Great read: Innoculated Investor’s “Enduring Lessons of the Last Ten Years”

Innoculated Investor is one of the best blogs out there and you should definitely check it out. I found this excellent piece that compiles a bunch of the author’s own “enduring lessons” about investing from the last decade. It’s not a short piece, so I’ll let people read and evaluate for themselves and I’ll skip commenting on where I agree or the few places where I disagree. The URL to their post is: http://inoculatedinvestor.blogspot.com/2009/12/enduring-lessons-of-last-ten-years.html

They write:

The Enduring Lessons of the Last Ten Years

As the ‘naughties’ (what a perfectly descriptive name for the 2000-2009 period) come to a somewhat anti-climactic close, it is important for those of us in the investment community to take stock of what new lessons have been learned, what immutable laws have been reinforced, and what changes in policy, strategy and execution need to occur in order to avoid a repeat of the booms and busts of the last decade. The reason I think such an analysis is critical is that I do not believe most investors are cognizant enough of the dangers lurking in the world’s financial markets. Memories are very short and despite suffering through a number of serious market downturns over the last 10 years, I worry that we have already started a snowball rolling that has the potential to cause even more lasting damage than the dot com bubble or the real estate bubble and subsequent financial collapse. Therefore, it may be true that only by understanding the past can we hope to avoid such a fate.

The following list is not meant to be all encompassing. I’m sure each individual investor can come up with additional items and could justifiably disagree with some of my conclusions. Also, you will surely recognize some of these rules and guidelines as often repeated clichés. That is the point. I am not trying to re-invent the wheel or point out things that are not relatively obvious. However, I do believe that people who keep these beautifully simplistic lessons in mind have a much better chance of successfully navigating through persistently treacherous financial waters than those who ignore the past.

1. Trees cannot grow to the sky: This rule is number one for a reason. No matter how many times this idea is repeated or shown to be true in the market setting, another hot investment invariably comes along that causes people to forget that appreciation has its limits. However silly it may sound at a time of irrational exuberance, the restrictions on unending price increases consist of these pesky little things called fundamentals. For example, since no company can compound revenue growth at 20% indefinitely, fundamentals rarely justify paying exorbitant price to earnings multiples for stocks, regardless of the sell side’s bullish extrapolations. Or, since rents often do not increase by more much than CPI inflation on a yearly basis, real estate price appreciation that is significantly above the inflation rate is not likely to be sustainable. Basically, aside from commodities that are valued mostly based on supply and demand dynamics, most assets need to be valued based on the cash flows they can produce. It really is that simple. Accordingly, when price increases become decoupled from cash flow growth, the ensuing bubble is likely to eventually explode and devastate those who forgot that those annoying fundamentals will invariably win out.

This is a lesson that was reinforced a number of times over the last ten years within a number of disparate asset classes. However, this is the one lesson that is never sufficiently learned. As true as it is that the sun will rise in the east and will set in the west, investors will inevitably be willing to pay far too much for certain assets based on unrealistic assumptions about growth. Therefore, the solution for prudent asset allocators is to find investments in which it is possible to buy at a price less than intrinsic value and get any future growth for free.

1. Fighting the Fed means you can lose your shirt: All I can say is that I totally underestimated what near zero interest rates, a flood of bank liquidity, and an implicit government backstop of all risky assets would do to the price of everything but the US dollar. In retrospect the valuations of many stocks at the 666 low on the S&P in March reflected a draconian outcome for the US economy that was probably unlikely, especially with the Fed stepping up to the plate. It is now abundantly obvious to me that incredibly low interest rates punish savers and force people to go further out on the risk curve. Even worse, historically low rates apparently can cause lasting distortions when it comes to asset prices. Thus, it was foolish not to expect some rally in stocks. The length of the current rally has been impressive and clearly driven by some extent by the Fed’s money printing. Anybody who was significantly short during the last nine months has suffered mightily at the hands of the Fed’s attempt to reflate all asset classes (but the dollar) simultaneously.

Accordingly, this is a lesson that any and all short sellers should take to heart. When both the Fed and the officials in charge of fiscal policy make known their intentions to throw money at a situation with impunity, it likely to be very profitable to cover and go long risk, regardless of the underlying fundamentals. For investors who shun such speculation, when the Fed gasses up the Helicopter and loads up the money bags, it appears that the best course of action is to take short exposure way down and if valuations are right, add more to existing long positions.

Now the question facing all investors is whether or not the Fed’s actions will continue to stimulate price appreciation in various asset classes. My guess is that the corollary to the above rule is also true: when the Fed is eventually forced to take away the punch bowl, it is the longs who are bound to suffer while the shorts prosper. Therefore, it may be prudent for long-biased investors to take some profits if and when the Fed finally starts to consider hiking interest rates and shutting down the money spigot.

1. Ignore the warnings of The Oracle of Omaha at your own peril: I am just about finished with Alice Schroeder’s epic biography of Warren Buffett entitled The Snowball. The book serves as a fabulous reminder that investors should heed the advice of their elders. At the annual Sun Valley meeting in 1999 Buffett notoriously warned the crowd that technology stocks and the equity markets appeared overvalued and that stocks were poised to deliver mediocre returns in the coming years. What happened? You might recall that the tech bubble burst and many people, especially retail investors, experienced severe wealth diminution. Then, over the next few years Buffett wrote about and spoke of derivatives as weapons of mass destruction and indicated that he believed some kind of crash would come as a result of their proliferation. If you can’t see the prescience imbedded in those statements I suggest that you review what happened to AIG and what that company’s near demise did the global financial markets.

Recently, Buffett has made “all in” bets on America after his October 2008 op-ed piece in the NY Times and his enormous purchase of Burlington Northern Railroad (BNI) in 2009. What he hasn’t said directly about some of his recent moves (but has discussed in other contexts) is that these investments are actually hedges against inflation. In an inflationary scenario the best assets to own are solid businesses that have the ability to raise prices and those that will benefit from spikes in the prices of commodities (railroads for example). The Oracle is telling people to be positioned for coming inflation. After the number of things he has gotten right over the past 10 years it would be absolutely foolish to dismiss his words this time.

1. While being early may look and feel a lot like being wrong, investors must stick to their convictions: John Paulson knows this better than anyone and the tremendous profits he made shorting the housing market serve as an example of the need for investors to stick to their guns. I saw Paulson speak in New York earlier this year and the insight into his thought process during the 2006-2008 period was invaluable. From what I recall, Paulson was early in making bets against the RMBS market and actually closed out some shorts at a loss. However, he then discovered the magic of credit default swaps as a way to profit if the housing market tanked and by staying with his investment thesis was able to make billions of dollars for his fund and himself in 2007. It would have been easy to have gotten scared out of these contrarian positions, especially when people like Ben Bernanke were swearing that a widespread housing crisis in the US was just about impossible (isn’t it amazing this guy kept his job AND got re-nominated for another four years?). Fortunately for Paulson, he had done the necessary in-depth research and understood the dynamics and risks inherent in the RMBS market better than central bankers, policy makers, investment banks and institutional investors.

What current investors need to remember is that markets are absolutely not efficient all the time and the herd can potentially be wrong for an extended period. Thus, as long as you can stay solvent longer than the market remains irrational (a big if for firms that employ a lot of leverage), you can make fistfuls of money when your thesis plays out, even if you are a bit early.

