Of course, I couldn’t ask for more out of a lazy man’s portfolio. Being some 17% in cash brings me no joy; but, this portfolio has continued to outperform the S&P 500 Total Return Index (the S&P 500 with dividends reinvested) by 19.7% a year, growing 4.2% annually versus the S&P 500′s -15.5% annual return. That said, the F Wall Street portfolio is going bye-bye. Though I will continue to write about investing and individual companies, I can’t maintain the portfolio in real-time (or even somewhat real-time).

Still, this “value investing” stuff works. And though we’ve only been going two years, if you don’t believe by now that buying good businesses on the cheap and ignoring the markets is the way to go, it will probably never sit right with you. As Buffett says: You either quickly get the concept of buying $0.50 dollars, or you never do. Let’s jump into some interesting questions from visitors, and concepts in intelligent investing.

Did You Miss The Recent Rally?

Two of the great things about intelligent investing are:

• you never “miss the boat” because there’s always going to be another boat, and
• your results, though volatile, will be largely independent of the market’s returns.

Think about that for a second. If you’re lamenting the fact that you weren’t fully invested in March and you missed the rally – that you “missed your chance” – think about who is promoting that idea, and then remember back not only to March, but to the dot-com bubble, burst, and recovery.

When the markets are flying high, they say that you have to get in – you’re missing the action. When the markets are at their lows, you should “keep some powder dry” because they’re going lower. Then, a massive recovery comes and everyone says, “We told you to buy! You missed the action!”

Interestingly enough, it’s the same people that scream, “Get in! Stay in cash! We told you to get in!” They don’t put a guy like me on television because I’ not fast and actionable.

Reporter: Joe, what should investors do today?
Joe: Buy assets for less than they’re worth.
Reporter: But the markets are [up/down] 40% in the last year, and you said that a year ago!
Joe: Yep.
Reporter: Thanks for another scintillating interview.

I won’t name names, but it’s all garbage. When I talk about Rose in the book, I mention some of the crazy markets she saw – up 40% in a year, down 50% in a year. Rose never concerned herself with the markets. She never timed anything. She paid good prices for good businesses, and ended up a wealthy woman.

But It’s Different This Time!

Bull.

The “September Event” that occurred after Lehman Weekend was different that anything we’ve seen in 80 years. But that’s behind us now (it was behind us a while ago). And even still – had the world economy stopped completely, had everything collapsed, your money market, your stocks, your gold ETFs – all worthless. Even those gold bars they’re selling on television – they’d only be as good as the ammo you have to protect them.

If you’re still looking for the end of capitalism and wondering how to profit from it, get in the ammo business. Otherwise, keep looking for good businesses at cheap prices.

At this point, the economy is still ugly. Unemployment is still rising. Foreclosures. Volatility. Inflation or deflation – take your pick. Rates will go up in the future, putting added pressure on stocks. These things – all of these things – we’ve been through them before, in varying degrees.

It’s not different, it’s just scarier because the internet and the media throw it in our faces more often than they could twenty years ago. And our next crisis, whenever that may be, will seem even more dire and hopeless because we’ll have more information from more sources, adding to the fear and confusion.

Is everything we’re seeing now unprecendented? Yes. But it doesn’t change the game. It’s not “different.”

The markets work. Definitely not on a daily basis. Sometimes not even on a yearly basis. But over the long run, an asset purchased on the cheap will usually work out just fine regardless of whether or not we “retest the lows” or hit Dow 10,000 before the end of the year.

Questions from Visitors

Jason asked about the value of goodwill and intangibles. When figuring out “invested capital,” you should ignore the cost of intangibles and goodwill as you try to determine what the business can earn regardless of what management does with the excess cash. For example, Johnson and Johnson makes a lot of acquisitions; but, you shouldn’t bet your retirement on the hope that they’ll continue to make acquisitions to grow. In determining CROIC, you want to know what the business can earn from its operations as a healthcare company, or retailer, or whatever.

A prime example – and I hate to keep picking on these guys – is Lucent. Lucent doesn’t seem to have a very good business; so, they constantly try to grow through acquisitions. What happens when the financing runs out and they can’t make any acquisitions for a while? You’re stuck with Lucent’s business, and whatever returns they’ll generate on the existing capital.

ajay asked a few questions. Question 1: Do we include X, Y and Z in shareholder equity, and is it the same as net worth, book value, etc.? Shareholder Equity is all of the assets minus all of the liabilities. There is a difference between Shareholder Equity and book value in that book value is often considered the tangible book value – the net value of the tangible assets minus all of the liabilities. Book value excludes certain accounting “assets” such as goodwill or the value of trademarks. That distinction is critical when investing in break-ups, bankruptcies, and net-nets. (More on net-nets in another post.)

He also brought up Pfizer, a topic discussed recently at a book signing I did. Is it a good investment? My two cents on pharmaceutical companies is that they’re generally only as good as the drugs coming out of their pipeline. They have to invest massive amounts in research and development, and often seek growth through acquisitions. Every product they make generally has a very limited revenue stream, as opposed to a Coca-Cola. If you can predict the value of their pipeline, you can invest in a pharmaceutical company…but you have to have a thesis on the pipeline, just as you have to have a thesis on where oil is going before you buy a company that makes money on oil.

Joie asked about whether or not goodwill should be included in shareholder equity, and the answer is: it depends. If the goodwill is truly valuable, then it should be included. If not, ditch some or all of it. When I wrote about Adobe Systems, I talked about their goodwill from their purchase of Macromedia. The goodwill was the difference between the purchase price of Macromedia and the value of its actual, tangible assets. I felt that Macromedia was so integrated in Adobe’s business that the goodwill carried was much too high relative to the ongoing, resale value of Macromedia in the event of a sale; so, I reduced the goodwill somewhat.

Joie also asked about capital expenditures. Some companies break down their capital expenditures for you so you can easily deduce which ones are required and which are temporary; some don’t, and you have to use some math and logic to work it out. (See this post on Wal-Mart.) When looking through annual reports, look at the notes to the financial statements. And don’t be afraid to skip it if it’s too hard to figure out!

Ari Greenberg also asked about capital expenditures, but more specifically: Does depreciation equal maintenance capital expenditures. Answer: No. Over the course of the business’ lifetime, depreciation will equal capital expenditures because that’s how the accounting works. Depreciation allows a company to spread out an expense over a certain period of time, and that depreciation works out to the purchase price minus the sale or scrap price of that asset. There will also be costs in upgrading the equipment, maintaining it, etc. which may be significant. The fact that the accounting regulations allow the company to write off a piece of equipment over a number of years doesn’t mean that the ongoing expense of maintaining, upgrading, and repairing that equipment can be ignored – and that’s the number you want to figure out as well.

Avishek asked about moats and Morningstar. The “moat” you want is that key ingredient that virtually ensures that the business will be profitable in the future. I wouldn’t rely on anyone but my own research, because most people get it wrong which is why you have the opportunity to buy a great asset on the cheap. If you’re not comfortable reading annual reports and identifying moats, you can learn over time by continuing to look and read. Start with big companies and work down the line. And on that note: It won’t all be in the annual report. Avishek mentioned “switching costs.” You don’t necessarily learn that in the company’s filings, but in learning about the industry, how it works, and who the customers are.

Finally, Ron asked why I thought that Harley Davidson had high capital expenditures versus a Wal-Mart. Make sure you check out this post about Wal-Mart to understand the growth vs. maintenance capital expenditures. HOG, like most auto manufacturers, airlines, and heavy steel/iron operators, have to rely on massive, old, clunky machines to build their products. These machines require constant maintenance, upgrades, and repairs. This leads to large capital expenditures. Wal-Mart, on the other hand, merely needs to buy a building and set up shop. The massive jumps in capital expenditures over the past few years was largely due to growth capex (including expansion into China) and, perhaps moreso, due to their revamping and building out of their massive distribution center – a cost that isn’t likely to occur indefinitely in the future. When looking at two similar businesses at similar prices, you’ll likely be better off with the company that doesn’t have to spend huge amounts just to keep the doors open.

