The Single Biggest Mistake Investors Make
Paul Samuelson put it best when he said investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas. The biggest mistake people make when it comes to investing is looking for sexy stocks. These are stocks that are always in the spotlight and always in the news. Sexy is great if you are looking for lingerie, a mail-order Russian bride, or an Italian sports car – but it has no place in investing.
Here are three steps you can apply to avoid falling into the "sexy trap".
Step 1: Invest in a Business Any Idiot could Run
The more simple the business the better. Warren Buffett, the great American investor, never invests in a business he does not understand. This wisdom, or lack thereof, helped him avoid the dot.com bubble. He avoided investing in technology companies because he did not understand them.
Peter Lynch echoed this in his book "One Up On Wall Street" – a fantastic insight into the world of simple and common sense investing. Lynch said that you should invest in a company any idiot could run because pretty soon an idiot would be running it.
He provides the example of an undertaking business. What could be simpler than collecting dead people, slapping on a little rouge and eyeliner, presenting them to friends and family, and then tossing them into the ground or into an incinerator? The beauty of this business is its simplicity (any idiot with a black station wagon and a Mary Kay catalog could do it), it is not cyclical (people die regardless of whether the economy is booming or in a recession), and business is always guaranteed (the only certainties in life are death and taxes).
In addition to understanding the business, you also need to understand the financial statements. This is where normal humans lose their erections.
In Rebel Finance, we try to explain boring concepts in simple and interesting language, so don't go nodding off.
The balance sheet is a photo of the assets and liabilities (equity is the capital owed to the shareholders and therefore is seen as a liability). Income statements are a record of the revenue, income, and expenses. Cash flow statements show cash that was generated and used in operations, financing, and investing. Understanding accounting is important to value a company because it is a scorecard of company performance.
A few final points on what Buffett likes to look for. The biggest risk in value investing is that you misread the mood of Mr. Market. The company may, in reality, be a flea-infested swamp donkey. You, however, are off your game and believe it is an Arabian thoroughbred. You mistakenly believe Mr. Market is manic and offering the stock at a depressed price. In reality, Mr. Market is valuing the stock efficiently and the company is heading to hell in a handbasket. To avoid these errors, Buffett provides a handful of tips.
Firstly, he looks at the debt to equity ratio. Bad companies go broke because they stink. Sometimes good companies also go broke because they are unable to manage their debt. Cemex is the largest cement and concrete producer in Mexico. It almost went to the wall in 2008 during the financial crisis, not because it was a bad company, but because it had taken on too much debt in the years before the crisis to acquire foreign businesses.
If a company has 10 units of assets, and 1 of debt, it is not going to go bust anytime soon. If that 1 unit of debt, suddenly shoots up to 8, while the assets stay at 10, there is an exponentially higher probability that the company could go broke. The advice from Buffett is to pay close attention to the total debt versus total liabilities. Try and keep that relationship below 100 percent which means that there should be more equity than debt in the business.
Buffett also has an affinity for monopolies and duopolies. He likes businesses that are like castles protected by moats that keep out the competition. He says owning a monopoly is like owning an unregulated toll bridge. You have the freedom to increase prices when you want and by as much as you want.
Facebook and Google are both monopolies but fall outside Buffett's wheelhouse. But we should not take Buffett literally. He is not telling us to only buy monopolies and duopolies. The Oracle is angling us towards companies with healthy profit margins and returns on equity. This means that they are dominant players in their space and are executing on their strategy better than the competition.
Step 2: No-One is Covering the Stocks
Buffett is looking for diamonds in the dirt. Are you going to find them alongside the busiest highways or do you need to do some bushwhacking? For the city slickers who think that milk comes from a carton and wild animals roam freely through the streets of big African cities, let me regale you with the definition of bushwacking: to make one's way through the woods by cutting at the undergrowth, branches; to travel through woods; to pull a boat upstream from onboard by grasping bushes, or rocks. To find these gems, you need to sharpen that machete and get rid of some bushes.
One way to find them is to focus on stocks that have little or no analyst coverage. In other words, very few people cover the stock which means that it is flying below the radar.
Analysts prefer to cover sexy stocks because those are the stocks that the unwashed masses want to buy. This comes directly from the playbook of Peter Lynch in "One Up On Wall Street". According to data from Bloomberg as of November 2019, 50 stocks were covered by more than 40 analysts.
They were mega large-cap stocks like Apple, Amazon, Google, Facebook, Alibaba, and Tencent. What diamonds are you going to find in these blue chips if they are being analyzed to death by an army of analysts who have collectively spent billions of dollars in Ivy League educations, personal tutoring, and psychoanalysis?
We are interested in stocks that have two, one, or zero analysts. Of the 91,326 public stocks around the world, more than twenty percent are covered by two analysts or less. On this list, there are many penny stocks – rats and mice companies that are effectively worthless. Some companies are in far-flung regions where we do not understand the language.
To weed out the rats and mice, we look at stocks with a minimum market capitalization of $500 million. To avoid the language barrier we limit the search to major English-speaking countries (United States, United Kingdom, Canada, South Africa, Australia, and New Zealand). The universe now filters down to 118 companies.
One gem that stands out is Amerco. How about this for a boring business (the information is courtesy of Reuters): AMERCO is a do-it-yourself moving and storage operator through its subsidiary, U-Haul International, Inc. (U-Haul). The Company supplies its products and services to help people move and store their household and commercial goods through U-Haul. It sells U-Haul brand boxes, tape, and other moving and self-storage products and services to do-it-yourself moving and storage customers at its distribution outlets and through uhaul.com and eMove Websites. The Company operates through three segments: Moving and Storage; Property and Casualty Insurance, and Life Insurance.
As of November 2019, two analysts were covering the stock: Ian Gilson from Zacks and George J Godfrey from CL King and Associates. For the 10 years ending November 5th, 2019, the stock delivered a total return of 966 percent assuming all dividends were reinvested in the stock. This is an annualized return of 26.7 percent which was more than double that of the Standard and Poor 500 Index. This is not an investment recommendation – I am simply singling this stock out as an example candidate.
Step 3: Low Institutional Ownership
This is another strategy from the Peter Lynch playbook and works in tandem with the analyst coverage metric. It is unlikely that institutions will own large slugs of stock in a company that has little or no coverage. In this case, we have the perfect example – Buffett's very own Berkshire Hathaway.
As of November 2019, Berkshire was the sixth biggest company in the world with a market capitalization of half a trillion dollars. Only four analysts were covering the stock and only 21 percent of the shares were held by institutions. The largest institutional holder was Fidelity with 4.25 percent of the shares followed by Capital Group with 3.36 percent.
This stands in stark contrast to the ownership and analyst profile of General Electric. As at the beginning of November 2019, 65 percent of the shares were held by institutions and 30 analysts were covering the stock. In terms of performance, Berkshire has destroyed GE delivering 460 percent more total return to shareholders over the 20 years ending 2019.