1. Risk is not the same as volatility: The distinction between risk and volatility is crucial and investors must always be on the lookout for opportunities that arise from a general lack of understanding of the difference. Risk should always be defined as the potential for permanent capital impairment. Specifically, risk implies a drop in the value of an asset. In contrast, measures of volatility are derived from fluctuations in prices and have nothing to do with a change in intrinsic value of an asset. For reasons that have to do with behavioral and structural biases, investors continue to confuse these concepts and subsequently sell assets whose price has dropped but whose value has remained intact. Situations in which selling is based solely on declines in prices are the best times to be a value investor because companies with solid balance sheets and distinct competitive advantages can fall out of favor when sentiment turns against them. This creates an opportunity for knowledgeable investors who focus on the measurement of intrinsic value to back up the truck and load up on shares of their favorite companies. Accordingly, volatility is the friend of a value investor while risk is something that needs to be guarded against. If we have learned anything in recent years it is that it’s imperative to spend time attempting to evaluate the cash flows a company will generate as opposed to a completely useless metric such as a stock’s beta.
2. Never forget that politicians’ main objective is to get reelected: What this very sobering lesson implies is that there is almost never the political will to make tough choices that will lead to short term suffering even if current sacrifices are likely to lead to future prosperity. As a group, lawmakers seem to be consistently unwilling to risk their political aspirations for the good of the country or to hold to true to their beliefs. This is especially true in elections years like 2010. However, as a result of the exorbitant cost of running a political campaign, even in non-election years our elected officials are forced to continue to raise money and become even further indebted to special interests and powerful lobbyists.

The takeaway from this perverse situation and overwhelming desire to be reelected at any cost is that investors can count on legislators and the White House to kick the can as far down the road as possible and even create laws that exacerbate the problem in the long run but serve as a potential quick fix. The perfect example of this behavior was the passing of the Medicare part D legislation, a program that Paul Krugman argues created an $9.4 trillion unfunded liability over the next 75 years. Such giveaways are a nice way to get reelected, may help boost the stock market temporarily, but could end of bankrupting future generations of Americans. Therefore, long term oriented investors must be prepared to deal with the lasting secular trends that result from knee-jerk reactions to cyclical events.

1. Relying on so-called experts—central bankers, economists, and financial pundits—can lead investors down a slippery slope: If you turn on CNBC you have the wonderful luxury of being able to hear the opinions of hundreds of people who work with the markets on a day to day basis. Since these folks spend all of their time living and breathing financial markets, they should know best, right? Well, it turns out that experts are often wrong; not necessarily because they are bad people or are fools, but because accurately predicting the future is incredibly difficult. Accordingly, investors should remember that any prognostication, no matter who it comes from, needs to be taken with a grain of salt and that person’s particular incentives and biases must be taken into account as well. In the end people need to make up their own minds based on the facts in front of them and the extensive research they have performed. Making investments by relying on the advice of strangers or as a result of minimal time invested in understanding underlying valuations and fundamentals is not much better than random speculation. As the past ten years have shown, such behavior is a fantastic way to lose money.
2. When a market dynamic does not make sense fundamentally, that probably means the trend will not last: I think this is one of the most important takeaways from the numerous bubbles we have witnesses in the past decade. If you can’t understand the rational for specific trend or the fundamentals fly in the face of that trend, you have to believe that a severe reversal or correction is inevitable. On great example I remember of one such situation occurred in early 2008 with Martin Marietta Materials (MLM). With the stock trading well above $100 a share I continued to read sell side analyst reports touting the strength of the company’s aggregate reserves and resilient revenue stream. Unfortunately, at the time the US economy was going into the tank AND there was a huge supply of aggregates coming online over the next year. Not very bullish fundamentals for a company whose stock price depended on the price of aggregates. Predictably, the subsequent free fall in the US economy caused demand to decline dramatically at the same time the company had ramped up production. Despite the bullish predictions of sell side analysts the stock proceeded to go from close to $120 in September 2008 to just over $60 in November. Now, I have nothing against the company and have no opinion about the current stock price. But, at the time the gravity defying price of the stock did not make any sense based on the very obvious headwinds facing the company.

So, when you see zombie companies like Fannie, Freddie and AIG trading way up one day or notice their prices consistently climbing higher, keep in mind that if the reason for such activity completely confounds you, it is unlikely to be based on sustainable fundamentals.

1. Sexy financial and economic models often fail to capture the idiosyncrasies of actual functioning markets: Honestly, I don’t think I can do this topic sufficient justice. If you need a refresher on why intricate models have failed so badly, check our Nassim Taleb’s recent testimony in front of Congress. Let’s just say that cute models look great on paper but when irrational people get involved, they often fail to predict how markets will react. You would think that the world would have figured this out when LTCM blew up and almost dragged all the banks down along with it. The sad thing is that companies continue to use flawed models like Value at Risk (VaR) to assess risk. Shouldn’t we have realized the models’ limits when David Viniar of Goldman Sachs admitted that the company was seeing 25 standard deviation events several days in a row? No, the world was not experiencing some tectonic shift that caused asset prices to do things that should happen once every 100,000 years. The models were just wrong and continuing to rely on them is only going to enhance the risk of an extreme tail event that would even make a black swan blush.
2. When it becomes impossible to distinguish economic theory from religious theology, economists are likely to become blinded by their own beliefs: Why did so few economists see the financial crisis coming? Maybe they were too busy calling each other names to see the unsustainable debt levels and financial company excesses building up in plain sight. While the financial crisis has allowed the behavioral economists to gain deserved popularity, it is an indictment of the entire economics community that so many people who dismissed the rational actor fallacy were marginalized by the mainstream. Now, in spite of compelling conclusions about the way irrational people impact markets, somehow many neo-classical economists continue to hide behind their theories in a curious attempt to try to explain away the recent financial crisis.

Now on to the disciples of John Maynard Keynes. Could it be that the neo-Keynesians are so wedded to the belief that unlimited fiscal stimulus and deficit spending are the only paths back to sustained prosperity that they have lost sight of the risks of such profligacy? What if the Keynesian response to the recession was the correct reaction but the magnitude of the fiscal policy was far too strong and will eventually lead to some very unpleasant outcomes? With Keynes no longer alive but still deified by his followers, could the true believers even see it if they had it all wrong?

In my view, the constant bickering between the saltwater and freshwater economists and complete inability to see the to the other side of the argument (not to mention the absolute dismissal of the Austrian school’s tenets) seems more like an entrenched religious battle in which each side believes only one methodology can be right. Unfortunately, unlike arguments about the existence of god, market outcomes are not necessarily binary and the nuanced truth could lie in between economic theories. Thus, people who are willing to defend their position in the face of mountains of contrary evidence are likely to be so biased that they cannot be trusted to assess the state of the economy.

Even more concerning is this article in the Huffington Post that argues that the Fed effectively controls, monitors and censors what is published in economic journals. That’s the last thing the US needs: formerly autonomous and free thinking economists being controlled by the banking oligarchs who have a definite inflationary and Wall Street bias. We have already seen where that has gotten us and it is not pretty.