That leads me to the second part of his question: What is a good inventory turn rate to profit margin? It depends on what you consider a good profit margin. A business with one inventory turn a year and a 20% profit margin is no better or worse (at least from a profit margin standpoint) than a company with two turns and a 10% margin, or four turns and a five percent margin. Don’t rule out a company solely because of profit margins. Wal-Mart’s margin is about 3.5%, but it is wildly profitable because it turns its inventory seven or eight times a year, for a “true” profit margin of 26% or so.

Think of it this way: If you buy a rock for $100 and sell it for $102, you’ve made one inventory turn and a 2% profit margin. If you’re doing that once a year, close up shop because your shareholders are better served if you stop buying rocks and invest solely in U.S. Treasuries. But, if you’re buying and selling these rocks twice a month – twenty four times a year – you’re laying out $100 to earn $48 a year. Though your profit margin would still be 2%, your “true” margin would be 48%. That’s one heck of a business.

And of course, don’t take it all at face value. Two companies with “true” profit margins of 40% won’t necessarily grow rapidly. The one that has to lay out more in capital expenditures is going to grow more slowly (all else being equal).

Keep On Trucking

There are values out there. I recently purchased a stock around $7.80, even though it was up some 92% from its March low. Think we’ve “come too far too fast”? I don’t know. What if we fell too far to fast?

There is no way to know what the markets will do next week or next month. The nice thing is: So long as you keep investing intelligently, you’ll never have to worry about it.

Since our launch, we saw the S&P 500 climb to an all-time high in October of 2007, only to watch it plummet nearly 58% to a level first seen in May of 1996. Some of the causes of the drop were highly predictable. Some of the events, such as the September 2008 disaster, were completely unpredictable. And through it all, we were largely, if not entirely, invested in individual stocks.

Let’s see how we did.

Portfolio Performance

If you recall, I started the F Wall Street portfolio with $100,000, and compare it to the Diamond Trust Series (DIA) – an ETF that tracks the Dow – and the Vanguard S&P 500 index fund (VFINX). I compare to these two funds because investors can’t invest directly in an index; so, these are two of the broad “index-type” investments.

In the roughly two years since F Wall Street was launched, $100,000 in the F Wall Street portfolio grew to $103,224 (+3.2%) while $100,000 invested in the DIA and VFINX fell to $68,246 (-31.8%) and $63,225 (-36.8%), respectively. On an annualized basis, we have outperformed the better of the two investments (the DIA) by 19.6% per year.

What’s In Our Portfolio?

The portfolio snapshot below is as of yesterday’s close. This morning, I sold DBB because it didn’t work out as planned. I will discuss it in a later post.

Thoughts on Our Portfolio and Performance

Had I been able to spend more time and energy on the blog, I am certain that our results would have been much better. As the markets plummeted, I found myself with less and less time to post, as is indicated by my lack of activity here over the past year. I first mentioned this problem in March of 2008 in this post:

When the markets were flying high, I had all the time in the world to write posts for an hour or two a day. Trying to maintain that pace in this market would be detrimental to our future returns.

It is important to remember that I am not a professional blogger, living off advertising revenue and blogging for dollars. Nor am I a professional author, living off book royalties. (Trust me – there’s no money in writing books unless you’re Steven King.)

Some opportunities that were missed in the F Wall Street portfolio:

• Graham Corporation, which was discussed ex post facto and never included in our results.
• The InBev acquisition of Anheuser-Busch workout which, at one point, offered a substantial premium.
• As I mentioned in this interview on First Business and back in November to my friend Barry Pasikov, Managing Partner at Hazelton Capital Partners, Sears Holding Company was an amazing opportunity in November, when it was trading at just $30 and less.
• And, of course, Wells Fargo which, in February, fell to just $7.80 a share. In response to Dan’s question whether or not WFC was a screaming buy, I responded: “Screaming,” but didn’t have the time to post more about it.

These investments would have had a significant impact on our results. The total impact of these investments, as of June 1, 2009, would have added another 33% or so to our returns, broken down as follows:

• about 2.5% from Graham, in which a 5% investment would have doubled,
• about 0.5% from the InBev workout, in which a 10% investment would have grown about 5%,
• 10% from Sears Holding Company, in which a 10% investment would have doubled, and
• 20% from Wells Fargo, in which an additional 10% investment would have tripled.

And that’s net of some of my more boneheaded moves, like overpaying for American Eagle or getting my butt kicked in the Landry’s workout-gone-bad.

The point here is not that I’m backward looking or playing with the numbers, but that the market presented investors with some amazing opportunities over the past year, if, of course, you were looking at the business and not the media or stock markets.

On a relative basis, I’m bubbling over with joy at how we continue to outperform the markets and at the amount of safety our portfolio enjoys. On an absolute basis, I am upset that I didn’t have more time to discuss some of these amazing opportunities in greater detail and include them in the F Wall Street portfolio.

Still, we own some wonderful businesses at great prices. While my primary responsibility is to manage money for our clients, I will continue to run the F Wall Street portfolio on this part-time basis because, as I discuss in the book, casual investors can invest conservatively, confidently, and at satisfactory rates of return without taking a lot of risks. This portfolio will continue to be run “casually,” unlike the portfolios we manage at Ponzio Capital.

Thoughts on Diversification and Buy-and-Hold

Clearly, and once again proven over time, broad diversification just doesn’t cut it. Having extremely small positions (1% of the portfolio, or broadly diversified mutual funds) doesn’t allow your best ideas to have a meaningful impact on your returns. And though the losses have a greater impact (and we’ve had a few), a 5% loss in the portfolio due to a 50% loss on a 10% position is not impossible to overcome, so long as you can remove emotion and media hype from the equation and focus on making smart business decisions.

The number of positions an investor should hold is inversely correlated to the predictability and discount one receives in any investment. You could put your entire net worth into a single U.S. Government bond, and never diversify outside of that one bond because you have absolute certainty and predictability. Conversely, if you’re going to invest in a highly speculative, debt-laden, poorly run company, you wouldn’t want to risk too much of your savings.

That, of course, is one of the problems with mutual funds, and particularly index funds. Both the DIA and VFINX held General Motors as it fell from $90 to bankrupt and worthless over the past ten years. From a value standpoint, it was as worthless at $90 as it is today; however, if you have to own a GM (like when you invest in index funds), you certainly want it to be a very small portion of your portfolio.

This, of course, leads us to the constantly-asked-and-wrongly-answered question: Is buy-and-hold investing dead? The short answer is an emphatic “no.”

Whether stocks are rising, falling, or hanging flat, Wall Street wants you to believe that “it’s a trader’s market.” When the markets are rising, it’s a trader’s market because easy profits are aplenty. When the markets are falling, it’s a trader’s market because you need to be nimble and liquid. When the markets are flat, it’s a trader’s market because “buy and hold ain’t working” and you have to do something to make money.

The truth is that it’s always a trader’s market on Wall Street because Wall Street gets paid when you’re buying and selling. The broker handling the F Wall Street portfolio couldn’t buy an iPhone with the money he would have made from us.

Buy-and-hold is a poor strategy if you’re buying anything at any price, and holding it no matter what. If, however, you are buying great businesses at great prices, the overwhelming majority of active traders won’t be able to match your results over the long-term.

I had written the following to clients a few weeks back about this exact topic. Though it’s not an exact comparison, I think you’ll get the gist of it:

Warren Buffett has built his fortune on buy-and-hold investing. His company, Berkshire Hathaway, is not only larger than every brokerage firm in the United States (many of which are much older than Berkshire Hathaway), but it is larger than Goldman Sachs, Morgan Stanley, State Street, Citigroup, Charles Schwab, and E*TRADE combined. (Based on market capitalization at the close of business on May 7, 2009.)

A Final Thought, On Volatility

It’s easy to look at our results and think that the ride was smooth. All you see in the above chart is three points in time, and a straight line joining each of them. The truth is that the results were volatile, and we suffered wide swings in the prices of each of our investments.

There is no way to control the daily swings of the markets or any individual position. Then again, there is no need to worry about it if:

1. You hold great investments at great prices, and
2. You have no intention of selling that day.

When the markets pounded Wells Fargo down to $7.80 per share, we were down 67% from our initial purchase at $23.41. We invested again at $16.63, but that only gave us an even larger loss on a dollar-basis, and we were still down 63% in a matter of days.

