Thursday, March 04, 2004

Attitude is Everything

March 4, 2004 - Street Insight Paraphrasing Yogi Berra, investment is 90% mental -- the other half is skill. The right emotional state of mind is critical since investing is not an exact science. An ability to make rational decisions under uncertainty with incomplete information is what investing is all about.
Our investment process starts with asking the questions that put us in an "investor state of mind." By that, I mean we focus our thought processes on deciding whether to make an investment in the company. We're not trying to make a speculative trade in the stock. The first questions we ask ourselves when we look at a stock are: Do we want to be in this business? If we do, at what price? Very often investors look at the company's financial statements, at ratios, at the stock price and forget that there is a business with products and people behind those numbers. By buying a stock, we are hiring company's management to run a business for us. We have to like the company's business to buy the stock, no matter how cheap the stock is.
We prefer to own businesses that consistently grow revenues, have predictable earnings and generate healthy free cash flow. This means that we avoid deep cyclicals. Their revenues and earnings are unpredictable, and their capital intensiveness tends to cause sub-par free cash flow. Another question that we ask ourselves is: Would we feel comfortable buying the stock if the stock market was closed for a couple of years and we could not sell the stock? This question addresses the issue of sustainable competitive advantage.
A couple of months ago, my partner, Michael Conn, and I were discussing Hewlett Packard (NYSE: HPQ). The stock was beaten down and looked cheap. When we asked ourselves the question, "Would we own this stock for years?" the decision not to own HP became very clear. HP is a mature company that produces commodity-like products with constantly declining prices (servers and PCs). HPQ's main competitor, Dell, has a much lower cost structure (which is key in a commodity business) and is eyeing HPQ's cash-generating gravy train: printers. In these circumstances -- declining prices and the entrance of a lower-cost competitor -- we could not comfortably own HP for very long. It might be a good trade, but we are not traders.
In our mind, long-term investing is more than just holding stocks for a "long" period of time. Let us not confuse investors with stock collectors. Long-term investing is an attitude, a state of mind. The liquidity of the stock market often lures investors to become traders. We don't pay a lot of attention to everyday rants in the stock market. We look for opportunities that are created by that noise.
We love it when investors over-penalize a company for a short-term snafu and create a buying opportunity; or become overly optimistic and push the stock (of the company we own) to a ridiculous valuation, allowing us to unload the shares to a greater fool.
We try to find inefficiencies in the market that are created by the difference in investment time horizon between us and most mutual funds. Mutual funds focus (with few exceptions) on outperforming their peers (and corresponding indices) in the current quarter. Fund inflows and outflows are driven by the fund's latest quarterly performance. A stock that stands in the way of short-term performance gets dumped as a curse, giving us a chance to buy it on the cheap.
A good example of us buying a fine company on a short-term stumble in the stock price is our purchase of insurance broker A.J. Gallagher (NYSE: AJG) last year. AJG's management took advantage of a competitor's weakness and hired away over a hundred sales reps. That calculated decision caused a decline in gross margins and lower earnings per share (EPS) growth for a year and half -- exactly the time it takes for a sales rep to become profitable. Management made a conscious decision to sacrifice short-term EPS for long-term growth. The company's long-term fundamentals improved, but the stock declined from 35 to 25.
We look at a couple of dozen new stocks a year, but very few meet our stringent criteria. The ones that we find to be good companies but overvalued stocks we put on our watch list and patiently wait for opportunity to present themselves. We love it when a good company stumbles -- that is when our fundamental analysis comes in handy. If the stumble is short-term in nature, then we buy it with both hands. Disclosure: position in AJG Copyright 2004


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