The conclusion that needs to be drawn about those who belong to what appears to be a very closed-minded and divided economic establishment in the US is that many have been compromised and may not be the most reliable evaluators of the past, present or future global economy.

1. Leverage is miraculous on the way up and a killer on the way down: My favorite analogy regarding the risks of too much leverage comes from none other than Warren Buffett. Buffett likens carrying too much debt to driving a car with a dagger attached to the steering wheel pointed at your heart. Everything is fine until you hit a bump and that dagger goes right into your chest. Of course if you are lucky and there are no bumps for a while you can make an incredible return on your equity. However, eventually that bump in the road is going to come and smart companies and households never put themselves in a position to allow that bump to be life threatening. Further, there is some compelling data that suggests that financial bubbles are almost always driven by too much leverage. The good news is that by in large companies have solidified their balance sheets over the last two years and households are finally starting to deleverage a bit. Thus, at least in the private sector and among consumers, the dagger is slowly being pushed further away.

However, I do worry that there is one particular institution that has ignored the above lesson and has taken on far too much leverage. Who is that you ask? Why the US government of course. One risk is that something unexpected happens, the government is forced to print even more money, the deficit spirals out of control, and in the end the quality of life for all Americans is impacted. We are already fighting two wars, have thrown trillions into the financial markets, have huge Social Security and Medicare obligations and on top of all that have passed stimulus legislation in an attempt to prevent a depression. Therefore, we can ill afford any unexpected expenditures. Even now it is hard to imagine how the US will live up to all of its obligations. Let’s just hope that the economy improves, tax revenues come back, and our foreign creditors are somewhat appeased before we hit that next inevitable bump. If not, both equity and bond markets could be devastated by the fallout.

1. Wall Street wins whether the economy prospers or fails and whether markets go up or down: This may sound like populist propaganda, but it is hard to argue that this is not precisely how the last few years played out. Yes, Lehman and Bear are gone and Merrill Lynch is now a part of Ken Lewis’s failed empire. There have clearly been a few losers in the aftermath of the dramatic financial crisis. But, in aggregate, Wall Street has not only survived, but has also prospered immensely at the expense of American taxpayers and businesses. Expected record bonuses this year are only icing on the cake. When many Americans spent this Christmas wondering if they were going to lose their jobs or whether they will be able to feed their families, I’m sure many on Wall Street enjoyed a very comfortable holiday. If this seems unjust given the fact that without government assistance many firms might not exist anymore, that’s because it unequivocally is.

At the center of all of this (but not alone) is Goldman Sachs. First, Matt Taibbi documented the success of Goldman in up and down markets in his July 2009 piece. Then, just before Christmas Gretchen Morgenson alerted the masses to what the investment community already knew: Goldman consistently bet against the same clients it was selling dodgy assets to. Don’t forget that despite unemployment rising above 10% Goldman somehow managed to only lose money on trading on one singular day in the 3^rd quarter of this year. If a baseball player batted .900 or higher for 3 straight months he would quickly be crowned the greatest hitter who has ever played the game. But when Goldman accomplishes a similar feat in what used to be a zero sum game, we don’t even blink anymore.

What all of this means is that through their political connections and too big to fail status, Wall Street firms are just about guaranteed to receive favorable treatment relative to the rest of us no matter how well or how poorly the economy is doing. Thus, investors who short these firms are at the mercy of the actions of a Fed and Treasury that do very little to protect against moral hazard. In fact, at a certain point, regardless of the dubious activities such as high frequency trading and so called trade huddles, it almost makes sense for investors to give in any say, “if you can’t beat ‘em, join ‘em.” Well, I said almost.

1. The most dangerous words in investing are “this time is different” but this economic cycle in the US may really and truly be different than the recent ones: The book by Carmen Reinhart and Ken Rogoff entitled This Time is Different is on my seemingly endless reading list but I have yet to get to it. But, from the reviews and commentary I have read, the authors do a great job analyzing past boom and bust cycles and disproving the notion that individual situations are different and thus certain countries can avoid experiencing the devastating and enduring impacts of financial crises. The title of the book is obviously ironic in that the authors show that there are common factors that cause financial debacles. Surprisingly, people make the same mistakes over and over again under the false premise that their own personal or country-specific circumstances will allow for a different outcome than others have experienced. Inevitably, such beliefs end in tears.

What does this have to do with the current economic and fiscal situation the US finds itself in? Everything. First off, the duo provides lessons about governments accumulating too much debt and pinpoints what leads to sovereign defaults. Second, if the US is following the same path as Japan (as the authors assert) in terms of dealing with the insolvent banking system, why should we expect a different outcome? These are just two of the topics addressed in the book that give investors a way to understand the risks associated with investing in government debt and bank stocks, for example.

In the end, my real worry is that the title of the book has a double meaning. While financial crises and the associated lasting effects on economies may be similar, I am concerned that many policy makers are viewing this downturn as if it were a typical inventory recession that can be cured by low interest rates and some targeted government stimulus. I fear that it may be that this recession is actually different from ones like the post-September 11^th slump. Accordingly, if Reinhart and Rogoff are right and this financial crisis is going to play out like others have around the globe, the template suggests that the US’s experience this time may be dramatically different from other recent domestic recessions. What that could mean for investors is a long slog of mediocre GDP growth and substandard returns on equities as the powers that be prolong making the tough choices needed to purge the system of debt and get back to fiscal sanity.

As the ‘naughties’ (what a perfectly descriptive name for the 2000-2009 period) come to a somewhat anti-climactic close, it is important for those of us in the investment community to take stock of what new lessons have been learned, what immutable laws have been reinforced, and what changes in policy, strategy and execution need to occur in order to avoid a repeat of the booms and busts of the last decade. The reason I think such an analysis is critical is that I do not believe most investors are cognizant enough of the dangers lurking in the world’s financial markets. Memories are very short and despite suffering through a number of serious market downturns over the last 10 years, I worry that we have already started a snowball rolling that has the potential to cause even more lasting damage than the dot com bubble or the real estate bubble and subsequent financial collapse. Therefore, it may be true that only by understanding the past can we hope to avoid such a fate.

The following list is not meant to be all encompassing. I’m sure each individual investor can come up with additional items and could justifiably disagree with some of my conclusions. Also, you will surely recognize some of these rules and guidelines as often repeated clichés. That is the point. I am not trying to re-invent the wheel or point out things that are not relatively obvious. However, I do believe that people who keep these beautifully simplistic lessons in mind have a much better chance of successfully navigating through persistently treacherous financial waters than those who ignore the past.

1. Trees cannot grow to the sky: This rule is number one for a reason. No matter how many times this idea is repeated or shown to be true in the market setting, another hot investment invariably comes along that causes people to forget that appreciation has its limits. However silly it may sound at a time of irrational exuberance, the restrictions on unending price increases consist of these pesky little things called fundamentals. For example, since no company can compound revenue growth at 20% indefinitely, fundamentals rarely justify paying exorbitant price to earnings multiples for stocks, regardless of the sell side’s bullish extrapolations. Or, since rents often do not increase by more much than CPI inflation on a yearly basis, real estate price appreciation that is significantly above the inflation rate is not likely to be sustainable. Basically, aside from commodities that are valued mostly based on supply and demand dynamics, most assets need to be valued based on the cash flows they can produce. It really is that simple. Accordingly, when price increases become decoupled from cash flow growth, the ensuing bubble is likely to eventually explode and devastate those who forgot that those annoying fundamentals will invariably win out.

