Thursday, 6 July 2017

Highlights from Book - Common Stocks and Common Sense - Edgar Wachenheim

Common Stocks and Common Sense by Edgar Wachenheim is a case-study based book on investing. In structure it is similar to Beating the Street by Peter Lynch. Edgar used to run Greenhaven Associates with an excellent long term track record. In the book, he goes through some of his picks, the rationale of why he bought them, his process of stock selection and the emotions that goes with investing. It is a good book dealing with real-life examples of a good value investor. 

Below are the key points I noted from the book.

The strategy is to try to purchase deeply undervalued securities of strong and growing companies that hopefully will appreciate sharply as the result of positive developments that already have not been largely discounted into the prices of the securities.

I do my best to make decisions that make sense given everything I know, and I do not worry about the outcomes.

When an investor is barraged with particularly bad or good news, he can reread the memos, notes, and models he wrote before the occurrence of the news. He then can ask himself three questions: What really has changed? How have the changes affected the value of the investments under consideration? Am I sure that my appraisal of the changes is rational and is not being overly influenced by the immediacy and the severity of the news?

When we purchase a stock, we are interested in what the company will be worth two or three years

I knew that my projections of IBM’s earnings and values were nothing more than best guesses based on incomplete information. However, having the projections to work with was better than not having any projections at all, and my experience is that a surprisingly large percentage of our earnings and valuation projections eventually are achieved, although often we are far off on the timing.

I greatly admire Warren Buffett. He is one of the great investors of all time. But I strongly disagree that the shares of most wonderful businesses can be held forever because most wonderful businesses become less wonderful over time—and many eventually run into difficulties.

My job would be a lot easier and much more relaxing if I could fill a portfolio with outstanding companies that I never would sell. But our ambitions lead us to seek shares that are temporarily deeply undervalued and then sell the shares when they become fully valued. This is an approach to investing that is less relaxing and that requires considerable effort and time, but that has worked for us.

I almost always start my analysis of a company by studying its balance sheet. It is said that a shareholder makes money off the income statement, but survives off the balance sheet, and I agree.

When studying a balance sheet, I look for signs of financial and accounting strengths. Debt-equity ratios, liquidity, depreciation rates, accounting practices, pension and health care liabilities, and “hidden” assets and liabilities all are among common considerations, with their relative importance depending on the situation. If I find fault with a company’s balance sheet, especially with the level of debt relative to the assets or cash flows, I will abort our analysis, unless there is a compelling reason to do otherwise.

If a company’s balance sheet passes muster, I then try to get a handle on management. The competence, motivation, and character of management often are critical to the success or failure of a company. To form an opinion on management, I normally pay careful attention to the management’s general reputation, read what the management has said in the past, assess whether the management’s stated strategies and goals make sense, and analyze whether the management has been successful carrying out its strategies and meeting its goals.

However, I am humble about my abilities to accurately assess managements. Experience shows that investors can be unduly impressed by executives who are charismatic or who purposely say what investors want to hear—who play to their audience. Also, investors frequently will undeservedly credit management for a company’s favorable results and vice versa. Favorable or unfavorable results often are fortuitous or unfortuitous.

After trying to get a handle on a company’s balance sheet and management, we usually start studying the company’s business fundamentals. We try to understand the key forces at work, including (but not limited to) quality of products and services, reputation, competition and protection from future competition, technological and other possible changes, cost structure, growth opportunities, pricing power, dependence on the economy, degree of governmental regulation, capital intensity, and return on capital.

Our models normally include earnings projections for the next two or three years. Our valuation is based on a multiple of projected earnings and cash flows.

In the stock market, it is best to be flexible and not be tied to conventions or rules.

My own policy is that no single stock should equal more than 12 percent of the total value of a portfolio and that no single industry should equal more than 25 percent of the total value. When measuring the percentages, I use the cost of the stock rather than its market price. That way, I am not forced to reduce the size of a position that appreciates faster than the portfolio as a whole.

Current fundamentals are based on known information. Future fundamentals are based on unknowns. Predicting the future from unknowns requires the efforts of thinking, assigning probabilities, and sticking ones neck out—all efforts that human beings too often prefer to avoid.

In the investment business, relatively unpredictable outlier developments sometimes can quickly derail otherwise attractive investments. It comes with the territory. So while we work hard to reduce the risks of large permanent loss, we cannot completely eliminate large risks. However, we can draw a line on how much risk we are willing to accept—a line that provides sufficient apparent protection and yet prevents us from being so risk averse that we turn down too many attractive opportunities. One should not invest with the precept that the next 100-year storm is around the corner.

I revise models frequently because my initial models rarely are close to being accurate. Usually, they are no better than directional. But they usually do lead me in the right direction, and, importantly, the process of constructing a model forces me to consider and weigh the central fundamentals of a company that will determine the company’s future value.

I strongly believe in Warren Buffett’s dictum that he never has an opinion on the stock market because, if he did, it would not be any good, and it might interfere with opinions that are good. I have monitored the short-term market predictions of many intelligent and knowledgeable investors and have found that they were correct about half the time. Thus, one would do just as well by flipping a coin.

In the end, the psychological rewards of being right can be as important as—or more important than the monetary rewards. And they are interrelated. When you feel good, you are more likely to do well.

But I believe that investors sometimes need to be open to new ideas that challenge previous convictions. In the investment business, as in life, one becomes disadvantaged if one develops tunnel vision.

Often, when I am in a quandary about whether to sell one of our holdings, I sell half or some other fraction that makes sense under the circumstances.

Occasionally, a black swan adverse event does derail one or more of our investments. When this happens, we must be ready to unemotionally rethink the economics of continuing to hold the investments—and, if necessary, sell.

When we are wrong or when fundamentals turn against us, we readily admit we are wrong and we reverse our course. We do not seek new theories that will justify our original decision. We do not let errors fester and consume our attention. We sell and move on.

Our central strategy is to purchase deeply undervalued securities of strong and growing companies that likely will appreciate sharply as the result of positive developments.

To successfully assess probabilities and make good investment decisions, an investor should hold considerable amounts of information about the companies and industries he is investing in. Having superior information (both quantity and quality) can give an investor a competitive edge. To obtain information, we spend a large percentage of our time researching the fundamentals of companies.

Pay more attention to what managements do than to what they say. Remember, managements, like most other people, tend to act in their self-interest.

Favor managements who are highly incentivized to achieve higher prices for their shares.

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