How to invest

I did an interview with Complete Growth Investor (GCI) a month or so ago and it has now been released.

Complete Growth is a newsletter service but focuses on discussing their portfolio holding events, analysis and buy and sell reasons. You get a look at holdings of a real time money portfolio. The value portfolio is managed by Ragu Chandrasekaran and Jeff Annello, while the growth portfolio is run by Jason Fitnitch.

The names may be familiar to some, as both Ragu and Jeff used to run fantastic blogs before joining Complete Growth.

In the interview, you’ll get a glimpse of my background and investing strategy and philosophy. At 8 pages, the interview is quite long but I hope you find something useful.

Jae Jun Complete Growth CGI Interview

Netflix Case Study

“Netflix made a subtle change to their website in December of 2009. The “Watch Instantly” option was moved to the first position on its row of website navigation tabs. The DVD rental company has always been about convenience, but this change from sending discs in the mail to streaming video over the Internet is no small deal.

Netflix ships 2.2 million DVDs every day and the round trip ticket for each of those discs costs 84 cents. Netflix will spend close to $600 million this year in getting discs to their customers. That gives the movie rental company a pretty big incentive to pursue alternatives delivery methods.

The cost to stream the same gigabyte of Hollywood magic over the Internet: 5 CENTS.

If Netflix can convert 10% of their volume from postal to digital, $60 million falls to the bottom line.” – Fixed to Flexible EBook

Value investing involves understanding the business. I’m sure most NFLX investors understand the business as summarized in Google Finance and the annual reports, but how many people actually spent time analyzing the website which is a huge factor for the company? This is also something that would never come up in any conference call.

After reading this one paragraph, my view of NFLX has radically changed. I was in agreement with this article from seekingalpha, but now I see how wrong it is. I sure wouldn’t want to be shorting NFLX now.

Interpreting a Business with Insight

Such simple things can make quite a difference with businesses. I’ve come across similar “what if” examples due to my interest in design, usability and marketing.

E.g. Take a look at Zappos.com, an online retailer for shoes, bought out by Amazon. This designer created a mock up version of a spruced up, much easier to view Zappos website which I’m sure will certainly help convert visitors into customers at a higher rate, which means more profit. The interesting thing is that the Zappos website has actually changed since then.

What would happen if airlines redesigned their totally crap  boarding passes? Creating an aesthetic look will not only help direct travelers, but it could build brand awareness.

Think beyond the barrier and imagine what the top line could produce if airlines starting printing simple text Google Adwords type ads on their boarding pass. This is just a “what if” example but one which wouldn’t make it to the annual report or quarterly conference calls. This is why Buffett, Munger, Peter Lynch were so successful. Their business insight and hands on experience is amazing.

You’ve heard the cliche that valuation is more art than science. The above examples are prime examples of art.

Valuation is an Art

Numbers, accounting and financial statements can only tell you so much, but it’s being able to interpret, understand and having insight to a business that is extremely valuable in any stock analysis.

Take the time to read the following ebook. It’s an amazing primer to get you started in thinking about costs, prices, margins and how it affects businesses.

Fixed to Flexible – The Ebook

Disclosure

None

I’m always late with these types of things but here are my thoughts on 2010 and how I plan to go about this year.

Thoughts on the Market

From March 2009 to Dec 2009, the market rose like crazy. I fully admit those who were in the game during this period, benefited greatly as the water level rose back up, but we are now at a point where you are just as likely to lose money.

I’m not just talking about this January. Ever since Nov 09, this is how I felt but I was lucky to have strong performers to round out the year. However, what we forget is that the effects of a bull market invites the greater fools to join the game again. When things are going good, it is human nature to forget what happened just the other day. We then put our guards down, chill and put things on autopilot until we see that the engine has caught fire.

My discipline has severely waned over the past couple of months as I was caught up in so many activities and didn’t apply the time and focus towards ideas. I already made a couple of silly mistakes that were easily avoidable by not double checking my calculations and it looks like one of those mistakes could cost me money.

So I’m cleaning up my portfolio at the moment to prevent a fire. Some stocks I own have reached what I deem to be its intrinsic value based on its current state and it’s time to sell rather than hold even if the fundamentals support it.