This is a lesson that was reinforced a number of times over the last ten years within a number of disparate asset classes. However, this is the one lesson that is never sufficiently learned. As true as it is that the sun will rise in the east and will set in the west, investors will inevitably be willing to pay far too much for certain assets based on unrealistic assumptions about growth. Therefore, the solution for prudent asset allocators is to find investments in which it is possible to buy at a price less than intrinsic value and get any future growth for free.

1. Fighting the Fed means you can lose your shirt: All I can say is that I totally underestimated what near zero interest rates, a flood of bank liquidity, and an implicit government backstop of all risky assets would do to the price of everything but the US dollar. In retrospect the valuations of many stocks at the 666 low on the S&P in March reflected a draconian outcome for the US economy that was probably unlikely, especially with the Fed stepping up to the plate. It is now abundantly obvious to me that incredibly low interest rates punish savers and force people to go further out on the risk curve. Even worse, historically low rates apparently can cause lasting distortions when it comes to asset prices. Thus, it was foolish not to expect some rally in stocks. The length of the current rally has been impressive and clearly driven by some extent by the Fed’s money printing. Anybody who was significantly short during the last nine months has suffered mightily at the hands of the Fed’s attempt to reflate all asset classes (but the dollar) simultaneously.

Accordingly, this is a lesson that any and all short sellers should take to heart. When both the Fed and the officials in charge of fiscal policy make known their intentions to throw money at a situation with impunity, it likely to be very profitable to cover and go long risk, regardless of the underlying fundamentals. For investors who shun such speculation, when the Fed gasses up the Helicopter and loads up the money bags, it appears that the best course of action is to take short exposure way down and if valuations are right, add more to existing long positions.

Now the question facing all investors is whether or not the Fed’s actions will continue to stimulate price appreciation in various asset classes. My guess is that the corollary to the above rule is also true: when the Fed is eventually forced to take away the punch bowl, it is the longs who are bound to suffer while the shorts prosper. Therefore, it may be prudent for long-biased investors to take some profits if and when the Fed finally starts to consider hiking interest rates and shutting down the money spigot.

1. Ignore the warnings of The Oracle of Omaha at your own peril: I am just about finished with Alice Schroeder’s epic biography of Warren Buffett entitled The Snowball. The book serves as a fabulous reminder that investors should heed the advice of their elders. At the annual Sun Valley meeting in 1999 Buffett notoriously warned the crowd that technology stocks and the equity markets appeared overvalued and that stocks were poised to deliver mediocre returns in the coming years. What happened? You might recall that the tech bubble burst and many people, especially retail investors, experienced severe wealth diminution. Then, over the next few years Buffett wrote about and spoke of derivatives as weapons of mass destruction and indicated that he believed some kind of crash would come as a result of their proliferation. If you can’t see the prescience imbedded in those statements I suggest that you review what happened to AIG and what that company’s near demise did the global financial markets.

Recently, Buffett has made “all in” bets on America after his October 2008 op-ed piece in the NY Times and his enormous purchase of Burlington Northern Railroad (BNI) in 2009. What he hasn’t said directly about some of his recent moves (but has discussed in other contexts) is that these investments are actually hedges against inflation. In an inflationary scenario the best assets to own are solid businesses that have the ability to raise prices and those that will benefit from spikes in the prices of commodities (railroads for example). The Oracle is telling people to be positioned for coming inflation. After the number of things he has gotten right over the past 10 years it would be absolutely foolish to dismiss his words this time.

1. While being early may look and feel a lot like being wrong, investors must stick to their convictions: John Paulson knows this better than anyone and the tremendous profits he made shorting the housing market serve as an example of the need for investors to stick to their guns. I saw Paulson speak in New York earlier this year and the insight into his thought process during the 2006-2008 period was invaluable. From what I recall, Paulson was early in making bets against the RMBS market and actually closed out some shorts at a loss. However, he then discovered the magic of credit default swaps as a way to profit if the housing market tanked and by staying with his investment thesis was able to make billions of dollars for his fund and himself in 2007. It would have been easy to have gotten scared out of these contrarian positions, especially when people like Ben Bernanke were swearing that a widespread housing crisis in the US was just about impossible (isn’t it amazing this guy kept his job AND got re-nominated for another four years?). Fortunately for Paulson, he had done the necessary in-depth research and understood the dynamics and risks inherent in the RMBS market better than central bankers, policy makers, investment banks and institutional investors.

What current investors need to remember is that markets are absolutely not efficient all the time and the herd can potentially be wrong for an extended period. Thus, as long as you can stay solvent longer than the market remains irrational (a big if for firms that employ a lot of leverage), you can make fistfuls of money when your thesis plays out, even if you are a bit early.

1. Risk is not the same as volatility: The distinction between risk and volatility is crucial and investors must always be on the lookout for opportunities that arise from a general lack of understanding of the difference. Risk should always be defined as the potential for permanent capital impairment. Specifically, risk implies a drop in the value of an asset. In contrast, measures of volatility are derived from fluctuations in prices and have nothing to do with a change in intrinsic value of an asset. For reasons that have to do with behavioral and structural biases, investors continue to confuse these concepts and subsequently sell assets whose price has dropped but whose value has remained intact. Situations in which selling is based solely on declines in prices are the best times to be a value investor because companies with solid balance sheets and distinct competitive advantages can fall out of favor when sentiment turns against them. This creates an opportunity for knowledgeable investors who focus on the measurement of intrinsic value to back up the truck and load up on shares of their favorite companies. Accordingly, volatility is the friend of a value investor while risk is something that needs to be guarded against. If we have learned anything in recent years it is that it’s imperative to spend time attempting to evaluate the cash flows a company will generate as opposed to a completely useless metric such as a stock’s beta.
2. Never forget that politicians’ main objective is to get reelected: What this very sobering lesson implies is that there is almost never the political will to make tough choices that will lead to short term suffering even if current sacrifices are likely to lead to future prosperity. As a group, lawmakers seem to be consistently unwilling to risk their political aspirations for the good of the country or to hold to true to their beliefs. This is especially true in elections years like 2010. However, as a result of the exorbitant cost of running a political campaign, even in non-election years our elected officials are forced to continue to raise money and become even further indebted to special interests and powerful lobbyists.

The takeaway from this perverse situation and overwhelming desire to be reelected at any cost is that investors can count on legislators and the White House to kick the can as far down the road as possible and even create laws that exacerbate the problem in the long run but serve as a potential quick fix. The perfect example of this behavior was the passing of the Medicare part D legislation, a program that Paul Krugman argues created an $9.4 trillion unfunded liability over the next 75 years. Such giveaways are a nice way to get reelected, may help boost the stock market temporarily, but could end of bankrupting future generations of Americans. Therefore, long term oriented investors must be prepared to deal with the lasting secular trends that result from knee-jerk reactions to cyclical events.

