Wednesday, June 24, 2015

A Dozen Things I Learned from Todd Wenning About Investing

Todd Wenning is leaving Morningstar for another post in the investing world. Not sure if he will be able to post as much going forward, so this seems a good time to summarize the lessons I, and I am sure many others, have learned from his work.

1. Importance of Dividends
Dividends are everywhere now, but Todd has been writing about dividends for a long time. A lot of what I learned about the importance of dividends comes from Todd's work. These include focusing first on the moat, which is more important than the dividend itself, signs of what companies to avoid, and minimizing transaction costs.

2. Think Different
Most guidance on dividends includes the safety check for how sustainable the dividend is. These guidance pieces almost always point you in the direction of the Payout Ratio. This is a good indicator to check, but its based on earnings. Todd points out that free cash flow is the more important metric for dividend investors.

"Many companies and investors primarily focus on earnings cover (earnings per share/dividends per share or net income/dividends paid). As such, earnings cover is also important to consider, but "earnings" are simply an accountant's opinion of the company's profits and not necessarily a good measure of cash flow. In fact, a company can have sufficient earnings cover but negative free cash flow cover.

Because dividends are paid in cash, we want to use a metric that helps us measure cash inflows and outflows. That's what the free cash flow cover metric can do.

Free cash flow is how much cash flow is left over each year after the company has reinvested in its business. Think of it as spare or surplus cash flow. It's from these surplus cash flows that dividends, buybacks, debt repayments, etc. are funded."

3. Think Small
Morningstar is a great service with a lot of useful information. However it has one gap - lack of small cap coverage. The fundamental construct that Morningstar uses to assess companies' durability is the economic moat. For sure, there is a good case to be made that the moat concept is just as relevant to a small cap as it is to J&J. Todd wrote a series on Small Cap Moats, that uncovered lots of interesting smaller companies from WD-40 to Badger Meter, there are a lot of interesting ideas in this space.

The goal of the Small Cap Moat series is one that resonates with individual investors:

"identifying smaller firms that exhibit moatworthy characteristics and are run by skillful management teams. This is a promising combination for any company to have, but it’s particularly attractive for smaller companies with long growth runways, as they have the ability to compound shareholders' capital at high rates of return over long periods of time."

4. Look Outside the US
Investors should not limit their holdings to the US. Many companies in general, and dividend payers specifically exist out side the US. Go where the opportunities are.  Further some of the more interesting investors to follow are outside the US, for example Neil Woodford. Todd uncovered a number of Woodford quotes I really like this one:

"In the short-term, share prices are buffeted by all sorts of influences, but over longer-time periods fundamentals shine through. Dividend growth is the key determinant of long-term share price movements, the rest is sentiment."

5. Make Tools  
Churchill said we make our buildings and then they make us. The same is true in investing. We make our analytical tools and our tools make our portfolios. Todd published the Dividend Compass tool which is a great way to analyze the key data to dividend investors and monitor changes.

6. Separate Income Investing from Value Investing
Like a lot of people, I came into dividend investing thinking about it as a subspecies of value investing. I like both styles of investing, but unless we are talking about 2008-11 timeframe its pretty hard to find great bargains on dividend payers.

Todd's post Income Investor Manifesto gets to the heart of this distinction:

"a high yield can sometimes be indicative of an undervalued stock, but the objective of a pure income strategy differs from value investing in that its primary focus is to generate a growing and sustainable stream of dividends. Capital gains are an important, yet secondary concern. For value investing, the opposite is true -- indeed, companies don't necessarily need to pay a dividend to make it an attractive investment to a value investor.

Further, income investing has a distinct research process that focuses on a company's ability to sustain and increase its dividend. Where value research typically begins with a company's balance sheet and growth research starts with the income statement, dividend research commences on the cash flow statement.

From the cash flow statement, for instance, we can determine free cash flow coverage, earnings coverage, how the company approaches dividends versus buybacks, debt repayment trends, acquisition trends, and more.

This analysis is critical in determining a company's dividend health and therefore the cash flow statement is the necessary starting point for dividend research."