Psychological Game

Draw the next part of the graph. Which direction would the graph follow?

If I was a gambler, I’m betting that you felt something good about the direction of the graph and the path it would take. Did you know that because of the optimistic attitudes of the western culture, you were likely to believe it would go up and vice versa.

This is directly related to how people view the market. They look for trends, but this year, I’m tightening my belt because things should be much tougher. It’s shameful that I don’t have data, graphs and historical figures to prove my case, but no amount of data could predict what happened in Haiti or with the tsunami….

What I’m saying is that anything could happen.

2010 Plan and Actions

Here are some things I need to improve for 2010 and beyond. It’s basic stuff but I wanted to remind myself.

• Risk reduction will be utmost important. Place even more emphasis on protecting the downside than last year. Make it so that even if I get it wrong, the margin of safety will still allow me to exit at a profit.
• Capital allocation. Knowing how much to assign to a particular investment based on the level of your analysis and conviction is a fundamental discipline of investing. Last year, it was easy to put 100% into a single stock and make out like a bandit, but that won’t work anymore. Prepare to roll up sleeves for more work.
• Don’t be afraid of cash. Up until last month, I had about 20% of my portfolio in cash. But I kept wanting to do something with it. Don’t believe that you have to be 100% invested. Patience always wins.
• Read books. Get back to reading one investment book a month. (I’m scrutinizing Quality of Earnings again to wring out as much wisdom and info as possible)
• Improve spreadsheets and tools to streamline basic redundant processes.
• Never take it at face value. Question as much as possible and seek the answer. There is a reason why Jewish people have won most of the Nobel prizes; they question everything and learn by sharing.
• Leverage strengths. Leveraging, increasing and fortifying my strengths is far more important than trying to strengthen my weaknesses. My strength lies in my thirst for knowledge and to dig deeper into the numbers and analysis to visualize what the financial statements are telling me and the validity of a business. By trying to improve my weakness, I am only doing it at a mediocre level. Admit the things I lack and stay away from it.
• Do more by not doing. By nature I have to run things efficiently. Guess it’s why I’m an engineer by trade. By eliminating the tasks where I waste even 30mins, I could spend the time effectively and apply it to rewarding activities.
• Understand emotional reactions to events. Knowing the range of my emotions related to the stock market will help in how to overcome it and the level of conviction I have.
• Do it old school. Always remember why and how it started. Back to basics.

“It turns out that value investing is something that is in your blood. There are people who just don’t have the patience and discipline to do it, and there are people who do. So it leads me to think it’s genetic.” – Seth Klarman

Markets go up and down. It’s unavoidable, but how do you handle it?

Over the past couple of weeks, one aspect of investing that has frequently come up in my discussions has been related to price but ultimately it all leads to volatility.

Value Investor’s Guide to Volatility

• The higher the beta, the more chances you get to pick up stocks at cheaper prices and the quicker you can realize the intrinsic value of your stock
• Volatility is just another day. Focus on the business. The taste of a Coca-cola doesn’t change every second as it tries to follow it’s stock price.
• Price is useless on its own. Compare it to intrinsic value.
• Volatility reveals how focused and confident you really are.
• Conquer volatility and it will make you a better investor.

Even if all of the above is attributed to genetics as Klarman states, it’s nothing that can’t be trained.

Compare Price to Intrinsic Value

What many people forget about price is that, it is merely a tool. Price does not indicate the future of the company. The fundamentals determine what price the company should be trading at. The price does not determine the fundamentals. One way is to perform your own fundamental stock analysis.

So in the current volatile, yet upward market, the important thing isn’t to fret over what price to buy.

Just recently, I bought more ROIAK, even though I am up 230%. Why? simply because it is cheap compared to what my intrinsic value calculation.

Price has to be compared to something for it to be useful. The majority of people compare it to earnings (EPS) to determine the cheapness factor but the real comparison should be made to intrinsic value.

If you bought a stock originally at $1 because the calculated intrinsic value was $5 and 2 months later, the price is at $2 and you still believe it to be worth $5. Do you buy or do you sell?

