Folks – it’s great to be back. A lot has happened over the past few weeks; then again, you should not have been surprised by any of it. The airlines are shutting down (you could have seen it coming from a mile away – serious note: my heart goes out to the employees); Bear Stearns has fallen (someone had to – serious note: my heart goes out to the employees…again); GE missed Wall Street’s optimistic earnings estimates (with more than 35% of 2007 revenue from GE Money and a sever credit crisis? No way!)
(Oh, and someone stole my identity. Moving on.)
With the markets in a dizzying undulation – not quite ready to plummet, not quite ready to soar – it’s common to ask yourself, “Did I make the right decision? When should I reevaluate? If it’s going to get worse, should I stand on the sidelines for a while and look for a bottom or the signs of a recovery?”
The question on the table is, “Should I reconsider my purchase of American Eagle Outfitters?” There has been a lot of talk about it in the comments of that post. Let’s break it down in pieces, and then use that logic for all investing:
1) A Drop in Cash Flow
AEO saw a drop in cash flow this past fiscal year. A fairly significant drop at that. This is where understanding your business is so critical. Looking at the capital expenditures, we see a significant jump in the last two years – from about $80 or $90 million to about $250 million. This is certainly going to eat into cash; so, what the heck is going on?
AEO is generally not a very capital intensive business. In addition, we know that they are expanding into a new kid’s brand. Starting a business – a major launch of a new line – often requires a ton of capital, and that is going to burn cash for a while. It is a step back in hopes of taking a leap forward.
2) A Single Point in Time
After analyzing a company and buying the stock, it is easy to use that purchase date as the “point forward” for all information and analysis. That’s a mistake. When valuing a business, we look at multiple four- and five-year timeframes. We can’t just throw that out the window once we become the business owner.
I discussed this on August 2, 2007 – When growth slows down. Buffett tells us:
Do not take yearly results too seriously. Instead, focus on four- or five-year averages.
Was (fiscal year) 2008 a tough year for AEO? Or, was 2007 really stellar? There is no way to know for certain, so we must look at the business over various cycles. That “multiple cycle” analysis must carry forward.
3) The Commitment as a Business Owner
When buying a business, you can’t focus on quarterly or annual results. You must give your business time to grow; you must let it stumble. Unless you see a BIG RED WARNING SIGN telling you to get the heck out, you have to relax a bit.
There is no magic holding period; still, you can’t look at ten years worth of a business, try to predict where it will be in the next five or ten years, and then focus on (and freak out about) quarterly or a single year’s performance.
Sometimes your stock will soar before you can buy enough of it; sometimes it will drop significantly and stay low for years. Throw the price out the window, take a step back, and look at your company over various timeframes. (In fact, ignore the price entirely and pretend you were in the board room with nothing more than quarterly and annual reports.)
4) The Portfolio and Annualized Returns, as a Whole
You must recognize that “shooting for 20% and 30% annual returns” means that:
- some of your winners will come very quickly,
- some of your business will go south and you’ll lose money,
- sometimes, you’ll wish you had everything in workouts,
- sometimes, you’ll wish you had everything in long-term businesses,
- other than in workouts, you must look at everything in long timeframes (ie., your portfolio, your returns, your businesses).
At 20% a year, it takes almost four years to double your money. During those four years, anything can happen (and it usually does).
5) An Exercise in Business Investing
Making decisions based on value are not always easy because, at any time, we can see the price and let it skew our perception of value. That is, we can outthink ourselves.
When prices are dropping, most people second-guess their valuations; when prices are on the rise, many people find reasons to increase their valuation to invest further into the winners.
It doesn’t work that way.
If you know that price follows value in the long-term, but you are fixating on the short-term, try this little exercise:
- Pick four or five (or ten, or twenty) companies that have been around for at least twenty years,
- Don’t look at a chart of their past price,
- Go to the SEC database and pull their quarterly (10Q) and annual (10K) reports for the past ten years,
- Starting in 1997 or 1998, read the reports and try to figure out the business’ value for that year,
- Repeat for each subsequent year.