7. Be Long Term
Lots of people "talk" long term, but its even more important for dividend investors. Further, individual investors do not have many advantages, but the ability to be long term is one absolutely one. Buying high quality + high yield and holding for the long term really works. Todd says it well-

"Individual investors, on the other hand, don't have to worry about underperforming in a given year and can thus maintain a patient and long-term focus. You can hold a large cash position or take a contrarian position, for instance, and give your thesis a few years to play out without worrying about investors pulling money out of your fund."

8. What to Avoid
Todd advises to ask yourself these questions before investing:

  • What do I know about this stock that other investors don't? 
  • Does this company have a sustainable competitive advantage? 
  • If the stock loses 50% of its value over the next three years, what happened? 
  • In two minutes, can I explain to a friend how this company makes its money?
  • When will I sell this stock?

Not only are these solid questions to ask, they also get to get to a critical issue - mistake avoidance. Asking these questions helps to ensure that that you have a margin of error in your own thinking process.

9. Learn from Your Mistakes
Mistakes are inevitable, learning from them is not. One way to try and learn is to first recognize your mistakes and identify where it went wrong. Todd revisited his purchase in Tesco that did not work out.  Buffett also got burned on Tesco. Interestingly enough I was looking at Tesco around the same time, and the thing that convinced me not to invest was the metrics that Tesco showed on Todd's Dividend Compass tool.

Suffice to say, the world in general and investment world in particular is rife with people talking about their success and ten baggers, but the mistakes get somewhat less review.

In the case of Tesco, Todd summarized the key lessons learned:

  • When you find yourself making a lot of excuses for a company’s missteps, it’s time to reevaluate your investment thesis. Remember, you don’t work for the company and there’s no reason to spin bad results in a positive light. Call them as you see them. 
  • If a company holds its dividend flat after years of steady growth, it’s likely a sign that the competitive landscape and/or company’s strategy has changed. The board and management are clearly not confident in their medium-term outlook. Something is up. 
  • When figuring out when to buy or sell a stock, don’t concern yourself with which investors are also buying or selling the stock. Fund managers with large assets under management can have very different investment criteria and objectives than you and I do. They can also make mistakes like anyone else. 
  • Forget the price you paid for the stock. The question you need to answer is, “Would you buy the stock today?” Anchoring is a powerful behavioral bias. To combat anchoring, write down your original thesis and periodically review it and update your assumptions. Has anything materially changed? 
  • Even a solid research process can have a poor outcome. On average and over time, a good process should yield better results, but on a case-by-case basis this isn’t always true. Learn from the poor outcome and move onto the next investment.
10. Share Ideas
Harold Edgerton developed a number of ground breaking technologies, including high speed strobe, and ran one of the major labs at MIT. His motto was ""Work like hell, tell everyone everything you know, close a deal with a handshake, and have fun."

There are a lot of investment analysts out there, but not many share as much insight and tooling as Todd has. I suspect that like Shelby Davis observed years ago, there is a lot of value to the person sharing because it forces more rigorous thought. Virtuous cycle.

11. Process Matters
I think processes are unlikely to automagically turn up huge ideas, but what processes are very good at is mistake avoidance. That matters in any kind of investing, but mistake avoidance matters even more in dividend investing. If you are a biotech investor you know going in that you will flame out half the time, but you have some huge upside on the ones you are right on. In dividend investing, you are not going to see the huge upside this decade, so you have to stay in the game and avoid losers.

Todd's good process traits:

Stoic: It can endure both good and bad short-term outcomes without getting emotionally swayed in either direction.

Consistent: It doesn't adjust to current market sentiment and sticks to core competencies. 

Self-critical: The process is periodically reviewed, includes both pre-mortem and post-mortem analysis on decisions, and is refined as needed. 

Business-focused: Rather than rely on heuristics like "only buy stocks with P/Es below 15," a good investment process focuses on understanding things like the underlying business's competitive advantages (if any) and determining whether or not management has integrity and if they are good capital allocators.

Repeatable: A process gets more valuable with each application -- insights are gained, deficiencies are noticed, etc. 

