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February 19, 2014 – Comments (13)

What is it that makes you want to buy a stock?  What is it that makes you want to hold that stock?  Does a nice 2, 3, or even 4% dividend get your attention?  Or does a momentum boost, such as a positive increase in comps or same store sales, get you on the momentum bandwagon?  Does it involve growth in earnings, dividends, or book equity? 

Perhaps it’s a volume trigger or a technical breakout.  Maybe it’s an upgrade from your favorite research organization or analyst (Dear God, I hope not).  Does an attractive industry lure you in, regardless of the details of the specific stock (I remember a Motley Fool post titled “Any Gold Stock Will Do.”)? 

Maybe something like high operating performance, such as ROA, ROE, or profit margins is your ticket to buy.  Maybe you’re looking for that “cigar butt” or asset play, where you find a company trading near its working capital.  Or maybe it’s the potential for future growth – a company with a market cap of $2B now, but with the potential to reach $20B in the next decade, is sure to the next 10-bagger, right?

Buffett and Munger have always claimed that they look at 4 criteria for owning a stock: “We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.” Berkshire has also grown a liking for companies with high returns on equity, and managers of their insurance investments (including Buffett) are willing to “pay up” slightly for companies with such returns.  

So what do I look for when buying a stock?  Well, it’s varied quite a bit over the years.

When I first got started, roughly 7 years ago investing, I really, really didn’t know what I was doing.  I simply looked for stocks with high dividends, whose stock prices were trading well off the 52 week highs.  If I remember correctly, my first purchase was GE in 2007, on a day it took a ~5% tumble.  I employed this “method” of stock picking a lot longer than I wish to recollect. 

I also got crazed in buying companies that were trading at dirt-cheap multiples, regardless of the business. I chased a lot of Chinese [fraudulent] small-cap companies down that rabbit hole.  Ugh. 

I started looking at companies from an enterprise perspective, selecting only companies trading with large net cash or net investment balances.  (The markets are surely valuing their “operating assets” incorrectly, right?)  This led to purchases like JOSB, MLR, SUP, and GLW.  Well, it turns out that these aren’t the highest-performing companies from an operational perspective.

Quick note about enterprise investing, and the subsequent EV/XX multiples that go along with it:  You’re not an enterprise investor.  You’re a common stock investor.  Invest accordingly.

And my most recent [realized] mistake with investing was reading that damn William O’Neil book a couple of years ago. 

Buy more after a breakout, he said.

It would lead to great returns…he said. 

Now I’m sitting on JMBA at an average buy-in price of $15/share and SODA with an average buy-in price of $55/share.  I’m not proud.

I used to buy and sell stocks over periods of days and weeks, rather than months or years.  Trading fees ate into my accounts like termites into a 2x4.

I’ve learned a lot.  It’s been frustrating.  It’s been educational. 

So what do I look for now?  What makes me want to buy?

Well, I have taken a few pages out of Buffett’s manual.  I like to attempt to stay in my circle of competence, and I like companies that have high returns on equity (and returns on assets, even more so).  And to take a page out of Munger’s book, I like cannibals - companies that do a really good job of reducing outstanding shares.  I’m certainly not opposed to dividends, though I think too many investors favor dividends over buybacks.  (If I hear that BP, Chevron, or Conoco’s dividend is bigger than Exxon’s one more time, I might throw my laptop out of the window.)  I also still have a bit of that enterprise bug in me – I’d much rather invest in a company with little-to-no debt, than a company burdened with as much debt as market equity.

But ultimately, I want to see that a company is making progress - value-increasing progress that’s impactful and consistent.  Are increases in earnings good progress?  Sure, as long as the increases in earnings are proportionate to (or exceed) increases in invested capital.  Are increases in book equity progress?  Sure, as long as the company can maintain a stable ROE.  Are increases in dividends progress?  Yes, as long as the payout ratio as a % of cash flows remains stable and low.  Are annual cash outlays issued toward buybacks good progress?  Only if the outstanding share count is actually being reduced (not simply negating stock-based compensation).

Regardless of the itch that drives you to invest in a stock, becoming good at picking winners is something that takes practice, patience, dedication, and lots of stubbornness.  Anyone that tells you they started investing last year, and they doubled their money in 6 months is either lucky or lying.  It’s something that you’re gonna have to work at.  I’ve been at it 7 years now, and I still have a long ways to go.  But the ride has been fun and the future rewards will [hopefully] be satisfying.

13 Comments – Post Your Own

#1) On February 19, 2014 at 5:28 PM, awallejr (79.46) wrote:

Personally I am the poster child for bad timing.  I played the market in the 1980s then stopped for other business reasons.  I got back in March of 2008.  What a difference a year made.

My first blog gave my plan.  I started listening to the pundits such as Cramer and then the crash happened and my portfolio got crushed.