Most people sell just because they’ve reached 100%. I still don’t understand the logic behind this though…

Keep it Simple

I like to tell people to keep it simple.

I also explained that a no brainer value investment criteria has to be simple. Don’t cloud your thoughts and facts with information that isn’t very important. You’ll end up wasting your time poring over the 30th piece of information when you should be focused on the top 5 or so facts.

You wouldn’t stuff yourself at dinner time only on the sides right? The important part is the main dish. So stop confusing the side with the main.

You should also be able to clearly express why you purchased a stock in 2-3 sentences. Any more and I think you need revisit your holdings and why you purchased.

Here are some simple explanations of the positions I hold.

• INSM is a net net stock offering a big margin of safety. It’s current position with a huge cash balance allows it to pursue strategic alternatives to increase shareholder vale. Bio-pharma is outside of my circle of competence but I feel the downside is very well protected.
• Radio stocks (SALM, ROIAK, ETM, EMMS) are cheap because the perception is that they will all die. Huge over-reaction. All radio stocks were hit by the credit squeeze but have since paid off huge amounts of debt straight from their operations and have been cutting costs while advertising has slowly been recovering. Huge margin of safety.
• DCU is a very boring, overlooked business able to generate good FCF by good management. Balance sheet is strong with good conservative management. Time will correct the current mispricing.

The only thing that you shouldn’t be saying about your stocks is

• I bought _____ because Jae did

Stop Focusing on How Much You are Down

This year I was down 30% at one point. I bet you didn’t know right because the eyes always just fixate on the highest point of the graph in my portfolio updates.

I tried to pick up pennies in front of a bulldozer with the EMAG arbitrage and ultimately got run over. It doesn’t feel good when your portfolio drops about 30% in value but as much as I was sickened, I started seeing value everywhere. So I bought. I sold some bad positions at a loss and bought what I felt were very cheap.

It’s easy to drown yourself in calculating how much you are down but re-focus on how you can allocate capital, or better yet, just grab a cup of coffee knowing that in the end price meets value.

To put everything into perspective, just ask yourself one simple question.

Q: Is this stock cheap compared to the intrinsic value?

A: Yes (then buy more). No (then sell)

Disclosure

I hold all stocks mentioned at the time of writing

All value investors aim to find the perfect value stocks and make that purchase.

What I define as value has been ridiculed and called speculation many times. Vice versa, what I deem speculation has been embraced by others.

I’ve gone over how to find the best value stocks and special situations, but the following are a few things I look for in any value stock investment.

Value Stock Criteria

Butt Ugly

I love the butt ugly stocks. The uglier it is, the more I like it. I consider myself an investment softie so if a company is neglected, rejected, abused and thrown to the curb by analysts and investors alike without good reason, I like to nurture it in my portfolio.

These are the types of companies that many people assume will go bankrupt, fail or never recover. A little deep analysis shows that they are far from ch 11. These companies are also cigar butt type net net stocks where there is always one or more good remaining puffs.

The thing is, most people just assume they know a company will do this or that without actually digging in. A majority of people just read the press release and news headlines to grasp an overview of the company.

Now this is your advantage, your playing field. You control the court and define the rules… Only because no one is there to play with you

Keep it Simple

Buffett has said to invest only in what you know. i.e. circle of competence.

Let me take it further to explain why I think I’ve been able to do so well this year.

Invest in companies that are so cheap, you don’t need to understand what it does.

Of course it’s a good idea to know what they do but you don’t have to understand every single detail about the company. The simpler the investment scenario, the less risky. The less risky, the more capital you will invest. The more money you put, the more conviction you have.

It all leads to higher returns. This is also what value investors define as concentration.

Most of my multi-baggers this year only required 1 or 2 questions before I made a decision to buy.

e.g. Q. Will the company go bankrupt?

A. No

e.g. Q. What’s the margin of safety?

A. A lot

This is why I don’t invest in growth and story stocks. Too many variables to figure out in order to make money.

Keep the ideas simple and don’t over complicate or cloud it with unnecessary facts.

Correct data + incorrect data = incorrect data.