Simple: The less complex, the better. If you can hand off your process to another investor without creating significant confusion, you're on the right track.

12. Simplicity and Patience Win
Processes are great at limiting errors, but what about finding excellent ideas? Search strategy should seek out different ideas. But what are we really searching for? The answers have less to do with advanced math and more to do with investor behavior:

Investment + good company + right price + patience

Without the investment, for instance, nothing else happens. I know this is obvious, but bear in mind that only about half of American households own stocks at all. Not everyone is taking that first step and planting the seed.

It's also a matter of where the seed is planted. Just as rocky soil wouldn't allow a tree to grow to its full potential, investments in poorly run companies will likely struggle over long periods of time. Instead, look to own good companies -- that is, firms with durable competitive advantages and strong financials that are run by able and trustworthy management teams. It's these companies that will give your investment the best chance to grow over the long-term.

Good companies should also be purchased at the right prices, of course, just as an apple tree needs to be planted in the right type of climate. As I noted in this post, an investment can be made in a good company and held patiently, but if it was bought at too dear of a price, it won't yield as much as the same company bought at a discount.

The final step is the trickiest one of all. Having the patience to hold a single investment for more than a few months isn't easy, let alone a few decades, yet you wouldn't tear down a tree for not producing bushels full of fruit right away, would you? It's only over longer periods of time that both yield great rewards."

As Todd is moving on to other things, I am glad I took the time to distill a lot of lessons I have learned from his work. I am also glad that even though he may not post as much, these are lessons that do not have an expiration date and so individual investors like me can leverage them for a long time down the road.

Saturday, June 13, 2015

How to Lie with Statistics

This is a book that two of my favorite people report that they give as their holiday gift of choice. Bill Gates recommends it on his summer reading list. After finishing How to Lie with Statistics, I can see why.

Just on the craft part of writing, the book is a great example for how to communicate important but dry concepts in an engaging, entertaining way.

"Permitting statistical treatment and the hypnotic presence of numbers and decimal points to befog casual relationships is little better than superstition. And it is often more seriously misleading. It is rather like the conviction among the people of the New Hebrides that body lice produce good health. Observation over the centuries taught them that people in good health usually had lice and sick people very often did not. The observation itself was accurate and sound, as observations made informally over the years surprisingly often are. Not so much can be said for the conclusion to which these primitive people came to from their evidence: Lice makes a man healthy. Everybody should have them"

Huff's book is written in a tongue in cheek way as if the reader wants to use stats for a tool to fool other people, of course plenty of people do do this. It can be hard to tell the difference. The current age has so much data, but far less quality analysis and consequently we have very little information relative to data we are awash in.

"It's all a little like the tale of the roadside merchant who was asked to explain how he could sell rabbit sandwiches so cheap. 'Well' he said 'I have to put in some horse meat too. But I mix 'em fifty-fifty: one horse, one rabbit.'"

Anyone who has tried, say, Kona coffee and Kona coffee blend can relate to this. Statistical models are often wielded to distract from important points. As Sherlock Holmes said "there is nothing more deceptive than an obvious fact."

As to investing, we need look no further than dividend yield to see a great example of misleading stats. Once a yield gets too high, say triple the current S&P yield, you are generally in "sucker yield" territory. The company that says its going to payout 8% dividends today should not be taken at face value, and in fact it should be looked at as a negative, because once you look at the quality metrics you are likely to find the company will have a hard time delivering on that number.

The last chapter should be required reading for any citizen, frankly, as a self-defense mechanism in the so-called information age. Its a set of rules for how to talk back to a statistic, always ask:

  • Who says so?
  • How does he know?
  • Did somebody change the subject?
  • Does it make sense?
I might add to this list - how can you test this to see if the trend holds or not? The reason I see this book as required reading is that people with agendas are wont to throw out stats to prove their point, if you do not ask these questions you miss important points. 