1. Relying on so-called experts—central bankers, economists, and financial pundits—can lead investors down a slippery slope: If you turn on CNBC you have the wonderful luxury of being able to hear the opinions of hundreds of people who work with the markets on a day to day basis. Since these folks spend all of their time living and breathing financial markets, they should know best, right? Well, it turns out that experts are often wrong; not necessarily because they are bad people or are fools, but because accurately predicting the future is incredibly difficult. Accordingly, investors should remember that any prognostication, no matter who it comes from, needs to be taken with a grain of salt and that person’s particular incentives and biases must be taken into account as well. In the end people need to make up their own minds based on the facts in front of them and the extensive research they have performed. Making investments by relying on the advice of strangers or as a result of minimal time invested in understanding underlying valuations and fundamentals is not much better than random speculation. As the past ten years have shown, such behavior is a fantastic way to lose money.
2. When a market dynamic does not make sense fundamentally, that probably means the trend will not last: I think this is one of the most important takeaways from the numerous bubbles we have witnesses in the past decade. If you can’t understand the rational for specific trend or the fundamentals fly in the face of that trend, you have to believe that a severe reversal or correction is inevitable. On great example I remember of one such situation occurred in early 2008 with Martin Marietta Materials (MLM). With the stock trading well above $100 a share I continued to read sell side analyst reports touting the strength of the company’s aggregate reserves and resilient revenue stream. Unfortunately, at the time the US economy was going into the tank AND there was a huge supply of aggregates coming online over the next year. Not very bullish fundamentals for a company whose stock price depended on the price of aggregates. Predictably, the subsequent free fall in the US economy caused demand to decline dramatically at the same time the company had ramped up production. Despite the bullish predictions of sell side analysts the stock proceeded to go from close to $120 in September 2008 to just over $60 in November. Now, I have nothing against the company and have no opinion about the current stock price. But, at the time the gravity defying price of the stock did not make any sense based on the very obvious headwinds facing the company.

So, when you see zombie companies like Fannie, Freddie and AIG trading way up one day or notice their prices consistently climbing higher, keep in mind that if the reason for such activity completely confounds you, it is unlikely to be based on sustainable fundamentals.

1. Sexy financial and economic models often fail to capture the idiosyncrasies of actual functioning markets: Honestly, I don’t think I can do this topic sufficient justice. If you need a refresher on why intricate models have failed so badly, check our Nassim Taleb’s recent testimony in front of Congress. Let’s just say that cute models look great on paper but when irrational people get involved, they often fail to predict how markets will react. You would think that the world would have figured this out when LTCM blew up and almost dragged all the banks down along with it. The sad thing is that companies continue to use flawed models like Value at Risk (VaR) to assess risk. Shouldn’t we have realized the models’ limits when David Viniar of Goldman Sachs admitted that the company was seeing 25 standard deviation events several days in a row? No, the world was not experiencing some tectonic shift that caused asset prices to do things that should happen once every 100,000 years. The models were just wrong and continuing to rely on them is only going to enhance the risk of an extreme tail event that would even make a black swan blush.
2. When it becomes impossible to distinguish economic theory from religious theology, economists are likely to become blinded by their own beliefs: Why did so few economists see the financial crisis coming? Maybe they were too busy calling each other names to see the unsustainable debt levels and financial company excesses building up in plain sight. While the financial crisis has allowed the behavioral economists to gain deserved popularity, it is an indictment of the entire economics community that so many people who dismissed the rational actor fallacy were marginalized by the mainstream. Now, in spite of compelling conclusions about the way irrational people impact markets, somehow many neo-classical economists continue to hide behind their theories in a curious attempt to try to explain away the recent financial crisis.

Now on to the disciples of John Maynard Keynes. Could it be that the neo-Keynesians are so wedded to the belief that unlimited fiscal stimulus and deficit spending are the only paths back to sustained prosperity that they have lost sight of the risks of such profligacy? What if the Keynesian response to the recession was the correct reaction but the magnitude of the fiscal policy was far too strong and will eventually lead to some very unpleasant outcomes? With Keynes no longer alive but still deified by his followers, could the true believers even see it if they had it all wrong?

In my view, the constant bickering between the saltwater and freshwater economists and complete inability to see the to the other side of the argument (not to mention the absolute dismissal of the Austrian school’s tenets) seems more like an entrenched religious battle in which each side believes only one methodology can be right. Unfortunately, unlike arguments about the existence of god, market outcomes are not necessarily binary and the nuanced truth could lie in between economic theories. Thus, people who are willing to defend their position in the face of mountains of contrary evidence are likely to be so biased that they cannot be trusted to assess the state of the economy.

Even more concerning is this article in the Huffington Post that argues that the Fed effectively controls, monitors and censors what is published in economic journals. That’s the last thing the US needs: formerly autonomous and free thinking economists being controlled by the banking oligarchs who have a definite inflationary and Wall Street bias. We have already seen where that has gotten us and it is not pretty.

The conclusion that needs to be drawn about those who belong to what appears to be a very closed-minded and divided economic establishment in the US is that many have been compromised and may not be the most reliable evaluators of the past, present or future global economy.

1. Leverage is miraculous on the way up and a killer on the way down: My favorite analogy regarding the risks of too much leverage comes from none other than Warren Buffett. Buffett likens carrying too much debt to driving a car with a dagger attached to the steering wheel pointed at your heart. Everything is fine until you hit a bump and that dagger goes right into your chest. Of course if you are lucky and there are no bumps for a while you can make an incredible return on your equity. However, eventually that bump in the road is going to come and smart companies and households never put themselves in a position to allow that bump to be life threatening. Further, there is some compelling data that suggests that financial bubbles are almost always driven by too much leverage. The good news is that by in large companies have solidified their balance sheets over the last two years and households are finally starting to deleverage a bit. Thus, at least in the private sector and among consumers, the dagger is slowly being pushed further away.

However, I do worry that there is one particular institution that has ignored the above lesson and has taken on far too much leverage. Who is that you ask? Why the US government of course. One risk is that something unexpected happens, the government is forced to print even more money, the deficit spirals out of control, and in the end the quality of life for all Americans is impacted. We are already fighting two wars, have thrown trillions into the financial markets, have huge Social Security and Medicare obligations and on top of all that have passed stimulus legislation in an attempt to prevent a depression. Therefore, we can ill afford any unexpected expenditures. Even now it is hard to imagine how the US will live up to all of its obligations. Let’s just hope that the economy improves, tax revenues come back, and our foreign creditors are somewhat appeased before we hit that next inevitable bump. If not, both equity and bond markets could be devastated by the fallout.

1. Wall Street wins whether the economy prospers or fails and whether markets go up or down: This may sound like populist propaganda, but it is hard to argue that this is not precisely how the last few years played out. Yes, Lehman and Bear are gone and Merrill Lynch is now a part of Ken Lewis’s failed empire. There have clearly been a few losers in the aftermath of the dramatic financial crisis. But, in aggregate, Wall Street has not only survived, but has also prospered immensely at the expense of American taxpayers and businesses. Expected record bonuses this year are only icing on the cake. When many Americans spent this Christmas wondering if they were going to lose their jobs or whether they will be able to feed their families, I’m sure many on Wall Street enjoyed a very comfortable holiday. If this seems unjust given the fact that without government assistance many firms might not exist anymore, that’s because it unequivocally is.

