The Wine Cellar - Brett Arends on Bunting's Laws

The Wine Cellar series journals investing analysis that I find valuable over the long haul. This entry is more like a nice warm pint of ESB. One hidden gem I came across last year is Brett Arends' account of Bunting's laws - 12 stock investing rules for the next forty years.

One of my favorite aspects of these rules is that the first seven rules are on reasons to avoid investing in companies:

1. Sell stocks of companies that announce huge acquisitions, that overdiversify, or that spend a fortune on a lavish new headquarters.

2. Avoid stocks where management picks fights with analysts (or, by extension, hedge funds). See Overstock.com in 2005; Netflix in 2010.

3. Watch out when executives start selling a lot of stock — regardless of plausible-sounding excuses. Top execs in homebuilders, mortgage underwriters and Wall Street dumped billions before the 2008 crash.

4. “Run a mile” from all stocks in an industry going through a huge investment boom: Massive overcapacity and consequent collapse is inevitable.

5. Steer clear of investing in manufacturing companies. Their industries are usually plagued with extreme cycles of boom and bust, overcapacity and slumps.

6. Pay little attention to economists or market gurus.

7. Mistrust all mathematical trading formulas as well — they invariably fail just when you most need them to work.

A current example of a violation of rule #1. Coach (COH) is a company with a lot to recommend it from an investment standpoint. Its been a leader over many years, trades for a bargain valuation (15 P/E), excellent margins  (20% Net Margin), Return on Equity at 47%, and no debt. What's not to like? This - a new $750 Million Headquarters.

As much as the valuation metrics are appealing, spending nearly one billion dollars on a new HQ sounds to me like the opposite of shareholder focus. Rules like Bunting's Laws serve as a critical checklist to get investors to think beyond just the numbers and look at behavioral and other factors.

As Brett Arends' wryly notes "Not all of Bunting’s Laws are about stocks to avoid.":

8. Look for companies where the insiders are buying lots of stock.

9. Look for companies generating a lot of cash — a great sign of sustained outperformance.

10. Look for companies which have monopolies (or near monopolies), and those which manage to take out their main competitors.

11. Remember you are buying businesses, not just stocks. Pay close attention to the quality of the business, and especially the quality of the management.

12. Look for companies which have earned the trust of consumers, and which have very strong brand names.

As to rule #8, insider buying is always a welcome sight. Recently, Kinder Morgan (KMI) was recently targeted by short seller. Last week, two insiders responded vigorously to the 6% drop. CEO Rich Kinder bought 500,000 shares and Director Fayez Sarofim bought 283,000 shares. Its always good to see management aligned with outside shareholders.

Investing relies heavily on analyzing financial metrics, but we have to go inside the numbers to better understand what's going on. In addition, the numbers out of context may not give a full picture and lead us to take undue risk. Think of the great looking metrics companies in the housing industry had leading up to the crash. For this reason its essential to have a combined view of the financial metrics with checklist like Bunting's Laws, the fact that the Laws are weighted with things not to do is a great example of how these rules are most helpful to the investor.

Its true that not all of Bunting's Laws are about stocks to avoid, but the laws on what to avoid are the most valuable because they illustrate traps for the investor to avoid and enumerate reasons to eschew investing in companies with otherwise compelling metrics.