I will give Mr. Huff the last word:

"Encephalitis cases reported in the central valley of California in 1952 were triple the figure for the worst previous year. Many alarmed residents shipped their children away. But when the reckoning was in, there had been no great increase in deaths from sleeping sickness. What had happened was that state and federal health people had come in in great numbers to tackle a long-time problem: as a result of their efforts a great many low-grade cases were recorded that in other years would have been overlooked, possibly not even recognized."

Tuesday, June 9, 2015

Markel Brunch Notes

I spend most of my time in investing looking for excellent dividend growth opportunities. However, there are two exceptions to this. One is Berkshire Hathaway, why should investors want a dividend from a company that has Warren and Charlie reinvesting the cash? The other exception is Markel.

I have been attending the Markel annual brunch in Omaha since about seven years ago. When I first started going, there were maybe 50-60 people in a small room like you might have for a regional sales meeting. Not so much any more, now its in the many hundreds.  The investing world seems to have caught on to what they are doing.

The meeting is the day after the Berkshire meeting in Omaha. Mohnish Pabrai mentioned that when he got started investing he was surprised that in an industry with thousands of funds, no one was copying Buffett and Berkshire. Likewise, Steve Markel, Tom Gayner, and the gang at Markel noticed that you could clone not just the investment approach, but the overall business model.

To recap, Berkshire is a three legged stool that starts with cash coming from insurance. Buffett really made his name by reinvesting the float intelligently into stocks (not just bonds like most insurers). The third leg is wholly owned businesses like See's Candy, Burlington Northern and many others, which now eclipse the stock part of Berkshire.

Markel has been successfully cloning the first two parts of this model for many years. The insurance operation regularly turns in excellent performance.  Over on the investment side, the past 15 years, Tom Gayner's stock portfolio has returned 11.3% versus the S&P 500's 4.2% performance. Really just those two legs of  the stool comprise a fundamentally quality operation. However, recently Markel has added the third leg - wholly owned businesses - through Markel Ventures. This collection of varied companies (everything from channel dredging to Belgian waffle makers) has been very interesting to watch unfold.  From the Annual Letter:

"From the start in 2005 when we purchased 80% of AMF with its roughly $60 million in revenue, Markel Ventures ended 2014 with revenues of $838.1 million and Adjusted EBITDA of $95.1 million. Markel Ventures now stands as a real, and meaningful contributor to the wealth creation underway at Markel Corporation.

Markel Ventures does two things for Markel. One, it gives us another option for capital allocation decisions. Secondly, it makes a bunch of money. As one frame of reference for that statement, consider Markel Corporation 10 short years ago. In 2004, we earned underwriting premiums of just over $2 billion and underwriting profits of $72 million. While the language used to describe underwriting profits from insurance operations, and cash flows from non-financial businesses, are different, it’s not that hard to translate. Underwriting earnings are generally comparable to Earnings Before Interest Expense, Taxes, Depreciation, and Amortization. They equal the acronym EBITDA. In 2014, the Adjusted EBITDA of Markel Ventures, which also excludes a non-cash goodwill impairment charge of $13.7 million, totaled $95.1 million. This stuff is starting to add up."

There is a more complete set of notes from the annual brunch meeting here, but I wanted to share my observations as well:

* The last question of the day was the best and most insightful. The question was - "what do you want Markel to become." Tom Gayner confirmed what I think a lot of long time Markel followers thought when he said - "we want Markel to be one of the world's great companies. That's what we want to be when we grow up." That's a heady statement and it was a great way to close out the meeting. When you step back from it, it makes sense. After all Markel has in place all three legs of the Berkshire model in place. Berkshire is indisputably one of the world's great companies. Now Markel's own snowball is rolling, why not aim high?

* Commenting on Markel Ventures, Steve Markel said that like Berkshire they want to buy well run businesses. They do not want to parachute in people to fix them. (Makes sense - Hard to imagine insurance people fixing a dredge or waffle making business)

* When Markel bought Alterra, they took on investments that were mainly in bonds. They are working their way towards more stocks, currently the combined portfolio is around 50% stocks, and could trend as high as 80% eventually

* You get a good sense for the culture at these events. Markel CEO Alan Kirshner says its ok to make mistakes, just don't make the same dumbass mistakes. Steve Markel described a key to Markel's strength as - "we don't believe our own bullshit." Steve Markel said that if you were the kind of person to sell off Markel shares when you got them to buy a boat, you probably wouldn't fit in.