At the center of all of this (but not alone) is Goldman Sachs. First, Matt Taibbi documented the success of Goldman in up and down markets in his July 2009 piece. Then, just before Christmas Gretchen Morgenson alerted the masses to what the investment community already knew: Goldman consistently bet against the same clients it was selling dodgy assets to. Don’t forget that despite unemployment rising above 10% Goldman somehow managed to only lose money on trading on one singular day in the 3^rd quarter of this year. If a baseball player batted .900 or higher for 3 straight months he would quickly be crowned the greatest hitter who has ever played the game. But when Goldman accomplishes a similar feat in what used to be a zero sum game, we don’t even blink anymore.

What all of this means is that through their political connections and too big to fail status, Wall Street firms are just about guaranteed to receive favorable treatment relative to the rest of us no matter how well or how poorly the economy is doing. Thus, investors who short these firms are at the mercy of the actions of a Fed and Treasury that do very little to protect against moral hazard. In fact, at a certain point, regardless of the dubious activities such as high frequency trading and so called trade huddles, it almost makes sense for investors to give in any say, “if you can’t beat ‘em, join ‘em.” Well, I said almost.

1. The most dangerous words in investing are “this time is different” but this economic cycle in the US may really and truly be different than the recent ones: The book by Carmen Reinhart and Ken Rogoff entitled This Time is Different is on my seemingly endless reading list but I have yet to get to it. But, from the reviews and commentary I have read, the authors do a great job analyzing past boom and bust cycles and disproving the notion that individual situations are different and thus certain countries can avoid experiencing the devastating and enduring impacts of financial crises. The title of the book is obviously ironic in that the authors show that there are common factors that cause financial debacles. Surprisingly, people make the same mistakes over and over again under the false premise that their own personal or country-specific circumstances will allow for a different outcome than others have experienced. Inevitably, such beliefs end in tears.

What does this have to do with the current economic and fiscal situation the US finds itself in? Everything. First off, the duo provides lessons about governments accumulating too much debt and pinpoints what leads to sovereign defaults. Second, if the US is following the same path as Japan (as the authors assert) in terms of dealing with the insolvent banking system, why should we expect a different outcome? These are just two of the topics addressed in the book that give investors a way to understand the risks associated with investing in government debt and bank stocks, for example.

In the end, my real worry is that the title of the book has a double meaning. While financial crises and the associated lasting effects on economies may be similar, I am concerned that many policy makers are viewing this downturn as if it were a typical inventory recession that can be cured by low interest rates and some targeted government stimulus. I fear that it may be that this recession is actually different from ones like the post-September 11^th slump. Accordingly, if Reinhart and Rogoff are right and this financial crisis is going to play out like others have around the globe, the template suggests that the US’s experience this time may be dramatically different from other recent domestic recessions. What that could mean for investors is a long slog of mediocre GDP growth and substandard returns on equities as the powers that be prolong making the tough choices needed to purge the system of debt and get back to fiscal sanity.

Book review: Pat Dorsey’s “The Five Rules for Successful Stock Investing: Morningstar’s Guide to Building Wealth and Winning in the Market”

His bio per Morningstar: Pat Dorsey, CFA, is Director of Equity Research for Morningstar and author of The Little Book that Builds Wealth and The 5 Rules for Successful Stock Investing.

Book URL on Amazon: http://www.amazon.com/dp/0471686174/ref=cm_sw_su_dp

Overview:

This book is an excellent intro-level handbook for equity investing newbies. The financial analysis segments are a bit too basic for most entry-level investment bankers and research analysts, but his clear explanations of basic equity and financial statement analysis is perfect for the aspiring single stock equity investor. His suggested investing style is pretty much a by-the-numbers Morningstar approach that advises buying shares of companies with competitive economic moats at prices that provide attractive investment returns and acceptable margin of safety (pseudo Warren Buffett style value investing). The book does a good job of explaining what an economic moat is and why it’s important, and lays out some basic rules of thumb that investors can use to identify possible moats. Anyone who’s read their Michael Porter or received their MBA probably won’t find many new ideas on competitive analysis in this book, but the book’s target audience probably doesn’t have that background. Since I like the idea of helping “the little guy” out when it comes to making it easier to succeed at investing (and I read nearly every darn investing book anyone recommends to me), I’ve gone through the book and summarized a bunch of the key takeaways. My notes aren’t comprehensive and don’t cover every chapter in the book, but they probably can help you decide if you should buy the book to explore these issues in further detail.

General/miscellaneous notes:

• “Great companies create wealth, and as the value of the business grows, so should the stock price in time.”
• None of the truly exceptional managers spend time thinking about what the market will do in the short-term.

• Always build-in a margin of safety into all of your investments. You might unintentionally overestimate future prospects for a company. You should have a larger margin of safety built-into investments that are shakier or riskier due to uncertainty about the company or industry.
• Short-term holding periods are inferior to long-term holding periods: you pay higher capital gains taxes and commissions eat up a larger portion of returns, which overall tends to explain why lower-turnover/longer-horizon investors have better results over time.
• Long-term stock performance is “largely based on the expected future cash flows of the companies attached to them” and doesn’t truly relate to short-term trading action.
• If you make a bad investment and your analysis was incorrect, don’t hold on to the position, just sell it. Cut your losses and prevent a major catastrophe and take the tax break on the loss to shield other gains. Use the capital to find something that has more attractive prospects.
• Avoiding losses is extremely important: It takes a lot of winners to make up for a few big losers. A stock that’s down 50% has to then appreciate 100% to get back to flat.
• “The four most expensive words on Wall Street are ‘It’s different this time.’”
• Going against the grain (being contrarian) takes courage, but it can be rewarding. Think for yourself and try to find good bargains based on value versus price. Look at areas of the market (industries, companies) that are out of favor instead of looking at the hottest sector/stock according to the herd/press/public.
• Don’t time to try the market. ZERO funds that Morningstar follows has consistently been able to “time the market” so it’s highly unlikely that you can do it.
• Don’t try to buy ahead of “positive news flow” or “strong relative strength” because it’s speculation based on what MIGHT be instead of what WILL be.
• Cash flow is more important than earnings. Accounting earnings do not equate to cash that the company spends or receives.
• Look at FCF margin to figure out what % of each dollar of sales (on average) the company is able to turn into actual cash that the company generates in profits that are truly “free” for management’s capital allocation decisions.
• His general rule of thumb: he considers FCF margins of 5%+ indicative of a company that could be a cash flow machine.
• He states that “Academic research suggest that a firm’s strategy is ROUGHLY TWICE as important as a firm’s industry when it’s trying to build an economic moat.” [Emphasis added]

Economic Moats:

• Moat describes a firm’s competitive advantage, the moat keeps competitors from attacking a firm’s profits.
• The most profitable firms attract competition, which is why the vast majority of companies see their profitability regress to the mean. They become less profitable over time due to competition (without a competitive advantage and a wide moat).
• Moats allow a small number of companies to post above-average profitability for long periods of time, which can make them superior long-term investments.
• Companies that succeed historically rarely perform well in the future b/c success attracts competition.
• Competitors try to offer a better product (which steals away your customers and erodes market share) or they offer lower prices (which also hurts your market share and hurts industry profitability).
• Two key aspects of an economic moat: depth and width. Depth = how MUCH profits can a company generate using their economic moat. Width = how LONG can a company sustain above-average profitability. Dorsey correctly notes that just being able to segment the duration of a company’s CAP into “a few years, several years, and many years” is extremely helpful in terms of thinking about a company’s prospects over time.