It’s easy to sweat over the market action if you need to sell, or if you don’t fully understand your reason for buying. Even my own brother, whom will remain nameless but trusts me implicitly (I have four, so don’t try to guess), commented on the unrealized loss and was tempted to swear off stocks completely until we had more clarity in the markets.

The truth is that stock prices, on a daily, monthly, and even quarterly basis, are quite silly. Buffett and Munger commented on this at the annual meeting, I discuss it in detail here on the site and in the book, but I’ll reiterate it: A major key to the success of one’s investment program is having the right emotional make-up to handle the market’s ridiculousness.

As I stated in this post, most people don’t have the emotional constitution for investing in stocks. With the markets down nearly 40% from their October 2007 highs, people that were plowing money into stocks two years ago are now sitting on cash and looking for bonds. It’s not just individual investors – many pensions, mutual funds, and other institutions operate with this backwards mentality that investing should be done when prices are high and may go higher, instead of when prices are low, even if they go lower.

Over the long-term, the markets work very well; but, your investment results will depend on how much time you can put into your investing and how well you suppress your emotions while focusing on making smart business decisions.

The results of the F Wall Street portfolio will not do as well as I’d like going forward (that is, very high, non-conventionalist returns) due to my lack of time for blogging; so, I’ll focus on trying to make smart business decisions when I can post here.

(Of course, we’ll keep on trucking at the firm!)

If, after reading this post, you think I’m fixating on the short-term, feel free to send me an e-mail to spark up a discussion.

On Selling Stocks To Raise Cash…

Let me pose somewhat of a rhetorical question, though you can answer it in the comments if you’d like: When buying a stock, what is the difference between taking the money out of cash, or selling a seemingly mediocre opportunity to raise the cash?

Why not invest your assets in the companies you really like? As Mae West said, “Too much of a good thing can be wonderful.”

Save Landry’s and AEO, I sold out of positions that I didn’t necessarily “really like.” I sold Adobe and Apple. Why? Let me bring up a quote from the August 9, 2008 Investment Performance post:

Adobe is fairly priced but I think it is a solid company. If I run out of cash and need to sell something, I’m happy to sell Adobe. If I don’t need cash, I think my money is better parked in Adobe at $34 and change than in a money market for a few years.

In this case, as the markets began to melt down, I felt that I’d have a chance to find companies I “really like” and wanted to have cash on hand to pull the trigger. What is the problem with dumping mediocre positions at mediocre prices? Why do I think they were mediocre opportunities? In my sphere of confidence and competence, if I had felt more strongly about these positions, I would have gladly invested 20% of the portfolio in them.

As an example: Though they are both down considerably from their highs, I never considered selling Johnson & Johnson or Wal-Mart, again keeping this quote from the same post in mind:

If you find four to six Johnson & Johnsons and Wal-Marts trading at discounts, you need not worry about owning anything else. You can put 20% or 25% of your portfolio into wonderful, rock solid businesses selling at discounts and walk away from your portfolio for years.

Selling Out of Landry’s

Landry’s was a workout that went bad. Plain and simple – no need to hang around.

Reassessing American Eagle Outfitters

While I don’t believe that valuations change rapidly based on price movements or that we should consider the current markets in investing, I do feel like I overpaid for American Eagle. Assuming I’m spot on with my valuation (which we never are, which is why we must demand a margin of safety), what could I expect from my American Eagle investment?

Buying at $26 when the value is just $18 or so, the only thing I can hope for is that the value eventually creeps back above my price point, and that I eventually break even on my investment. But note the key word: Hope.

Optimism and pessimism have no place in investing. From a realist standpoint, I’m not willing to wait for American Eagle to grow to that $26 level, nor am I willing to hope that “some fool” is willing to pay $26 for an $18 business like I did.

Which is the better allocation of capital: Hope that time will correct your mistakes, or admit your mistakes and move on to better opportunities? Remember: You don’t have to make it back the way you lost it.

Perhaps there are other solutions that make more sense than mine; however, wishful thinking – and its usual companion, thumb sucking – is not among them.

I don’t know if Buffett was talking about admitting mistakes and taking losses in that quote, but it is quite appropriate when you overpay for a business and then rely on time and hope to correct your errors. I’m not willing to suck my thumb, hoping that I didn’t make a mistake when other opportunities are so clear.

Now, you can make the case that AEO was not a wonderful business, and I’d agree – that’s why I didn’t invest 20% in it. I still think it’s a good opportunity…but at the right price. $26 is not the right price, and if it falls to $7 or $9, I’d consider buying again. Still, at $7 or $9, I’d have to first ask if there are any companies I “really like” out there at attractive prices. If not, AEO is an option.

How The Economy Affects The Valuation

The economy affects the valuation to the extent that AEO’s cash flow will likely pull back to a lower level, which would then be the starting point for a new valuation. We can’t use last year’s cash flow as a starting point for projecting future cash flows because future cash flows will likely have a lower starting point when the dust settles.

Lower cash flow means lower valuations. In this case, we have a lower starting point than we projected, and future cash flows will all likely be lower than projected as the business recovers from taking a step back.

It’s paramount to remember that these things are actual businesses. The fact that AEO generated $x of cash flow last year doesn’t mean it will necessarily do so in the future. Management will have an uphill battle to get people in the stores spending money, and they won’t rush back to do so. This is business, no matter how rosy the spreadsheet says the past was…and business is tough.

Maybe I’m wrong again on AEO. Maybe it really is a $25 or $30 or $70 per share business. And maybe you can find confidence in buying it today at $11 or holding it from $26. That’s what makes investing so great – the fact that we all see value (or a lack of value) in different ways.

This is my thesis, and the reason that Joe Ponzio sold American Eagle Outfitters. If you personally see more value or disagree, load up the truck. Don’t let me sway you one way or the other…you’ll never sway me just the same ☺.

The F Wall Street Portfolio

Excluding LNY which was a workout that went bad, I sold $18,000 or so worth of stocks, and turned around to purchase $25,000 worth of two companies – $20,000 of MMM and $5,000 of NTRI.

It’s a tough market for all long-term investors; and, because we’re looking to beat the markets by five or ten points a year over the long-term, that means we hope to lose less when the markets are falling, make money when they are flat, and hope to keep up or out-perform when they are on the rise over the long-term.

Since June 25, 2007 – the day the site started – the F Wall Street portfolio is up 2.9% versus a 30.2% loss in the Dow and a 35.3% loss in the S&P 500. The relative out-performance is still quite stunning. (There’s something to this “buy good businesses at attractive prices” hullabaloo.) A $100,000 investment in F Wall Street’s portfolio would be worth $102,898 as of 10/31/2008, versus $69,840 in the Dow and $64,681 in the S&P 500. (I didn’t have time to run it against the DIA or VFINX like I did in this review.)

We’re still sitting on about 28% in cash, waiting for another fat pitch from the markets.

For you visual folks:

Of course, the portfolio has only been running for about 16 months – way too short a time to judge performance. Still, I’m quite pleased with the results.

Keeping the long-term in mind…no matter what happens in the markets, we’re not going to look at the performance again until June of 2009.

I hope that clarifies things and satisfies curiosities. Happy Halloween!

That said, let me paraphrase many investors I talked to last week: Is the world coming to an end?

No, Chicken Little. It will still be here tomorrow. And you have to invest the same way for one simple reason: If everything does go to hell in a hand basket and the US (or your home) economy – and every business in it – fails, your money is worthless anyways. That’s true whether you hold stocks, bonds, cash, real estate. Even gold.

Just ask the fine folks in Zimbabwe. Eleven million percent inflation and growing. Yep – $100 million Zimbabwean dollars invested in gold last year would be worth less than $1,000 today – and that includes gold’s 50% rise in price.