Finally, compare your valuations with the past stock price.
Then, remember that you just looked at ten years of history and saw wild price swings on a daily basis, but saw the markets rationally price the businesses over time. Drill that into your head, and then look at your portfolio again.
(If you can’t come up with a reasonable valuation for the companies, you (i) are well outside your sphere of competence in those businesses, or (ii) need to spend a little more time understanding the businesses.)
Don’t be an optimist. Don’t be a pessimist. Be a business owner – a realist. (Optimists and pessimists rarely last long in business.)
Filed under: How to Think About Investing
Related Stocks: AEO
i think you raise a good point jeff and i am curious to hear what Joe thinks. Note thought that perhaps with the exception of 3rd Ave the others are really value investors concious of their benchmark so that might be the issue (as to their returns). The problem I see is that investors really are too attached to the benchmark which forces the manager to focus on the benchmark as opposed to absolute return. Prabai does better but this is dependent on who he has raised capital from and their understanding of his returns and vol of returns. My personal problem is that I am in the middle of your band on what i consider to be a buffet type strategy (though i can only hope that this continues) but am forced to notice that some commodity type strategies seem to throw off huge numbers (once you get past the drawdowns).
As an aside I think Prabai premise is that you can buy small companies at 50 and sell at 100, which is an opportunity no longer available to Buffett given size. Buffett’s strategy though makes complete sense to me though unless you actually get the company trading v far above instrinsic, i.e. Petrochina. Perhaps you are supposed to sell when stock trades 30-50% over intrinsic, but I really havent actually looked through the Petrochina trade so I’m just thinking out loud. Good idea though thanks.
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The reason most open-end mutual funds (e.g., Oakmark, etc.) can’t beat that 14% to 18% return (which, by the way, is phenomenal in the world of mutual funds) is because of their structure. By their very nature, the Investment Company Act of 1940 requires that:
- they hold at least 20 positions (ie, no more than 5% of assets in any one company), and
- they don’t own more than 10% of any single company.
To keep within the boundaries of the law, most funds typically hold at least 40 or 50 positions. If one grows too much too quickly, it has to be sold – in whole or in part – to stay within the letter of the law.
In addition, most funds keep a portion of their assets in cash to handle investor redemtpions. This is an additional drag on performance.
These restrictions do not exist for closed-end, non-diversified funds – whether public (like CGM Focus Fund) or private (like Pabrai Funds). (Though CGM Focus Fund is still bound by the “no more than 10%” rule above).
Assuming all three (Oakmark Equity Income Fund, CGM Focus Fund, and Pabrai Funds) all use exactly the same methods (they don’t) and look at exactly the same opportunities, you would see that, as a whole, the returns would likely increase from Oakmark to CGM to Pabrai, as would the volatility. Why?
Oakmark can only put up to 5% of its assets into its “best” idea, and has to put the rest of its money to work in other things. CGM can put up to 25% (according to IRS regulations) into its “best” idea, but can only acquire up to 10% of that company’s securities. Pabrai can put up to 100% of its assets into its “best” idea, even if that means owning the business outright.
Of course, Oakmark, CGM Focus Fund, and Pabrai Funds all invest differently so this is simply a discussion of the three types of entities and the obstacles they must overcome to achieve superior growth.
Make sense?
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You would be right sir. I guess its hard to contemplate all of the different handicaps they have. Even a non-diversified fund, whom is extremely Buffett-like, in Fairholme Funds, is in the 17-18% band. Absolutely phenomenal, but if I’m looking to do better than that (due to smaller size and more flexibility), I just want to pick the best possible approach. I feel that buy and hold (even while overvalued) won’t give those results. Buy and sell when overvalued…may.
Thanks though, Joe. It’s a thought I’ve always pondered. I’d like to think that if I focus enough, I can move above 20% over the long term.