Steps to analyze a company’s economic moat:

1. Evaluate returns on capital over time to see if the company can consistently generate profits that are acceptable and in excess of their cost of capital to create and maintain their enterprise. He considers consistent ROEs of 15%+ indicate a possible economic moat.
2. Evaluate the company’s competitive situation in terms of the industry, its competitors, and what the company does that keeps competition away. Ask why competitors aren’t stealing away customers and why couldn’t a competitor charge a lower price and succeed? Do customers accept price increases, and how often and how large? What value does the product offer the customer? Why use one company’s product and not a competitor’s? Are industry sales generally increasing or is the industry in decline? Are firms consistently profitable or is profitability cyclical? How concentrated is an industry in terms of number of competitors or the influence of key competitors? How profitable is the average industry participant?
3. Estimate and evaluate a company’s CAP (competitive advantage period), which is how long a company can fend off its competitors.

Methods to create a sustainable competitive advantage:

1. “Creating real product differentiation through superior technology or features” and offer customers the best product they can find. The best product usually enables companies to charge customers a premium price, which enables solid profitability. However, Dorsey notes that it’s very difficult to continuously beat out competitors by always having the best product, and it’s expensive to do so, so very few firms can use the “better mousetrap” strategy to create long-term excess profitability.
2. “Creating perceived product differentiation through a trusted brand or reputation” that motivates customers to pick the company’s product faster or more easily. He cites Tiffany jewelry as an example: the famous blue box allows them to charge huge premiums for products that can be reproduced identically from a quality perspective and yet people still pay the Tiffany premium. Point being: the brands that are actually VALUABLE increase a customer’s willingness to pay an above-industry-average price for a product. Additionally, Dorsey correctly points out that some brands are very well established but don’t help a company produce excess profits, whereas some brands actually motivate the customer to pick a certain product or to pay a higher price. I think Warren Buffett’s commentary about Berkshire Hathaway’s business when he first invested in the company is worth reiterating here: Even though Berkshire was an established industry leader in producing suit linings with a large and stable customer base, if they had tried to raise their prices by even a tiny amount they would have assuredly lost business to other companies. Lastly, Dorsey notes that valuable brands are expensive to maintain, and require a lot of advertising expenditures to support (think about Coke or Ralph Lauren).
3. Being the lowest-cost provider of the product by being the lowest-cost producer of the product. This is “an extremely powerful source of competitive advantage” because it takes a long time to develop and is hard to replicate (think of Walmart). In commodity industries like airlines and PCs, products are very hard to differentiate in terms of clearly superior value versus price, which means “low-cost strategies work especially well in these types of markets.” Low cost production advantages come from the development of more efficient processes or reaching larger-scale production that enables lower-cost acquisition of inputs required to produce the end product. Dorsey notes that scale advantages are especially valuable because they’re hard to match because as scale gets incrementally larger the benefit in terms of incrementally lower cost becomes greater (so it’s somewhat self-sustaining). The scale benefit “comes from simply leveraging fixed costs-in other words, spreading the cost of an asset such as a factory across an even-larger sales base.” Clearly, I could have rephrased that to avoid having to use quotes but the author’s words are perfectly to the point. This concept is extremely important to understand: if it costs you the same $1 million per year to run your factory/machine/business, you produce a heck of a lot more profits if you use that same factory to satisfy $5 million worth of sales than if you had $2 million worth of sales, because the “fixed cost” of keeping that factory running is roughly constant.
4. “Locking in customers by creating high switching costs” that discourage them from using a competitors product. Dorsey calls this “possibly the subtlest type of competitive advantage” because you have to fully understand the customer, the sales process, the product usage and life-cycle, and all the other variables that play into why a customer tends to stick with one company instead of using another one. The best ways to create “lock-in” is to make it either very expensive or very time consuming to switch to a competitor’s product, which enables a company to charge more for their product or to hold onto customers for longer-periods of time. Learning and training required by customers for a company’s product creates a lock-in, because the training and familiarity means a competitor has to have a very compelling reason why their product is worthy of starting over with. Three other pieces of evidence that Dorsey states can create lock-in include 1) tight integration of your product into a customer’s business process or their product, and 2) if your product is the “industry standard” like Adobe’s Photoshop (everyone basically HAS to learn to use it), and 3) does a company have long-term contracts with their customers?
5. “Locking out competitors by creating high barriers to entry or high barriers to success” that discourage them from even trying to compete in the industry or raising the likelihood that competitors will fail if they do try. He points out two basic ways to lock-out competition: government regulation that determines whether or not competitors are allowed to operate in an industry/market and patents that legally protect a product from competition for a period of time. Dorsey spends more time talking about the power of “network effects” and how they tend to be a more durable way to lock-out competitors by locking-in customers. A network effect is produced when the more users a company’s product has, the more valuable the company’s product is to each customer. Good examples include eBay and some of the financial exchanges: more buyers and more sellers make the market more vibrant and more valuable in terms of selection, lower price, or ease of transaction.

Some of Dorsey’s suggestions when conducting company financial analysis (for beginners):

• Look at the ratio of depreciation versus capex as a way to see if the cost of maintaining the company’s infrastructure is increasing or decreasing, and it can help spot rising allocation of capital into the business instead of returning capital to shareholders or reducing debt loads.
• Watch accounts receivable and how it changes relative to sales. Is the company booking sales that it hasn’t actually collected money for? Is there a potential accounting issue, or is the company easing its credit/payment terms to try to win new business because competition is increasing?
• Inventory falls into three buckets: raw materials, partially finished goods, and totally finished goods. All or none of them might be worth a lesser amount than the company thinks, or lesser than the value that the balance sheet indicates (although conversely they could clearly be worth more, particularly as it relates to LIFO/FIFO accounting and the trend in industry pricing).
• Inventory is a use of capital. You have to spend money to buy inventory that sits in a warehouse until it’s used in production and then sold, so you spend money before you get paid for a sale. For non-finance pros, this is a very key piece of what we call a company’s “working capital cycle.” The faster a company can buy inventory and sell it to a customer and actually receive cash from the customer, the better the profitability and cash generation of the company. The less time your cash is invested in inventory that has not been sold or has yet to be produced, the longer you can’t use that cash for something else, which is why we call it a “use of capital.”
• Dorsey advises being extremely skeptical of the value of “intangible assets” as listed on the balance sheet. I couldn’t agree more. Because the majority of M&A activity has historically proven that acquiring companies overpay for the companies they buy, the positive value for intangible assets like goodwill is highly uncertain to be justified over time, and it has little “cash” value in the short-term.
• Make sure you fully understand what goes into a company’s COGS (cost of goods sold) so that you fully understand a company’s gross profitability. COGS is composed of raw material costs, labor costs, cost of services to provide the product, and several other pieces. Some of them vary a lot with a company’s level of sales, while some of them might be relatively stable regardless of production volume and sales, which means that gross margins usually do not stay the same as a company expands and shrinks and deals with a dynamic marketplace.
• Be mindful of the difference between the basic and diluted share counts. The diluted share count reflects any stock option or convertible bond that can be turned into actual new shares of the company’s stock, which means that an investor’s % ownership of a business goes down when dilutive securities are exercised/converted. Stock options are still a very popular employee compensation tool these days, and they can materially lower non-employee ownership stakes in economic reality.