* Incentives and metrics came up - Gayner pointed to Exxon's vesting policy which is spread out over ten years as a good model. He also said that rate of book value change is the "Least worst" way to measure management success in Markel's case.

In 2005, Markel's Book value per share was $176/share. Today it is more than triple that at $564. Considering the turbulence of the past decade, the three legged stool not only weathered the storms, Markel thrived.

Wednesday, June 3, 2015

Neil Woodford BBC Interview

Neil Woodford does not get covered all that much in the US, but there is a lot to like about his approach. Todd Wenning's excellent Income Investor Manifesto post really gets at the heart of the subtle yet crucial difference in the Income investor approach compared to value investing and growth investing schools.

Todd's post clarifies the strategic difference very well. I would add one other factor - its a far easier approach for investors aka humans, to use. A colleague whose work I admire set up his portfolio to invest in very boring, yet essential dividend growth companies. The companies performed well and he has beaten S&P for several years. But the true value revealed itself recently when sadly there was a major family event and he was unable to closely monitor his portfolio. Yet the companies plugged away just fine. This point is lost on a lot of people - there are many things way more important than investing. Your personal and work lives will intervene, and you will very often not have time or inclination to process random events. Tesla may be a great company, but do you want to have to dig through the car fire issues when work is crazy or a major personal event comes along?

In general, a simple hedge against all that is to go for patient quality. Find companies that do not require a twitchy sell finger, hovering over every monthly report, and are unlikely to produce a lot of unclear decision sets.

Woodford's fund just completed its first year, and it thumped the market with a 21% return. The old school ways still work. Its worth noting that US investors can easily clone Woodford's approach.

Recently, Woodford was interviewed on BBC HardTalk here are some snippets:

[Buffett says if you don’t feel comfortable owning something for ten years, then don’t even hold it for ten minutes] 

Woodford: I couldn’t agree more, that’s the right philosophy. My investment holding period in my old firm was way beyond ten years. It was as high as fifteen years at one stage…My discipline is to focus on the long term

[So that’s the enemy of faddishness in investing then, because if you are thinking in those 15-20 year chunks of time, then what is hot today is really irrelevant to what you are doing]

Woodford: Yes. And having a very clear discipline on valuation. Making sure you don’t overpay for an investment. I think there are plenty of very good companies that will make very bad investments because the valuation reflects that they’re very good companies. My philosophy is to marry a very strong investment discipline of focusing on valuation with that long term approach.

[Where are the best places to put money today?]

Woodford: 70% of the earnings of UK companies come from non-UK sources. So where the companies are located doesn’t necessarily guide you to where the earnings and cash flows accrue from. So you can get a very internationally exposed portfolio by just investing in the UK. So to some extent I think more about what are the industries and the companies rather than do want to be in emerging markets or Latin America or North America or Europe or whatever. That’s always been my approach.


Woodford points out one of the key risks in Income Investing - overpaying.To build on Todd Wenning's manifesto that distinguishes income investing from value and growth:

I suggest to add another row- Key Risk

  • Value Investors
    • Key Risk - Value Trap
  • Income
    • Key Risk - Overpaying for quality
  • Growth
    • Key Risks - insert much time do you have?  
This further illuminates the appeal of patient income investing. Plenty of things can go wrong with growth investments and you have to watch closely how events unfold to tell the difference between a hot new thing and a flash in the pan. Value investing is filled with companies that could turnaround but for different reasons never do. The key downside in Income investing - overpaying - is one of the easier risks to avoid in that the earnings and cash flow based valuations based against historical norms can give investors very useful clues.

The Key Skills required show some variation too. For Growth investors, its about trendspotting. For value investors its contrarian insight or variant perception. For Income Investors its largely buy quality, i.e. don't overpay, and then sit on your ass for long periods (decades) of time.