Don’t get me wrong – we face some very tough times ahead. Let me take a quote out of a post I wrote when I was talking about the recession and the US Dollar back in March:

The credit mess needs to work itself out. (Later this week, I’ll talk about how stupid and irresponsible that Bear Stearns, Merrill Lynch, and crew have been for the last ten years.) Regular Joe American who can’t pay his mortgage today ain’t gonna be able to pay his mortgage at the end of higher-price, higher-inflation 2008.

I won’t try to predict the direction of the markets over the next six months. I’ll simply say this:

• Expect high inflation for a while;
• Expect to see some severe market swings – up and down;
• Expect to see trouble in the overseas markets if we do tighten up our trade policies;
• Expect to see trouble in US markets if we don’t;
• Expect to see the US Dollar strengthen if we do tighten up our policies;
• Expect a weaker dollar if we don’t;

Are our problems “fixable”? Yes. Still, it won’t happen in a quarter or two. We went through a trade problem like this in the mid-1980s and it took three or four years of fixing before we entered the boom of the 1990s. By that logic, our next boom would start around 2011 or 2012 – and that’s only if we can solve these more severe problems in the same timeframe.

Looking Down The Road

Five years from now, things will be better. They have to be, because planning for the alternative (total collapse of everything) will virtually guarantee your financial demise.

Think about this: Two weeks ago, Lehman Brothers, Merrill Lynch, and AIG stood tall. Today, they are all but gone. Do you think Johnson & Johnson or Wal-Mart changed their strategy or outlook over the past two weeks? Do you think that people will stop buying healthcare products…from Wal-Mart (the deep discount store)…because Lehman is gone?

At the Pabrai Funds annual meeting (I’ll post about that later this week), Mohnish said:

If you depend on borrowed money, you have to worry about what world thinks of you everyday.

You need to avoid toxic businesses. I can’t value financial companies, and that has helped us avoid this entire mess in financials. Then again, the “mess” reaches far beyond financials. Companies with toxic levels of debt are in for a real treat.

Spreading Beyond the Financials

Long-time readers know that I’ve discussed Amylin Pharmaceuticals a number of times on this site. I got some anonymous hate-mail on those (presumably from some of the management I ballbusted for taking home $21 million plus in compensation while the company’s value continued to decline last year).

Over the past six years, Amylin has increased its long-term debt by about 55% each year, and the shares outstanding have nearly doubled…without a split. In the first six months of this year, Amylin’s interest expense has nearly quadrupled on a 14% increase in revenues.

Amylin has a tough road ahead of it. It owes money to banks…banks that need to charge as much interest as possible to shore up their weak and withering balance sheets. And now, Amylin is between a rock and a hard place. Amylin has to worry about what the world thinks of it.

It can’t sell stock to raise capital. Additional debt is going to cost more than it had in the past. And Amylin can’t generate enough cash to finance its own operations. Today’s buyers of Amylin are hoping for one of two things:

• a miracle drug rushes out of the pipeline, increasing revenues so dramatically that the business can begin generating cash; or,
• a miracle cure to the credit crisis, so Amylin can continue to finance its operations and get their drugs to market.

Otherwise, Amylin will get nickel-and-dimed to financial death, as will many other companies that have to worry about what the world thinks of them.

Maybe there is something to this “buy great businesses” malarkey.

To My Friend Chicken Little

The world isn’t going to end. Sure, we have a long, tough road ahead of us. But, we’ll get through, and great businesses will survive and thrive. Five years from now, we’ll look back and say, “Man – that was crazy. I’m glad that’s over.” Twenty years from now (if not sooner), Wall Street will throw us into another mess, and Chicken Little will poke his head out again.

And if some businesses have to go away, so be it. Just because the stock market falls or stays flat doesn’t mean your investments have to. Invest in businesses that don’t have to worry about what the world thinks about them. As their competitors falter due to massive debt loads, huge interest expenses, and an inability to obtain financing, your businesses will grow more valuable.

Then, you simply have to wait a while. Price follows value, but it doesn’t necessarily happen overnight.

Changes to F Wall Street

Regular visitors will likely notice the redesign here on F Wall Street. I had to make some changes to make it more “user friendly” and get some of those old posts back out here. There is a lot of information on the site, and it gets buried deeper and deeper each time I write an article.

So, here’s what’s new:

• Amazon Banner Ad: Gone. It was slowing down the site and annoying me. We’re back to the old F Wall Street – articles and comments.
• Related Posts: Now appear at the end of each post. This randomly draws four articles in the same category so you can find relevant articles to read when you’ve finished the current article.
• Social Bookmarking: You can now add posts to Digg, Delicious, or Stumble. Admittedly, I have no idea what these are; but, the designer suggested this.
• Add Your Website: If you run a website or blog, you can now add your website to the comments section and it will appear as a link under your name in the comments.
• Latest Comments: They have returned and can be found on the left of the page (under “Categories”) as well as on the home page. You can still subscribe to the comments RSS feed; but, you don’t have to.

Those are the major changes. I hope you enjoy and thanks for visiting (and coming back) to F Wall Street!

In this “rough and turbulent” market, let’s take a look at the first year’s success and overall performance.

How Mr. Market Has Fared

I find it somewhat silly to compare performance to the indices for one simple reason – it is impossible for most investors to hold a portfolio equal to the indices. So, we’ll compare our performance to the Diamond Trust Series (DIA) – an exchange traded fund that closely tracks the Dow Jones Industrial Average – and the Vanguard 500 Index Fund (VFINX) – a mutual fund built to track the S&P 500. The Diamond carries fees of roughly 0.18%; VFINX has an expense ratio of roughly 0.15%.

From June 25, 2007 through August 8, 2007, DIA fell roughly 10.3% when factoring in the effect of reinvested dividends. Because we are looking at a period of just over 13 months, let’s convert to an average annual return – the average annual return for the DIA was (9.2%). A VFINX investor fared a bit worse – down 11.6% over the thirteen months, or (10.4%) on an average annual basis.

The F Wall Street Outperformance

Just following the blog closely, the F Wall Street non-conventional investor did much better. The total return for the thirteen months was 14.6%, with an average annual return of 12.9%. The relative outperformance was stunning. The DIA was the better of the two passive index investments, and F Wall Street outperformed it by 24.9% on a cumulative basis, and 22.1% on an annualized basis.

A $100,000 investment in the Diamond on June 25, 2007 was worth $87,765.63 on August 8, 2008. Throwing $100,000 into a brokerage account on June 25, 2007, patiently practicing your assiduity, and buying the no-brainers discussed on F Wall Street would leave you pleasantly surprised to find $114,629.08 in your account on August 8, 2008.

Admittedly, judging performance based on thirteen months is silly. You can’t look at ten years of business history, project the future of the company for twenty years, and then focus on daily or annual performance. Still, if visitors are on the fence about practicing assiduity, waiting for a fat pitch, and ignoring the markets, this first year might help push you off the fence and into the annual reports.

The Chart of Performance

For you visual folks out there:

F Wall Street Stock Holdings

The F Wall Street portfolio would currently contain just five investments:

• Johnson & Johnson (JNJ) purchased at $62.33 on June 27, 2007;
• American Eagle Outfitters (AEO) discussed on July 12, 2007, but purchased on July 25, 2007 when the price fell back to the $26.31 target;
• Wal-Mart (WMT) purchased at $43.43 on August 16, 2007;
• Adobe Systems (ADBE) purchased at $34.93* on February 1, 2008;
• Nutrisystem (NTRI) discussed a number of times, but ultimately purchased on July 9, 2008 at 13.79*.

* Because no price target was discussed, I used the average of the open, high, low, and close for the day.

You’ll note that I did not include any other positions discussed (eg. Graham Corporation (GHM), Pfizer (PFE)) because I never really analyzed them thoroughly on the blog or talked about them after the fact.

F Wall Street Workouts

In addition to the five long-term purchases, we engaged in two workouts – both of which were highly successful:

• Tribune Company, purchased on December 4, 2007 and sold on December 20, 2007;
• Radiation Therapy Services purchased on January 21, 2008 and sold on February 11, 2008.

I did not include the Clear Channel Communication workout that I bought and sold the week of March 25, 2008 because I never really discussed it here, I didn’t assume a double-dip on Tribune when the price tanked for a brief hour the day of the deal for no reason (but I think I mentioned it somewhere on here after the fact), and I didn’t assume an “average down” in RTSX – purchasing more when the price kept tanking to the mid-$20s prior to the deal’s close.

