but we faced a lot of tough issues in the 20th Century, too. World War I, the Great Depression, World War II, the inflation and malaise of the 1970’s, and more. And yet living standards and markets kept rising.

Like Warren Buffett, I believe in my fellow Americans. Future living standards will almost certainly continue to improve over time. Particularly if we can remember we are all in it together and unite against our problems, instead of seeking to pin the blame on others.

Gold Won’t Save You If The World Ends

If the zombie apocalypse happens, gold isn’t going to save you. It will be guns, ammo, bottled water, and canned food. Speculate if it makes you happy, but gold has no cash flows and therefore no intrinsic value. And gold mining stocks have been one of the prime places money goes to die, as mining CEOs are quite possibly the worst operators and capital allocators known to man.

Other thoughts:

Everything that is probable is possible, but not everything that is possible is probable.

Seek margins of safety, including beyond just price. A defensive business model can give a margin of safety of sorts. A low payout ratio and low debt levels can as well. Find all of these in one stock and you have hit the jackpot.

You need to balance probabilities and consequences. In general go with the probabilities, but be mindful of small but catastrophic risks that you should avoid. Like Howard Marks says, it’s not good enough to survive on average, you need to survive on the bad days.

Measure what you manage so you can manage what you measure. If you don’t know your performance figures, you can’t know if you are adding value or not. Concentrate on what you can control (risk), and not on what you can’t (returns). Process over outcomes.

Pay careful attention to portfolio construction and position sizing. While seldom talked about, these factors are at the core of good risk management.

See also:

Inverting the How-to-Invest Question: How Not to Invest?

Less than 1% of Daytraders Are Consistent Winners!

The Nature of Value

Creating a Latticework of Mental Models: An Introduction

Judgment Under Uncertainty: Heuristics and Biases by Tversky and Kahneman