The Investing World Today

Times are stable. Markets are doing well. Things aren’t a bubble yet, but any sort of out-of-left-field event could cause a chain effect on liquidity given that things like ETFs invested in bond funds and set-it-and-forget-it investing have taken over.

I try and look for investments that yield at least 10% as compared to 2% short-term investment grade bonds (Vanguard: VFSUX), but aside from Adient and Wells Fargo, that has been incredibly difficult for me.

The chart below shows how small the margin is between junk bonds and investment grade. Reaching for yield, through longer-term bonds or lower-quality bonds is dangerous. Especially given that you can pretty safely make 2% (or 1% in Vanguard’s money market fund). The additional yield doesn’t justify the risks.

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Learn from your mistakes: Old Analysis – (ARO)

Yikes, this is getting worse. GameStop wasn’t that bad. But this one highlights all my ignorance for the world to see.

Well, as a great musician said, “When you’re sitting in your room playing the guitar, you don’t have to worry about being successful…it’s not gonna happen”. In that vein, let’s see what I did wrong.

Aeropostale (ARO)

What I said then:

  • Look at the impressive return on capital, share buybacks, and increased EPS. Why is trading at 10x earnings? This is so cheap and things are very likely to stay at this level. In a better scenario, as the economy improves more people will be buying ARO’s clothing.
  • There’s potential upside in the new line of stores they are opening.
  • My downside is probably protected because this is trading at 10x earnings. That’s not expensive, especially given the incredible growth ARO has exhibited over the past decade.

What I would say now:

  • This is a temptingly easy industry to analyze (at least on the surface). Calculating free cash flow, debt levels (none!), or growth rates is easy here. Yet, simplicity does not equal safety.
  • ARO has no pricing power. In fact, it only has customers because it is so cheap. Any whiff of larger price increases than competitors and people will be heading for the exits.
  • Teen fashion has no economic moat. Just because they did well during the recession doesn’t mean they’re going to do as well going forward. Tastes change rapidly. Long-term anything can happen.
  • What is your downside? Sure ARO is trading at 10x earnings, but if earnings slip for whatever reason, a lower earnings number and a lower multiple on that could be a double whammy. Don’t calculate the negative possibilities. Just realize, you have unknown downside since revenues are not guaranteed to recur in this industry. Unknown downside = no investment.
  • Your return on capital ratios are off since you’re not including leases in the denominator.
  • Finally, you should learn about the concept of peak and trough margins. ARO, coming out of the recession as the low cost provider of fashion for teens, was likely hovering around peak margins – the point at which margins are unlikely to expand any further. Peak and trough margins are an important concept when looking at industries with commoditized products. While I generally avoid these industries, if you do invest you want to invest at the point in the cycle where you’re at trough margins. And that point doesn’t usually come after a decade of successive gains. Timing is risky.

Would I make the investment today?

  • No. The downside was unquantifiable. The upside was not exciting and I foolishly ignored the concept of peak and trough margins. There was no asymmetry in this investment opportunity.
  • The lack of competitive advantages or pricing power makes this a risky long-term investment.

Learn from your mistakes: Old Analysis – (GME)

What better way to show you the many ways I’ve been an idiot than exploring some of my past write-ups.

I’ve got some fun ones lined up: GME, ARO, RIMM (hopefully the worst one I will ever write). Eventually, we’ll hit some of my better ones.

In this post, I wanted to talk about Gamestop. I initially thought I would re-read my analysis and be horrified. While I think the write-up is generally too simplistic and does not dig deep enough into industry data, it wasn’t as bad as I thought. Without consciously doing so, I was able to nail down the (short-term) downside and the competitive advantages of this company.

Step #1 – Analyze your downside and make sure there is very little of it.

I assumed that GME’s game-trading business would be stable for a few years. While this wasn’t the main reason for my investment (valuation played a more significant role), it protected me. As you’ll see in other write-ups, I soon decided that downside analysis was unnecessary. I soon became an idiot.

GameStop (GME)

What I said then:

  • Cheap because it’s trading at 8X earnings (and FCF) and GME is buying back shares and significantly reducing debt
  • Game trading unit is a defensible niche and this is their economic moat
  • Potential upside with downloadable content

What I would say now:

  • Can you project cash flow beyond 3 years? Probably not. What happens when the trading business starts to erode? This is not a safe long-term investment.
  • Your upside is limited too. If downloadable content works out …great. But otherwise, any extra EPS is coming from share buybacks. You’re kind of playing on the railroad tracks.