In short – I didn’t pretend that every transaction was perfect and at the perfect price. Instead, I tried to use plain vanilla purchases and sales based on the dates I discussed them (or the day following the evening I discussed them) and I assumed $9.99 trades on the stock purchases and sales. I assumed we purchased every stock that was attractive, cheap, and timely. For example, I didn’t assume a late March purchase of Nutrisystem because I talked about it later. I did assume we bought it that day after I posted this comment one evening.

Sitting on Cash

As of August 8, 2008, the portfolio would have about 40.2% in cash.

Portfolio Construction

Building a portfolio is all about confidence and risk. If you find four to six Johnson & Johnsons and Wal-Marts trading at discounts, you need not worry about owning anything else. You can put 20% or 25% of your portfolio into wonderful, rock solid businesses selling at discounts and walk away from your portfolio for years.

In the F Wall Street portfolio, I put 20% into Wal-Mart and 20% into Johnson & Johnson.

The mid-caps and the “it’s a cheap mid-cap but I wouldn’t hold it forever” stocks may have a place in your portfolio, but each position shouldn’t be more than 5% to 15% of the overall portfolio. Adobe and American Eagle Outfitters both fell into that range; so, I put 10% of the portfolio into each.

The small-caps and the “it’s a cheap small-cap but I wouldn’t hold it forever” businesses are riskier in that a large competitor can crush them; so, each one should be less than 8% to 10% of your portfolio. Nutrisystem falls into that category and I assumed an investment of 5% into the company.

As many of you know, I don’t mind using leverage on workouts if I’m fully invested. In the case of the F Wall Street portfolio, there was a ton of cash; so, no leverage was needed. Each workout was 20% of the total portfolio, even though I’ve talked about using as much as 30% as well as leverage.

Investment Performance vs. Portfolio Performance

Throughout the year, the portfolio sat (and continues to sit) on a considerable amount of cash as we look for new ideas. That cash is a drag on performance. Though the portfolio grew 14.6%, that return includes the effect of cash. The investments, excluding the effect of cash, grew 24.4 % – an average annual return of 23.5% – which includes some stellar performance, some mediocre performance, and American Eagle’s 50% haircut.

The investments on F Wall Street outperformed an investment in the Diamond Trust Series by 34.7% over thirteen months.

The Portfolio Plan

The logical question is: Now what? What is plan for these holdings? Should we take our profits and/or beatings and run? The market may get worse. Should we cash out and wait to rebuy on the dips?

I look over the portfolio and I don’t see anything worth selling yet. American Eagle Outfitters has seen its business take a turn for the worse; so, I’d institute Phil Fisher’s three year rule. Management has two and a half years left to get the business growing again or I’m gone.

Nutrisystem was grossly overpriced last year at $70 and change. When it hit $13 and change, I felt like the slowed growth (and some shrinkage) was factored in and it was still cheap. Assuming things play out as I expect, I see no reason to sell considering my ultra-cheap buy price. Of course, I’ll monitor the business going forward, but not daily.

Adobe is fairly priced but I think it is a solid company. If I run out of cash and need to sell something, I’m happy to sell Adobe. If I don’t need cash, I think my money is better parked in Adobe at $34 and change than in a money market for a few years.

Johnson & Johnson and Wal-Mart are permanent holdings so long as their businesses remain solid.

I don’t have to make any real decisions today. Sitting 40% in cash, I have to look for new opportunities – not fret over taking profits or losses on long-term businesses I just purchased in the past thirteen months.

The Portfolio’s Expenses and Risk Measures

To date, we’ve effected nine transactions – five long-term purchases and two workouts (for two transactions each). The total paid in commissions was $89.91, assuming $9.99 trades. Thus, the total expense ratio of the F Wall Street portfolio was 0.08% – half that of the funds mentioned earlier, two of the lowest cost funds in the universe.

How “risky” was the F Wall Street portfolio? Let’s think of it this way – the two funds had to be fully invested the entire time, and they had to hold stock in all of the companies of the DJIA or S&P 500 respectively, regardless of how great, mediocre, or bad those companies (i) were or (ii) were expected to become. The F Wall Street portfolio was 81% invested at its highest, but largely held and holds a ton of cash as we looked around for great opportunities.

The two pillars of the portfolio – JNJ and WMT – are massive, international companies with little business risk. Though many will argue that having 20% of a portfolio in a single company is crazy, those same people would love to own JNJ or WMT outright, even if it was their only investment. Add to that the fact that these businesses were purchased when they were on sale based on our estimations of intrinsic value and our risk plummets well below that of other investors (speculators) that blindly invest 20% of their portfolio into a single company with absolute disregard to value or fundamentals.

I’ve said it before – beta measures are nonsense and I don’t even look at or consider them. Still, for you numbers-oriented investors out there: The beta of the F Wall Street portfolio was 1.3 and the R-squared was 0.57 (or 57, depending on how you like your numbers). So, the portfolio moves faster than the market – a good thing. And, it moves largely independent of the market – another good thing.

Putting It All Together

One year performance means nothing. To date, however, F Wall Street has largely been a series of posts with no coherent portfolio to track. Even I was getting confused as to what we’ve discussed. In the past thirteen months, we’ve had a lot of successes, we’ve taken a short-term beating (AEO), we’ve engaged in some successful workouts, we’ve missed some short-term beatings (BX, ALU, AMLN, to name a few), and we’ve missed some high fliers (RIMM). And we’ve done it all without any regrets – comfortably, confidently, and at high rates of return.

All in all, I think we’ve had some very intelligent discussions and I think our performance, albeit short-term, is quite satisfactory, particularly in relation to the overall markets.

Happy belated birthday F Wall Street. Thank you to the more than three million visitors around the world that make this website enjoyable and educational. Let’s have many more years just like the past one.

When it comes to business and investing, it doesn’t pay to be an optimist or a pessimist; the big money is made by realists. If you can take all of the emotion – yours and that of others – out of your investing, you can begin to more clearly predict the future with a degree of confidence and competence. Forget tomorrow. There is no tomorrow.

Here’s your crystal ball question.

What Will Happen Five Years From Now?

If you can answer that question with a fair degree of certainty, you will make very satisfactory returns over your lifetime. It is a question that great value investors like Buffett are able to answer with confidence, which is precisely why they can earn high returns and ignore short-term volatility, all while sleeping peacefully at night.

If you know what is going to happen five years from now, you needn’t care less what will happen tomorrow.

The Price of Gas, Gold, and More…Five Years From Now

The truth is that I have no idea where gold, gas prices, or interest rates will be in five years. Because of that, I have absolutely no business investing in gold, buying or shorting oil, or betting on or hedging against interest rates. On one side of the argument are oil bulls screaming that US gas prices are headed to $10 a gallon; on the other side, oil bears are calling a top. They both use statistics and compelling arguments to make their points.

I don’t understand it; so, I have to stay away. I trust Homer Simpson on this one:

Oh, people can come up with statistics to prove anything, Kent. 14% of people know that.

Your Business in Five Years

When you look at a company – any company – you need to first ask yourself, “Where will this company be in five years, regardless of where it has been or where it is now?” Whether or not your business is growing is inconsequential (though admittedly, I prefer growing businesses). It’s pretty easy to say that Coca-Cola will be here in five years. Then again, everyone knows that, which is why you will rarely find opportunities for growth in Coca-Cola’s stock.

Where you do make money is when you buy companies that Wall Street is unsure on for whatever reason. Peter Lynch does a great job explaining why Wall Street doesn’t look at these companies in his book One Up On Wall Street; so, I won’t rehash what he already said. Instead, let’s look at the Wall Street mentality versus that of the intelligent individual investor.

The Small Company

Many investors, and particularly Wall Street and mutual funds, find comfort in “big” companies – companies with a market capitalization over, say, $1 billion or $5 billion (or even $10 billion). And for a seemingly good reason – stock prices of small companies are often much more volatile. Then again, if you know that price is a tool, not a guide, and that price follows value over the long term, why would you ever equate volatility with risk? Is a business “riskier” because speculators are trying to profit on price movements?