Some of Dorsey’s pointers for analyzing a company as an investment and its overall economic prospects: *Note: I’m leaving out a ton of stuff b/c it’s a waste of time for me to type it up, so I’m gonna stick to the more important or less-obvious things.

• Be mindful of the risks and bear case for an investment. What are the risks? What are the best reasons NOT to invest? What’s the PROBABILITY of minor AND major “bad things” happening? Carefully examining the risks and bear case can help you make MORE money if you’re right and the bear case does NOT come true because it can serve as a reference to spot situations when the risk a company faced has actually gone away or is lesser, which might be a great time to add to your position knowing that the overall probability adjusted return is higher.
• Sales growth only comes from 3 sources: 1) gaining more customers in your addressable market or selling more of your product to your existing customers, 2) raising prices for your product, and 3) buying another company to add its sales to your own (inorganic growth).
• Dorsey is correctly very skeptical of corporate M&A. The historical track record indicate that the majority of acquisitions don’t produce gains for the acquirer. M&A made harder by the size of the company being acquired, because it’s more difficult to fully examine its business inside and out. M&A also takes time and money, which means it can be a distraction to your existing business and it costs money to pay bankers and lawyers to get deals done. M&A activity often means the financial statements drastically change after the acquisition is complete, which makes it easier for management to make questionable accounting changes without attracting the appropriate skepticism from investors and analysts, and it also makes analyzing the original business more difficult (tougher to parse-out true organic growth from inorganic growth).
• Dorsey is somewhat skeptical of companies that report lower tax rates or buyback their shares because they may not be sustainable over time. If the tax rate decrease is relatively permanent, I think it’s basically a clear-positive, and if repurchasing shares is a key piece of managements decision to allocate capital by returning it to investors then it’s not necessarily a one-time event.
• Return on assets (ROA) is important to keep tabs on, because it reflects a company’s strategy and cash flow generation capabilities. Companies can either charge high prices to boost margins and maximize the profit the generate from using their assets, or they can maximize volume of production to produce a greater number of cash flows to the company and more frequently “turn over” the company’s investment in assets.
• Return on equity (ROE) is more important to monitor for equity investors because examining the equity portion of the capital structure reflects the portion that is “owned” by common equity shareholders. Companies can issue debt which produces cash to buy assets, but it creates a liability that must be paid off before equity shareholders can benefit from either a firms profits or the value of a firm in the event of its liquidation. That means that financial leverage (using debt) is a key variable in ROE, and is most simplistically assessed by the ratio of a company’s total assets to its equity. Debt is important because it’s essentially a fixed cost of doing business, meaning each year the company has to pay a certain amount of money out to debt investors in the form of interest, and this interest is owed whether the company has a good year or a bad year (and even if a company loses money). That means that there is leverage in taking in money from debt investors and using it to try and generate much more profits, but the big risk is that if profits decline or turn negative then the cost of debt can become an existential issue of business survival. Leverage magnifies gains and losses: it works both ways and raises the possibility of both much better and worse outcomes.
• Return on Invested Capital (ROIC) is the most important piece of analyzing a company’s returns. ROIC reflects the capital a company uses that comes from equity, debt, and quasi-debt produced in the course of doing business like certain types of leases and payment plans. ROIC also measures profits using an after-tax number that ignores the impact of interest on net profits, which means those profits are theoretically available to benefit both debt and equity holders. NOPAT requires some subtle and tricky tweaks (as does Invested Capital) but it’s worth studying if you’re not familiar with it.

Dorsey’s suggestions to spot and avoid financial accounting tricks:

• Watch out for declining cash flow. Monitor FCF as a % of net income to see if accounting earnings are not keeping up with our questionably exceeding actual cash flow.
• Repeated charge-offs can indicate accounting tricks b/c mgmt can hide questionable results or accounting inside a big restructuring charge.
• Frequent M&A: financials get murkier and it can get harder to examine the fundamentals of the existing business.
• CFO departures can signal possible accounting problems, especially if the CFO isn’t leaving to take another opportunity that seems desirable.
• Problems with billing and receivables and payables: watch how AR changes in relation to sales, they should move roughly inline with each other. Keep an eye on the “allowance for doubtful accounts” which is a reduction in accounts receivable made at the discretion of management for bills that they expect might not get paid. Management might be overly optimistic regarding their customers’ ability to pay their bills.
• Gains from investments that are one-time or unusual. They’re usually not sustainable or repeatable.
• Pension problems: if the pension’s assets aren’t of adequate size to service the pension expenses, a company might need to allocate capital to the pension instead of into the business or to returning capital to shareholders. Pension income can also be a problem, because it’s not actual income that’s available to the company or to shareholders, so it can also be an issue. This income is dependent on the performance of stock and bond markets, not a company’s operations.
• Problems with inventory: Overstocked warehouses indicate that either a company is allocating too much capital to inventory or that a company is unable to sell its products the way it has in the past, which means that either the business might face declines or the company might have to discount its product prices to sell excess inventory, which then pressures profit margins.

Some of Dorsey’s tips on investment valuation and returns:

• P/E multiples are not as important as some might think: “Over the entire twentieth century, Bogle found that the 10.4 percent average annual return of US equities broke down into 5 percentage points from dividends, 4.8 percentage points from earnings growth, and just 0.6 percentage points from P/E changes.” The point is, look for dividends and look for growth, and don’t overly rely on changes on company P/E’s when you assess the attractiveness of long-term equity investments. It means you should focus on generating an investment return regardless of what happens with multiples and focus on a company’s fundamentals.
• Don’t rely on Price/book multiples for service firms and only place major importance on P/B for financial firms.
• Examine the cyclicality of a business and its profits, so that you value a firm based on its ongoing results and not the results from one segment of its product/industry/macro cycle. Think about what earnings look like peak-to-peak to assess upside and trough-to-trough to assess downside.
• Cross-reference the FCF yield of a company’s stock versus its corporate bond yields. If the yield of the stock is significantly greater than the yield a company’s paying on its bonds, then it’s a sign that the equity shareholders should expect excess profits to benefit them over time.
• When assessing the value of future cash flows generated by a company, you have to consider the amount, timing, riskiness and volatility of those cash flows.
• When determining appropriate discount rates for determining the present value of a company’s future cash flows, adjust for size (small companies are riskier and have more volatile results), leverage (highly leveraged firms have greater risk of distress), cyclicality (cyclical firms have less predictable cash flows), corporate governance and mgmt skill (trust and demonstrated skill are very important), an economic moat (wide and narrow moats should significantly influence the discount rate), and complexity (the less-certain your analysis is, the higher the discount you should place on a company’s future cash flows).

Dorsey then goes on to evaluate the major business sectors/industries and give an overview of how to look at them, and it’s not worth it for me to summarize each of them because either I personally care about only a few or already know what he’s talking about, or other investors might have different interests than myself.