When I opened my account I did tell my broker that the market will now crash.  He asked why and I said because they are waiting for me.

I decided to just listen to Bernanke.  I ignored the pundits trying to interpret what he meant.  I knew and acted accordingly.

I threw my funds into beat up BDCS, MLPS, REITS.  I also started selling puts in C and BAC because Bernanke said he would not nationalize them. My plan was to reinvest the income and the proceeds from the put sales into further shares.

I love selling puts of companies that are committed to doing major stock buybacks like XRX and ACAS.  I also like to take advantage of sector attacks or short attacks like what happened to POT, and BBEP, IPXL, QCOR, SDRL. And finally I am still a fan of yield.

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#2) On February 19, 2014 at 6:09 PM, Mega (99.97) wrote:

Great read, thanks for sharing your thoughts. 

Quick note about enterprise investing, and the subsequent EV/XX multiples that go along with it:  You’re not an enterprise investor.  You’re a common stock investor.  Invest accordingly.

Good point. I know many smart people use EV/EBITDA. In fact some of them have made a lot of money using it. But it is a dangerous metric which can be misused.

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#3) On February 19, 2014 at 6:41 PM, ElCid16 (97.41) wrote:

Thanks, Mega.

I am of the opinion that, ff you're going to use an EV-oriented metric - and again, this is assuming you aren't working for a PE firm - you should probably stick to EV/earnings or EV/FCF.  EBITDA is not completely worthless for stock investors, but close to worthless.  

The reason PE firms like EBITDA, is because many of them buy a company, slash CapEx, pay down the debt they used to finance the deal, and tout the increases in cash flows they achieved.  Then they dump the company at a higher multiple, based on higher cash flows, 3-5 years after they buy it.  Once they get done with a company, not only do they leave it entirely too levered up, they also have likely left it gasping for Capital Investment.  I'm not saying it's right or wrong, but I am saying that they're playing in a completely different ballpark than common stock investors.

Here are a couple of Buffett's thoughts on EBITDA (by the way - he IS an enterprise investor):

"Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?"

"After September 11th, training for commercial airlines fell, and today it remains depressed. However, trainingfor business and general aviation, our main activity, is at near-normal levels and should continue to grow. In2002, we expect to spend $162 million for 27 simulators, a sum far in excess of our annual depreciation chargeof $95 million. Those who believe that EBITDA is in any way equivalent to true earnings are welcome to pickup the tab."

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#4) On February 20, 2014 at 12:53 AM, baggerboy (< 20) wrote:

I'm a new investor and I have lots to learn. Thank you for the comments - good read.

I have invested a wee bit lately - but in companies recommended by TMF. So hopefully long term it will pay off...  

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#5) On February 20, 2014 at 12:13 PM, ikkyu2 (99.23) wrote:

Dividends are not terrible, but to me they are a sign that the company has run out of places to invest its retained earnings, and I do not regard that as a positive.  I have no particular desire to receive a dividend.  If I wanted yield, I would buy a bond.

I look for the same things Mr Buffet does.  I am more on Charlie Munger's side in the sense that I would prefer to buy a wonderful company at a fair price than a fair company at a wonderful price.

His #2 criteria, favorable long-term prospects, has resulted in the spillage of a lot of ink by a lot of people.  To me, there should be at least some kind of a moat - a barrier to entry for competition; a track record of earnings growth, consistent over medium-term periods of time - missing a quarter is fine, missing 5 years is not; and future prospect for more earnings growth.  I personally like a company that is paying for earnings growth with its own retained earnings, although with the abundance of cheap credit in the past few years I can't blame companies that have taken advantage of it.  I am probably more conservative than other investors in this way, which is one reason why my continued thrashing of the markets' return is a little puzzling to me.

Finally, with regard to price, I like a fair price.  There are entire years that go by where I don't find any company I like the price of.  I call it 'turning over rocks' - reading balance sheets, income statements, quarterly earnings call transcripts - to try to find an attractive value.  Sometimes I turn over a bunch of rocks and find nothing.  2014 is starting off as one of those years. 

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#6) On February 20, 2014 at 12:18 PM, ikkyu2 (99.23) wrote:

Let me give an example, by the way, of the way I look at a company.  

I recently trashed FB in a blog post because I think it's a crappy company.  Its valuation places it above some of the best companies ever to trade on an exchange.  Like Google, all its revenue comes from advertising.

It is growing earnings, growing subscribers, acquiring other revenue-producing companies.  It is doing all the things it is supposed to.  Just like Myspace.

I'm serious about that.  I see no particular barrier to entry for competition for what FB does.  I see no reason to believe it will continue to grow earnings the way the 10 companies that surround it in the sorted-by-market-cap list have done for decades.  I see only risk.  Someone responded to this pitch by pointing out how much I would have loved to grab shares of FB when its cap was only $20B.