In the early 1970s, Wal-Mart was a small company with a small, or even nonexistent, moat. By 1974, it had just 78 stores open, a number that would grow to 276 five years later. A great growth story? Yes. But most people never looked at the stock, which is why early investors that rode the volatile, value investing wave made immense profits.

How small and “scary” was Wal-Mart? It wasn’t until early 1981 that Wal-Mart became a billion dollar company on Wall Street. The graph below shows the daily market capitalization for Wal-Mart from August 1972 to August 1974 – a $60 million to $260 million company. Was it a crazy ride? You bet. Buying Wal-Mart on August 25, 1972 would have seemed like a disaster six months later when your investment was down 30%. By July of 1973, you would have been down more than 50%. Ouch.

The 77% Loss

It’s now December of 1974. You’re down 77% on your Wal-Mart investment, insisting that the company is much more valuable than the current price. Wal-Mart trades as low as $56.9 million of market capitalization. It’s small…real small. Still, you content that Wal-Mart will be more valuable in five years than it is today. It’s a tough pill to swallow; still, that’s the markets for you.

Five Years Later…

August 25, 1977. You’re sweating bullets. You still contend that Wal-Mart will be more valuable in five years than it is today, but you’re finally “even” on your investment. You remember the pain of being down 77% – of almost losing everything. Can you go through it again if the markets don’t reward you soon? Your portfolio is right back where it started; you’ve lost five years.

The company is definitely growing. When the hell will the stock price follow?

Another Five Years Pass…

August 25, 1982. Wow. What was a tiny, growing company just a few years earlier is becoming one of the greatest American growth stories of all time. Wal-Mart is trading at $2 billion, and you have hit pay dirt. A 23% average annual return – your $10,000 investment is now worth $77,500. Had you continued to add to your position in the mid-1970s, when this valuable business was trading for $60 million, you would have had even more astronomical returns.

Still, you think Wal-Mart is even more valuable; so, you hold.

Another Five Years Pass…

Wal-Mart is trading at $20 billion, and your $10,000 investment is now worth $830,000 – the result of earning 34% for fifteen years. Not too shabby.

I’ll Spare You The Rest

We all know the Wal-Mart growth story. Now a $220 billion business, Wal-Mart was once a $60 million company – trading well below the radar of anyone on Wall Street. It had a small, hidden moat in its pricing, but Wall Street was convinced it would easily be crushed by its larger competitors. From its August 25, 1972 open – trading at just $250 million – a $10,000 investment would have growth to $8.7 million, excluding any dividends you would have earned (and assuming you didn’t sell when it became fairly priced in the early part of this decade).

It All Comes Down To The First Question

Where will this company be in five years? It’s very easy to look back in time and say, “Sure. I would have held on and enjoyed my 21% average annual return.” Easier said than done. Can you stare at a 50% or 77% loss in the face and comfortably and confidently say, “I’m right”? Knowing that price is a tool, not a guide, can you answer the question and then wait five or ten years to be proven right?

Peter Lynch talked about “ten baggers” – stocks that would increase tenfold, the holy grail of investing. Don’t expect to find ten baggers in $20 billion stocks. Sure Wal-Mart grew from a $22 billion to $220 billion market cap, but it took eighteen years to do so, providing investors with a 13% average annual return during that time (excluding dividends). In the eighteen years prior to that, from August 1972 to March of 1990, Wal-Mart grew from $255 million to $22 billion – an eighty eight bagger – returning 29% a year to investors, excluding dividends.

Had you continued to increase your position during the “bad” years (that is, when Wall Street was offering an even better price), your returns would have been as high as 48% a year for nearly two decades. (From 12/1974 to 3/1990, Wal-Mart was a “398 bagger”)

Don’t Fear The Small Companies. Embrace Them.

Buffett once said he could “guarantee” 50% annual returns if he were working with smaller sums of money – say, $1 million. How would he do it? He told Shai Dardashti in a letter that he’d invest in small companies at extremely deep discounts.

If you can say with confidence where your business will be in five years, who cares if it’s selling for $60 billion or $60 million? So long as you purchase at a discount and its “business as usual”, you can make money in the long-term. Just remember: Until the company hits Wall Street’s radar and gets picked up by analysts and institutions, you’re likely headed for a bumpy ride in very small companies. So long as you predict the future with a degree of accuracy and confidence, you’ll make some very satisfactory returns.

Focus on the five-year picture. Only then can you truly ignore the volatility.

For more on why Wall Street had to ignore Wal-Mart in the 1970s, take a look at Peter Lynch’s One Up On Wall Street.

Through our investing, we can combat the recession, achieve growth, and keep our heads above water (or fly high). To help us in that endeavor, we must understand the effects of the recession so that we pick the opportunities out of the blood on the streets.

A recession (or worse, a depression) are periods during which the Gross Domestic Product (GDP) of a nation declines for a sustained period (at least two quarters). The formula to calculate GDP is fairly simple:

Let’s take a rational approach to each to see if things will get worse or if we’ve hit the bottom.

Consumer Spending

We know that consumer spending has slowed. We know that it is highly likely to continue slowing, especially as inflation rises and prices get out of control. On CNBC the other night, one interviewee said something to this effect: The consumer may not understand the rate cut entirely, but he sees it as a sign that things are getting better and he’s going to feel better about spending.

Bull.

The reality is that the consumer doesn’t even know the rates were cut. The small minority of us that watch the markets and control our own investing (and have a passion for it) know exactly where the fed rate is and that there have been numerous cuts. Regular Joe American doesn’t give a damn. He’s spending more than he’s saving; his credit card interest rates have not budged (or have risen); prices both at and away from the pump are on the rise; he’s earning spit on his savings account.

Do you think Regular Joe American cares about the rate cut?

The psychological effect of a rate cut (outside of Wall Street) is nothing compared to the psychological effect of the news. Foreclosures. Rising gas prices. Inflation.

My paycheck isn’t cutting it anymore. I really have to tighten my belt. The Fed cut rates again? Great! So why am I paying $4 at the pump? Why can’t I refinance right now? I’m barely keeping my head above water.

From a rational perspective, consumer spending is likely to slow some more. Keep in mind: The doom and gloom in the economy has only been in the news for a few months. As that continues to settle in, consumer spending will likely slow more.

(Not sure? Ask any “regular” person that is not in tune with Wall Street.)

Trade Surplus (Deficit)

When we export more than we import, we add to our GDP. When we import more than we export, we run at a negative. It’s much like personal spending – spend more than you make, and you go into debt. Do it for too long, and you’ll eventually have to downsize. Personally that’s called “bankruptcy”; in the economy, that’s known as a recession.

It’s painfully simple.

Gross Capital Investment

We’re not talking about Regular Joe socking $50 a month into his IRA. Gross Capital Investment is investment in goods that are not consumed, but used for future production. As business investors, we generally understand this as “Capital Expenditures” – investments in plants, property, and equipment that can be used for future production.

The more we import and the less we export, the more we can expect Investment to fall. If consumer spending keeps slowing, there won’t be a need for as much production. (Yes, it’s a slippery slope.) If our exports are strong, Investment can hold up because we can continue to make those Investments and ship the goods overseas.

Government Spending

Government Spending is a combination of Consumer Spending and Investment, only it’s done by the government. If the government is making capital investments or spending money on consumables, that’s generally good for the numbers. Why? In an economy like the US, the government is usually spending that money with US companies that will, in turn, make more Investments and create jobs, thereby increasing wages and allowing Consumer Spending to go up.

(Getting the feeling they’re all tied together? You are absolutely right!)

What’s the solution to a recession?

The solution is well beyond the scope of this discussion; still, you should take away one simple lesson: Get ready to feel some pain.