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Joe is absolutely right in his emphasis on his approach to focus investing in the Mohnish Pabrai style. A quote from Buffett’s 1989 letter to shareholders explains well how his investment style has changed over the years, and why he now prefers a buy and hold forever mentality.
“Because of the way the tax law works, the Rip Van Winkle style of investing that we favor — if successful — has an important mathematical edge over a more frenzied approach. We have not, we should stress, adpoted our strategy favoring long-term investment commitments because of these mathematics. Indeed, it is possible we could earn greater after-tax returns by moving rather frequently from one investment to another. Many years ago, that’s exactly what Charlie and I did.
Now, we would rather stay put, even if that means slightly lower returns. Our reason is simple: We have found splendid business relationships to be so rare and so enjoyable that we want to retain all we develop. This decision is particulary easy for us because we feel that these relationships will produce good – though perhaps not optimal — financial results. Considering that, we think it makes little sense for us to give up time with people we know to be interesting and admirable for time with others we do not know and who are likely to have human qualities far closer to average.”
In other words, yes, more optimal results can expected to be achieved by buying $.50 dollars and selling them for $.90, although this requires a more full-time commitment. I, for one, am committed to this approach.
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Nick,
You are absolutely right, and I agree with you 100%. I’m curious what Joe does himself? Very few posts on F Wall Street so far have concerned the sell discipline, mostly focused so far on the buy discipline.
Joe, any future posts coming on appropriate selling policy for entrepreneurial investors?
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I believe you are conflating Value Investing and Focus Investing.
Value
Benjamin Graham’s approach to value investing was to find companies that are selling well below Net Asset Value, and then sell when their price rises to meet NAV. Ben Graham was not interested in Moat, Management or any of the other qualitative assessments buffet uses to choose securities. Following Graham’s approach, you could buy stocks without even knowing what businesses they are in.
Graham recommended diversifying into (i think) 30 or so stocks.
Focus
Buffett’s approach is closer to Fisher’s approach, where you seek to know EVERYTHING about your business. Buffett could not sell at 90% of IV, because he would have to know EVERYTHING about too many stocks.
Buffet recommends holding around 10 stocks.
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Speaking about value investing, can someone help me with CHSCP? It looks like a bargain. (BTW I’m not asking for research on it or whatever, but for some clarification.)
Its a “cooperative company”; so in what ways is a cooperative company different from a normal one?
Is the number of shares outstanding 7 mil? Or is the cooperative’s members actually holding onto a much larger quantity than those traded publicly?
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I have a question and maybe this is obviously to everyone with a background in finance, which I don’t have, but when you say, “we must look at the business over various cycles,” I assume you mean the 4-5 year timeframe mentioned later in the article. As there are certain somewhat predictable fluctuations in the market (sells offs around Christmas and New Years,) is there a distinct and discrete portion of months that you compare year over year? Say, March to October ‘84-’88 vs. March to October ‘89-’93? Or do you just lump entire 4 year portions together and compare those over the life of the company?
Thanks!
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Hannah,
When you look at a company over various timeframes, the idea is that you capture various business cycles (i.e., when the business is widly profitable and when it is going through tough times). Keep in mind that we’re not talking about looking at the price over various months or quarters; you should look at the financial performance of the business (revenues, earnings, cash flows, etc.) over various 4- and 5-year timeframes.
Also, don’t worry about not having a background in finance. People on F Wall Street come from all sorts of backgrounds, from students to teachers, from stockbrokers to hedge fund managers, and more. We’re all here to ask and help!
PS: There are no predictable fluctuations in the markets, and the people that claim that there are usually have something to sell you!
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Joe,
How realistic do you think that 20-30% band is for Buffett-like investors, working very hard? I
‘m just going off of the returns from some well known mutual funds that work as such- Oakmark, Longleaf, Legg Mason, Third Avenue (a bit different but still buy and hold) who seemingly cannot escape the 14-18% band over the long term. I know Pabrai has talked about how buying at 50 and selling at 100 over time will produce much higher returns than buy and hold. What do you think about that?
-Jeff
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