They are wrong.  I don't love a company like that at any price.  The market can be wrong on a company for as long as it pleases.  Prices can fluctuate as much as they please.  I do not have to worry about that until the day I am electing to place a bid on the stock.  I will never place a bid on a share of Facebook, because of what I noted in the above paragraph; so it does not matter to me whether there is a 'breakout', or what it is trading at now, or what it traded at 3 years ago.   Technical trading is a way to make money, but it is not my way; so I feel free to ignore it.

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#7) On February 20, 2014 at 2:30 PM, ElCid16 (97.41) wrote:

I don't love a company like that at any price.  The market can be wrong on a company for as long as it pleases.  Prices can fluctuate as much as they please.  I do not have to worry about that until the day I am electing to place a bid on the stock.  I will never place a bid on a share of Facebook, because of what I noted in the above paragraph; so it does not matter to me whether there is a 'breakout', or what it is trading at now, or what it traded at 3 years ago.   Technical trading is a way to make money, but it is not my way; so I feel free to ignore it.

You stick to your guns.  I respect that.  Finding a method and sticking to it is something I should stive to get better at.

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#8) On February 20, 2014 at 2:34 PM, lemoneater (78.21) wrote:

Why do I invest in a particular stock, good question! Leaving aside the basic, simplistic reason of wishing to beat inflation in a way impossible to achieve with a high yield checking account, I buy stocks for a variety of reasons, but I always have a reason and know what that reason is. 

Some are "virtual" coupons like IMKTA my local grocery store or well known companies with facinating R&D like 3M. Some are ones my husband suggested I research like XLNX. Some are basic necessities like water CWCO or salt CMP. Some are growing niche products like kefir LWAY. Some are REITs like CUBE an unusual but necessary kind of real estate. Unlike ikkyu2 I'm fond of dividends which I reinvest. (Although if a yield is about 5% I treat it with caution.) Yet I have both ISRG and WWAV which pay no dividends.

 

 

 

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#9) On February 20, 2014 at 3:00 PM, ElCid16 (97.41) wrote:

Dividends are not terrible, but to me they are a sign that the company has run out of places to invest its retained earnings, and I do not regard that as a positive.

Ikkyu2 - I have a different take on dividends.  I realize that, to an extent, the decision to pay a dividend means that a company has hit a certain level on the corporate maturation cycle – but to say that it’s “run out of places to invest” is a bit bold. I don’t think companies like 3M, Medtronic, Becton Dickinson, Abbott, and Exxon have “run out of places to invest.”

I’m guessing you feel roughly similar toward buybacks, too?  A company that has made a decision to purchase its own stock has (in theory) decided that the capital investment options for that additional capital would yield inadequate returns.  This would also fall line with your thought that they have “run out of places to invest.”

Here’s a Buffett nugget, speaking about Coca-Cola (another dividend paying company that, I feel, has plenty of places to invest):

“When Coca-Cola uses retained earnings to repurchase its shares, the company increases our percentage ownership in what I regard to be the most valuable franchise in the world. (Coke also, of course, uses retained earnings in many other value-enhancing ways.) Instead of repurchasing stock, Coca-Cola could pay those funds to us in dividends, which we could then use to purchase more Coke shares.”

There are several ways that a company can use operating cash flow to generate “value-enriching” returns for investors.  Capital investment is one.  Dividends and buybacks are two others.

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#10) On February 20, 2014 at 5:39 PM, awallejr (79.46) wrote:

Dividends are not terrible, but to me they are a sign that the company has run out of places to invest its retained earnings, and I do not regard that as a positive.  I have no particular desire to receive a dividend.  If I wanted yield, I would buy a bond.

First reinvested dividends account for 40% of market appreciation.  According to Buffett one of the biggest tasks he has is trying to spend all the income BRK generates each year.  During the great crash GE and GS had to go to him begging for cash. So yield generation matters to him a lot.

There are many stocks that are specifically designed to generate distributions such as MLPS, BDCs and REITs. They certainly are not the equivalent to bonds.  Bonds are debt instruments with specific terms.  More often than not their yield is fixed. Dividends on the other hand can grow over time.

 

 

 

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#11) On February 21, 2014 at 5:50 AM, awallejr (79.46) wrote:

Hard for me to reconcile comment #5 here with comment #2 in the following:

http://caps.fool.com/Blogs/outperform-with-dividends-in/194976

 

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#12) On February 21, 2014 at 12:12 PM, Mega (99.97) wrote:

"A foolish consistency is the hobgoblin of little minds." - Ralph Waldo Emerson

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#13) On February 21, 2014 at 12:33 PM, awallejr (79.46) wrote:

"Never argue with success." - anonymous

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