There is no “one” solution. The stars have to align right – a balance must be made between all of the above. With inflation on the rise (and I expect it to continue for a while, and then stay high for a while), there is money to be made in certain opportunities. Here’s a short list – a starting point:

1. Real estate. It’s a four-letter word right now (which is precisely why you might want to consider looking at it.) As foreclosures continue to rise, people with now-horrendous credit will be looking to rent, and apartment occupancy rates should drop. Building owners that can raise rents to match (or beat) inflation will be able to earn more and more while owing less and less. As I explained to Dan, their cash flows will increase on a real basis while their debts will decrease on both a real and inflation-adjusted bases.
   What’s the move? In the stock market, you may want to look at REITs that focus primarily on residential rental income – preferably ones with strong current and historical balance sheets so there is less likelihood for sub-prime exposure.
2. Basic Needs. Everyone has to brush their teeth, wear deodorant, shave, do laundry, etc. Find the companies that provide basic services to consumers. Apple is nice; still, if the economy turns much worse, expect people to ditch i-Tunes and stop buying i-Phones before they give up personal hygiene. (Of course, we all know that one guy…)
3. Dominance in Basic Wants. When times are tough, you may decide to eat in rather than dining at a Chipotle. But when you need a Coke, you need a Coke. If things get bad, Coke can raise prices to beat inflation. A $15 burrito will drive people away.
4. Parents, Teens, and Tweens. When things take a turn for the worse, parents try to shield this from their kids. Mom may pass on a Coach purse to make sure that junior looks good when he goes out with his friends. If junior is working, he generally has no idea the economy is bad. If he has cash, he’s spending it. Though spending will likely decrease in this area, it will also be one of the first to pick back up.
5. Workouts, and then more workouts. Though workouts can appear at any time, they are most frequent when times are really good and really bad. In the good times, you’ll find a lot of puffy-head management teams trying to make lots of acquisitions because they “should”; in bad times, you’ll find a lot of very smart management teams making acquisitions because they can.

(Note: For 3, 4, and 5 – that’s why Wal-Mart looked so attractive in August of 2007. So long as it is perceived as or remains the place to go for the best price on 3, 4, and 5, it will dominate.)

By now you know that I’m not a bear or a bull, but a realist. I’m not saying we’ve hit the bottom; I’m not saying we haven’t. What I am saying is this: We are presently on a course that will lead us to higher inflation. There will be opportunities along the way, just as there were during and after every recession and depression.

And now you have an idea of where to look.

The Market and The Looming Recession

To help delay or stop the looming recession, the Fed cut interest rates by 75 basis points. What does this mean for silent partners/business owners? Not a whole lot. Mr. Buffett on this year’s stock market, economy, interest rates, and the upcoming election:

Stop trying to predict the direction of the stock market, the economy, interest rates, or elections.

The hardest part about watching the markets crash is, well, watching the markets crash. We will see the markets up 20% or down 20% (or more) in future years; still, great businesses will grow and their stock prices will follow. The solution? Stop watching the markets!

I’ll admit – it’s easier said than done. And yet, for decades leading up to the 1990s, that is exactly how regular people had to invest. Quotes were only available the next day, in the newspaper. To invest in the stock market, you had to buy great companies at great prices and then let time do its thing.

Yesterday morning, I work up to an e-mail sitting in my inbox that read:

Tomorrow (or I guess it’s today) is going to be a blood bath for U.S. markets. Right now, U.S. futures are posting steepest decline since 2001. I’m predicting the DJIA to be down 500 tomorrow. People are already calling tomorrow “Black Tuesday.” It’s going to be bad.

Watching CNBC in the morning, you would have thought the world was coming to an end. And what did I think? In fact, what was my exact response to that e-mail? (Word for word):

I know. I have been excited all morning. Businesses are going on sale today!

The Lesson

Buffett tells us:

Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.

If, for even a second, you became “panic-stricken” yesterday and sold – or considered selling – your great, underpriced companies because of market movements, you probably shouldn’t be in the markets. Unless there was a fundamental change in your business from Friday to Tuesday, there was no real change.

The Major Drops In Prices

I don’t know what you experienced, but here is what I noticed: A lot of great, underpriced companies have not dropped nearly as much as the markets. In fact, a combination of workouts, patience, and long-term outlook have provided some very rewarding results over the past six months. (Not a good timeframe, but appropriate for this discussion).

In the past six months, I have only showcased three underpriced companies (JNJ, WMT, AEO) and one complete workout (Tribune). Hey, investing is boring.

Putting 10% of your portfolio into each position at those prices (Note: Do your own research, don’t just buy what I say, and don’t judge your portfolio on six-months results!), your portfolio would be up 4.1% since June 27, 2007 (the JNJ post and first position) versus down 10.6% for the DJIA (and likely more for those fee-heavy mutual funds).

If you can lose less in down markets, gain in sideways markets, and keep up (in whole or in part) in up markets, you’ll end up with some very satisfactory results.

What Does This All Mean?

If nothing else, it should remind you that there are always a ton of overpriced companies that, from time to time, must be corrected by moderate to severe market drops. When the value of those companies cannot support the inflated prices, prices begin to drop. Considering that great, underpriced businesses are hard to find, it is no wonder that, regardless of the markets, you often get more protection in great, underpriced businesses than great, fairly priced businesses, speculation, or any other form of “investing”.

(What are the markets but a collection of businesses? When the majority of businesses are overpriced, that pricing will correct and the markets – the collection – will fall, regardless of any individual company’s price or value.)

What Should We Be Doing Now?

Look for opportunities – workouts, great businesses, etc. I’m not going to tell you to “stay the course” because, well, there is no “course” – just opportunities. If you panic when the markets are down, regardless of the health of your businesses, consider getting out now, buying individual bonds, and never looking back.

And for goodness sake, don’t even think about selling now, just to jump back in when the markets have “rallied” to new highs. If you don’t learn from history, you are doomed to repeat it – at the ultimate expense of your goals and dreams.

The Book

Enough market talk. What’s up with the book? Thanks to my superstar agents at Jonathan Scott, I have signed on with Adams Media to publish F Wall Street. Until the actual release date is firm, I can’t say when it will be out, but we are shooting for in or before mid-2009. Rest assured, you’ll know when I know.

Comment Housekeeping

I am working my tail off to keep up with comments, but please be patient. It may take a day or two for me to respond.

The new comment system has helped kill most of the spam comments, but I fear that some comments aren’t getting through. If you post a comment, you’ll get a “submitting comment” notice while it writes to the database and sends me an e-mail. If you leave during that time, I won’t get your comment.

When submitting a comment, please wait for the confirmation to appear – which may take a few seconds or, in the case of longer comments, up to a minute.

Sorry for cutting in to the Workouts Work Out thread. I’ll finish up on Friday. And thanks for visiting!

Quick, large profits can come from buying companies for well below their break-up value. I was revisiting some of Buffett’s early partnership letters (no, I can’t send them to you and I won’t post them without Buffett’s express permission), and I came across this 1960 play that resulted in massive, short-term profits from conservative value investing.

In his January 1961 letter to investors, Buffett revealed a secret play he had been making over the course of the previous eighteen or so months. In 1960, the Buffett partnerships gained nearly 23% while the Dow lost more than 6%. The large play? Sanborn Map.

The Sanborn Moat

Sanborn was a simple business – a mapmaker. The company published and continuously revised extremely detailed maps of all the cities of the United States. Every year or so, the company would revise these 50-some-odd pound maps detailing new construction, changed occupancies, new fire protection facilities, etc.

For seventy-five years the business operated in a more or less monopolistic manner with profits realized in every year accompanied by almost complete immunity to recession and lack of need for any sales effort.

Much of Sanborn’s business was done with insurance companies. Fearing Sanborn’s strength and pricing power dominance, some insurance companies placed insurance people on Sanborn’s board in a “watch-dog” capacity. Why? Control the supplier and you can control your profits. (Think Wal-Mart)

The Downward Spiral

In the 1950s, a practice known as “carding” began eating into Sanborn’s business and profits began to fall. By the late 1950s, Sanborn’s profits fell 80% from their 1930s levels of $500,000.

…this amounted to an almost complete elimination of what had been sizable, stable earning power.

In the 1930s, Sanborn was a $110 stock. In 1958, the company was trading for $45. (At a P/E of about 47. Still think P/E matters?)