Downside Protection

I like to look for companies where the downside is protect by the assets. The higher the liquidity and quality of the assets, the better the investment potential. It reduces the risk of a sudden erosion in the margin of safety.

e.g. if a company has a high amount of accounts receivables or inventory, there is a good chance that a substantial amount could be written off which immediately affects the margin of safety.

On the other hand, while cash can be burnt at a fast rate, cash can never be subject to impairment charges.

I prefer to keep the downside protection based off current and short term assets. Not long term assets such as patents or buildings and equipment.

Understand the Definition of Risk in Investing

• Probability of losing all your money
• Having too many scenarios, too many variables and over complicating
• Not protecting the downside

Some Value Stock Ideas

What about these potential ideas for you to consider? They are all on my to do list. Need to find time to go through them.

• TSR Inc (TSRI)
• Champion Industries (CHMP)
• Dry Clean USA (DCU)
• List of 20 net net stocks

Disclosure

Not positions in any stocks mentioned

The latest stock analysis spreadsheet available now!

I’ve generally never held more than 15 stocks in my portfolio at any one time.

I first started investing with $3000 and with each trade costing $12.95, it didn’t make much sense to break it up into 10 positions each making up $300.  Although my portfolio has grown as I kept adding cash along with the capital appreciation, I have never felt the need to add more stocks or re-balance my positions. It was either sell the entire position or keep it.

Recently I’ve liquidated two of my positions which I will detail when it comes time for a July portfolio update but one reason for the sale was that I was finding it hard to fully understand and keep up with the business. I must admit that I didn’t perform as much due diligence on that one and I preferred to sell something I wasn’t so sure about.

This leads to the discussion on concentrating a portfolio or diversifying, which Peter Lynch called deworsifying.

I don’t over concentrate by investing in only 2-3 stocks where the size of one position may be greater than 50% but I do prefer to hold anywhere between 10 to 20 stocks.

Diversify or Concentrate?

The common adage is “not to place all your eggs in one basket” because when something goes wrong and you drop it, a majority of the eggs will break, but then again, a few may not.

But what happens if you place every egg into its own basket? How do you carry 50 baskets? You are just as likely to drop 40 of them.

However, although value investors most often have concentrated portfolios, other types of investors such as pure dividend income investors, safety seekers, mutual fund investors and bond investors are best to diversify as people following this type of strategy tend to dislike volatility.

Diversify or concentrate.. it’s a common argument between many people so I’ll just end this section with a good reason for diversification.

We want to have enough good ideas at work that if we’re wrong or unlucky on one or two, we haven’t lost a significant amount of capital. It’s not unusual for us to make a good decision that has a bad outcome – this is a probabilistic business. If you’re really concentrated and have two bad outcomes out of ten perfectly good decisions, 10% of  our portfolio can blow up. I’ve heard the argument that if you have your top ten best investments, why would you want to dilute it with your 11th best investment? But if I had to order my top ten ideas by how much I thought they’d go up, I guarantee you that wouldn’t end up being the top ten in actual performance. So we’re just more comfortable being somewhat more diversified. – Zeke Ashton

Constructing a Portfolio

Whenever I find an opportunity I compare it with what I currently hold. This way, I can decide whether I should sell something to make room for the new idea or to keep everything as it is but include the stock idea as a small starting position and gradually build my way up.

This method also helps me to decide how much capital to allocate to the position relative to the overall portfolio. A mistake I made at first was simply buying the same amount in a stock regardless of the potential.

The following is a quote by David Einhorn which is a much better articulated explanation of how I construct my portfolio.

We believe in constructing the portfolio so that we put our biggest amount of money in our highest-conviction idea, and then we view the other ideas relative to that. We find things that we think are exceptional only occasionally. So if we find something that is really set up, where we think it’s mispriced, where we have a good understanding of why it’s mispriced, where we think the mispricing is very large and the overall risk is very small, we take an outsized position to make sure we give ourselves the chance to be well compensated for getting it right. - David Einhorn

What To Do?

I hate to leave this post open ended but the truth is that asset allocation and portfolio management is up to the individual and knowing thyself. Some people are perfectly content with holding 3 stocks while another person may need 30 to feel safe.

Just putting something out there for you to consider if you haven’t done so.