Would I make the investment today?

  • Nope. I made a significant amount of money on this one, but it was a mistake to make this investment. I now seek out companies with limited long-term downside and significant potential upside. GME was not an asymmetric (Step #2 -Find Asymmetry) investment opportunity. My filter was not honed.
  • I lucked out here. Unfortunately, my lack of downside analysis came back to haunt me when it came to Aeropostale and Research in Motion.

Step #3 – Re-analyze every one of your investments, regardless of if you made or lost money. Making money does not mean you made a good decision. It will come back to bite you.

How it began.

I discovered value investing in the Fall of 2008. I just graduated from college and was working at my family’s electronics distribution company and learning about operations, sales, and management. I walked through our massive warehouse each day in awe of the brute amount of product we had. I was swimming in business I had been raised around. It was fantastic.

A decade earlier, my dad and I opened my first brokerage account. I became interested in the concept of the stock market, but it seemed complicated and intimidating. The random fluctuations of prices made it feel more like a craps table than a legitimate investment apparatus. I was not interested.

A decade had passed. In the Fall of 2008 I had been perusing the investment section of Amazon when I stumbled across a book that had some good reviews; “Maybe this will teach me something about stocks…this could be useful”, I thought to myself as I added The Intelligent Investor to my shopping cart.

Each evening at 6PM I left the office and headed to the Starbucks down the street. With a black iced coffee in one hand and The Intelligent Investor in the other, my caffeine-fueled education had begun. I moved on to Snowball, Common Stocks and Uncommon Profits, and Security Analysis. I made summaries and outlines as I burned through books in that coffee shop, at home on the weekends, and on family vacations.

I internalized many of the concepts quickly because they resonated deeply. While no one had explained the concepts to me before, it all felt so familiar. Have you ever tried dating an ex again? Kind of like that. Except less tears.

In the Fall of 2008, I stumbled upon books that would change my career goals. I decided to allocate capital – and I felt I had the psychological makeup and analytical skills to do so.

My naive optimism in the Fall of 2008 led me on a unique path. It has been a challenging few years, but I now manage around 5 million dollars. I have made some major mistakes, but none fatal (though some very close). Most importantly, I am 10x better at investing then I was a year ago. A year ago I was 5x better at investing than I was in 2010. And in 2010, I was probably a 100x better investor than I was in the Fall of 2008.

The learning curve is steep, but hopefully my lessons can help you. And at some point, you need to start investing.

Fantasy Sports – Fun AND useful?

Some people consider fantasy sports to be a waste of time, but I don’t think they are. If you like sports and you like investing, it’s a creative way to hone your long-term investing skills in a fun way and via a competitive environment.

My favorite sites for Fantasy Football are ESPN Fantasy Football and Yahoo Fantasy Football. It’s a fun challenge to research the best and most underrated players and then try to find values during the draft. During the season, you’ll probably be scouring for deals via free agency and trying to setup opportunistic trades. You can also check various other fantasy sites for constant news updates on players. There are tons of resources out there so use your time smartly.

Unless you’re playing in a money league you’re not going to gain any level of wealth from this process but you will be honing some skills that bear an uncanny resemblance to those you use in long-term value investing.

Incremental Learning

Those who are the most successful in their fields often push themselves on a daily basis to learn new things and to hone their craft. Small, incremental steps each day or week will lead to huge dividends down the road.

For example, football players and their coaches constantly utilize new training methods in the weight room, Kobe Bryant studies the techniques of other NBA players, and Lebron James plays basketball with kids at summer camps (may not be as effective as other methods).

In the value investing community, it’s not surprising to find that various analysts and researchers do not have business degrees. Much of their learning and analytical skills are the result of years of reading and incremental learning. Learning how to analyze companies in different ways is extremely useful even if you don’t use the analysis to ultimately come up with an intrinsic value. By looking at a business from a different perspective, it’s possible that you may generate new questions or spot something you missed before.

Given my lack of background in valuation, a friend of mine recommended I take some of the courses at Breaking Into Wall Street (BIWS). I’m a happy paying customer of the service and have no other affiliation with the company.

It’s been a very helpful course in strengthening my excel toolkit and learning how investment bankers model. I am very skeptical of financial modeling, but it’s now another tool in my toolkit and I believe the courses have strengthened my overall value-based analysis and the questions I ask myself as I look at a company.