What Buffett Saw

During the early 1930s, Sanborn had begun to accumulate an investment portfolio. Over time, about $2.5 million was invested – half in bonds and half in stocks. While its map business began publicly deteriorating, its investment portfolio was silently growing.

By the late 1950s, Sanborn’s investment portfolio increased to equal roughly $65 per share. In effect, buyers of the stock at $45 a share were acquiring an investment portfolio for $0.70 on the dollar, and were getting a map business for free!

At the time, Buffett invested roughly 35% of his partnerships’ assets into Sanborn. Mind you, Buffett was only managing about $4-$5 million at the time. Now you naysayers will cry, “Buffett earned a seat on the board and then spun off the investment portfolio. I can’t buy enough to get on the board!” True. What did that really do for him? It allowed him to speed up the process of spinning off the investment portfolio by putting a proposal in front of the SEC. (He didn’t want to blow Sanborn’s money on a shareholder proxy battle even though he knew he’s win.)

The Information Age Empowers You

What if he couldn’t get on the board? What if he didn’t really have a voice in Sanborn? In 1959, he’d have a problem. Today? No sweat! A simple press release, an announcement of the stock’s situation, and you’ve got yourself a corrected stock price. What investors and institutions wouldn’t perk up if a wire came across touting the Sanborn deal? Sure, they may not care about your estimation of Sanborn’s intrinsic value; still, $0.70 on the dollar in hard assets and a profitable business to boot? You’ll get their attention.

Can you really do that? Of course! So long as you are not scheming or trying to create a fake market in a stock, you are free to tell the world about your analysis. Think no one will care what Joe Blow from Nantucket thinks about a stock? Offer them a Sanborn deal and you’ll have their attention.

I Digress; Let’s End The Letter

Mohnish Pabrai helped value investors understand the difference between 1950s Buffett and 21st century Buffett. Who was 1950s Buffett? I’ll let him tell you:

Necessarily, the [explanation of the Sanborn deal] is a very abbreviated description of this investment operation. However, it does point up the necessity for secrecy regarding our portfolio operations as well as the futility of measuring our results over a short span of time such as a year. Such “control situations” may occur very infrequently. Our bread‐and‐butter business is buying undervalued securities and selling when the undervaluation is corrected, along with investment in “special situations” where the profit is dependent on corporate rather than market action.

Sanborn Deals Today

In 1959, Buffett had no problem investing in thinly traded stocks with small revenues and profits. How thinly traded? How small? Assuming Sanborn had grown in output by 3.2% (the average annual growth rate of all US industries from 1960 to 2000), added another 3% to its growth through inflation price adjustments, the company would have (assuming all things being equal) earned roughly $1.79 million in net income in fiscal year 2007. Total shares outstanding at the time? 105,000.

The Point: Be Business-Minded

We have all heard the scare stories about buying low-priced stocks (They’re low-priced for a reason!), thinly-traded companies (There’s no liquidity and they are super-volatile!) and diversification (The markets are scary! Buy everything – good and bad – so you can make 5% over the long-term!). If you focus on the short-term markets (let’s face it, yesterday’s 200+ point drop in the Dow was crazy) you’ll go insane and take on a ton of risk with a side of panic. If you think like a business owner, you may find some real gems in those “scary, small stocks.”

Now, I’m not telling you to run out and buy penny stocks. But don’t feel the need to limit your searches to companies with $X of market cap. $0.70 on the dollar is a good deal in any market. Just make sure you uncover the next “Sanborn” and not some junk that is tiny for a reason.

Virtually every Buffett partnership letter began with something to this effect (taken from the aforementioned letter):

However, I have pointed out that any superior record which we might accomplish should not be expected to be evidence by a relatively constant advantage in performance compared to the Average. Rather it is likely that if such an advantage is achieved, it will be through better‐than‐average performance in stable or declining markets and average, or perhaps even poorer‐than‐average performance in rising markets.

I would consider a year in which we declined 15% and the Average 30% to be much superior to a year when both we and the Average advanced 20%. Over a period of time there are going to be good and bad years; there is nothing to be gained by getting enthused or depressed about the sequence in which they occur. The important thing is to be beating par; a four on a par three hole is not as good as a five on a par five hole and it is unrealistic to assume we are not going to have our share of both par three’s and par five’s.

If you are judging your investment success and savvy based on the events of the past few days, weeks, months, or year, you shouldn’t be investing in common stocks – buy an index fund or bonds and be done with it. Your success is not judged by the daily swings of the markets in relation to the speed with which the Earth spins on its axis or around the sun, but by the truth that price follows value. (I just made that up. Catchy, no?)

Here we go: Great businesses will grow; bad businesses will shrink; stock prices will follow in the long-term. Of course, when I say that, people respond with things like that’s no help or obviously or the likes. We all know that…so why can’t we believe it? And more importantly, why can’t we invest accordingly?

First things first, forget the calendar year. What will make 2008 different from 2007? Or 1997? Or 1967? When it comes to the stock market, the answer is a resounding nothing! The stock market will still be a place to buy and sell businesses – overpriced and underpriced companies, good and bad businesses, large and small operations.

Where is the economy going? The election?

Are we headed for a recession? Depression? What will the election mean to our portfolios? It doesn’t matter! If you are a short-term trader, these questions require a lot of thought and strategy. If you own businesses – businesses with moats that generate a ton of cash – you don’t have to worry. We’ve lived it (some of us, at least) and our businesses have thrived.

The Cold War. The Gulf War. 9/11. The Iraq War. Federal funds rates from 1.79% in 1955 to 16.39% in 1981, back to 4.79% in 2006. 6-month CD rates from 4% to 15% back to 5% over 40 years.

You ain’t seen nothing

In the last 40 years, over a period of six months we’ve seen the Dow drop as much as 32+% (1974) and run up as much as 48+% (1975). Great – but that was 30 years ago. Right – but it was also down 29+% (2002) and up 34+% (1999).

And yet, businesses continued to grow. As Buffett says:

You go to bed feeling very comfortable just thinking about two and a half billion males with hair growing while you sleep. No one at Gillette has trouble sleeping.

Do you own businesses run by management that can’t sleep when interest rates are on the rise? Are your companies largely successful because there is a Republican President? Will the next President’s party make or break their success?

What is 2008?

And that leads to the point of this discussion: Don’t focus on the calendar. Whether it is October of 2007 or January of 2008, the people at your company will be going to work every day to try and make you money. So long as they are banging away at their keyboards, ringing up sales, mixing chemicals, etc., they are working to make you more money. Your businesses aren’t likely to explode – for better or for worse – in just a few months or quarters. It will take years, and if you buy, hold, and sell on that premise, you’ll do very well.

Forget January. Forget 2008. Forget the stock market. Buy businesses and let time reward you for your good decisions.

My AEO stock is down and the markets are tanking!

But what about American Eagle Outfitters? The stock is at $18 and change! And it may go lower – a lot lower. Is it a good business? I think so. Are people still shopping at AEO’s stores? Yep. Is management still trying to reduce expenses, grow revenues, and generate more cash? You bet. Did you buy it hoping to make a quick profit? I didn’t.

When you buy an underpriced business, it may take years for the markets to correct their mistakes. Fortune smiled on us when JNJ and Wal-Mart ran up just weeks after I showcased them. The Tribune arbitrage play was meant to be a 3-week 10% profit. The fact that Amylin is down 23% since my July 26th cautionary post is a function of mere market fluctuations.

The stock market will do a lot of crazy things. It has always been that way; it will always be that way. Had you bought AEO in September of 1994, you would have seen your position slashed by some 80% over the course of the next year and a half. And had you held? A handsome, 13-year 22% average annual return at today’s price.

The market fluctuations are gut-wrenching. That’s why you have to ignore them. If not, you’ll drive yourself nuts and start making some really terrible moves.

If it works for Warren…

Buffett has been profiting from and holding stocks through the craziest, scariest, and wildest markets for more than 40 years. Think today’s markets are bad? You ain’t seen nothing compared to what he went through.

Price follows value. Maybe not today. Maybe not in 2008. But it does.

Now, let’s make some money the intelligent way and invest like real business owners/silent partners!